July 27th, 2021

Decentralized Finance (DeFi) concept with interconnected blockchain and cryptocurrency icons including Bitcoin and smart contracts over a backdrop of illuminated modern skyscrapers at night, representing the futuristic integration of finance and technology.

An Overview of Decentralized Finance (DeFi)

This is not to dismiss Bitcoin or to play down its role in bringing about the Blockchain revolution, but let’s say that the price of Bitcoin staggers back and forth like a dawning old grandpa who falls off his rollercoaster every time he encounters a resistance barrier of $10. And so, Decentralized Finance (DeFi) is like sprinting on the track with Usain Bolt.

Decentralized Finance (DeFi) relies on decentralized infrastructure for all its operations. You will not find any need to use Ethereum or any other blockchain technologies to build decentralized applications. Instead, DeFi services and apps are based on public blockchains, replicating existing offerings built on common technology standards and providing innovative services specifically designed for the decentralized financial ecosystem.

Decentralized Finance is Really Cool!

Unlike Bitcoin’s decentralization of money, DeFi seeks a broader approach to decentralizing the traditional financial industry. Broadly speaking, the components of decentralized finance are the same as those of any existing financial ecosystem, which means that they need stable currencies for various uses cases. At the same time, decentralized financial applications offer more control over their money to users through personal wallets and trading services aimed at both individual users and institutions.

DeFi is by and large an ambitious attempt to decentralize key traditional financial use cases (trade, lending, investment, asset management, payments, and insurance) via blockchain. By operating decentralized applications (dapps) on a protocol (blockchain), DeFi provides a peer-to-peer financial network. It taps into traditional financial services at its core by providing an unlicensed financial services ecosystem based on blockchain infrastructure. 

DeFi, short for decentralized finance, is an umbrella term used for various financial applications, cryptocurrencies, and blockchains aimed at disrupting financial intermediaries. It is global peer-to-peer asset storage and transfer system without the structures, constraints, and costs of traditional centralized banking systems. Supporters claim that DeFi can be a bank through digital smart contracts and public registers on blockchains like Ethereum – whether stationary or online.

This is important because centralized systems with human gatekeepers limit the speed and complexity of transactions and do not give users direct control over their money. DeFi is inspired by blockchain technology, digital currency Bitcoin, which allows multiple companies to keep copies of a transaction’s history, meaning that history is not controlled by a single central source. DeFi differs in that it extends the use of blockchain from simple value transfers to more complex financial use cases.

How do DeFi Applications Work?

DeFi applications aim to restore traditional financial systems such as banks in exchange for cryptocurrencies.

Borrowing and lending are the most common uses for DeFi applications, but there are much more complex options, such as becoming a liquidity provider for decentralized exchange. Decentralized services such as lending and borrowing take this to the next level. Instead of creating order books to facilitate matching, these services allow users to make or borrow loans directly from the Smart Contract themselves and raise or lower interest rates accordingly. In DeFi lending, users lend cryptocurrencies to a traditional Fiat-currency bank and receive interest from the lender in return.

For example, a large amount of crypto can be borrowed directly from the smart contract itself, which dynamically increases or lowers interest rates to meet the borrower’s higher interest rates. In order to borrow, users must provide collateral for the contract, provided that the amount is more significant than the money borrowed, otherwise the loan is over collateralized. With credit protocols such as Aave, Maker, and Compound Protocol, you can borrow cryptocurrencies in large quantities as long as you can prove that you can repay the loan in a single transaction. 

Decentralized finance includes digital investment protocols, smart contracts, and dapps built on the blockchain. Given the flexibility and scale of development, the Ethereum platform is the first choice for DeFi applications, but that does not mean it is the only blockchain platform. Uniswap is a decentralized exchange that allows you to trade Ethereum-based tokens whenever you want to earn money so that you can add liquidity to the token market. 

Other DeFi platforms offer insurance, wealth management, and other higher-order financial services. Think of DeFi as an open financial ecosystem in which you can decentralize various small financial instruments and services. DeFi services that are programmable and composable, for example, are just the beginning. 

DeFi Ecosystem – Open Finance

As the name suggests, digital money and credit platforms are built on the blockchain. The various products involved in DeFi are referred to as “open finance” or “DeFi ecosystem” because blockchain is an open-source digital asset that can be integrated into conventional financial structures. Because the blockchain network decentralizes global participation, DeFi activities do not require interaction with regulated financial systems or other national legal systems, such as taxation or national identity systems.

DeFi is a blockchain-based form of financial instruments that do not rely on key financial intermediaries such as brokers, exchanges, and banks to offer traditional financial instruments. Instead, it uses smart contracts and blockchains, Ethereum being the most common one. 

Open lending protocols have become increasingly popular in other open financial sectors in recent years, thanks to the extensive use of DAI and other peer-to-peer protocols such as Dharma and liquidity pools such as Compound Finance. MakerDAO’s blockchain-based credit platform is one of the DeFi applications to experience significant usage. 

MakerDAO is a stablecoin-based credit platform that allows users to borrow DAI, the domestic token that is pegged to the US dollar. By establishing intelligent contracts on the Ethereum Blockchain that regulate the repayment and liquidation processes of loans, MakerDAO aims to maintain the stable value of DAI in a decentralized and autonomous way.

Decentralized finance also uses cryptocurrencies and blockchain technology to manage financial transactions. DeFi aims to democratize the finance market by replacing old centralized institutions with peer-to-peer relationships and by providing a full range of financial services for everyday banking, loans, and mortgages without complicated contractual relations and asset trading. 

Traditional credit ratings based on identity, sophisticated deleveraging systems, liquidation algorithms, and insurance funds permit greater capital efficiency than centralized systems. DeFi challenges centralized financial systems by disempowering middlemen and gatekeepers and empowering ordinary people through peer-to-peer exchanges. The use of the DeFi – blockchain itself as a technological infrastructure enables fast and cost-effective transaction processing, the immutability of financial contracts, and contract automation.

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