Decentralized Finance (DeFi): A Beginner’s Guide
Decentralized Finance has always been a big player in the cryptosphere. As web3 advances in full sprint, the DeFi industry is not left behind in its endeavours to create capital utility and liberate its users from central or institutional players that can limit access, utility, and profitability.
What is Decentralized Finance (DeFi)?
If you’re no newbie to the world of crypto, you must have heard the term “DeFi”. DeFi means Decentralized Finance; it is a financial system that is a technologically advanced blockchain substitute for centralized financial institutions that provide all forms of financial services ranging from daily banking, mortgages, loans, trading, and contractual agreements.
The idea is that this system removes control from “centralized” financial institutions over your money, financial products & services and does not require the use of third parties or financial intermediaries to function properly. This is because DeFi is a web3 peer-to-peer financial system that uses technology based on a secured distributed ledger similar to cryptocurrency.
Let’s juxtapose the two real quick.
Centralized Finance (CeFi) vs Decentralized Finance (DeFi)
Centralized finance is the conventional system where resources and control of financial assets and services are held by corporations who dictate the terms of engagement, can restrict access, and require the involvement of third parties to complete transactions.
Third parties are a network of specific service providers who are independent contractors like an acquiring bank, a card network provider, or a merchant that form the transaction chain. Let’s say you went to get groceries at the mall, you paid with your card at the counter, and the money was credited to the mall. Well, what actually happens is that the charge on the groceries goes from the merchant (in this case, the mall) to an acquiring bank, who in turn sends your card details to the card network, the card network proceeds to verify and clear the charge then sends approval though the acquiring charge to the merchant.
This form of finance involves a lot of third parties and transaction channels, leaving a huge room for human, network, and system errors, as well as control over your assets. Interesting to note at this point that all parties also receive payments for these processes.
Decentralized finance uses emerging technology to eliminate the need for this third-party involvement by employing peer-to-peer networks that are embedded with software, hardware advancements, connectivity, and security protocols. The system can fuel financial utility through the use of smart contracts, a set of pre-written regulations, and rules of engagement programmed on a blockchain that ensures that action is certain and carried out without the involvement of intermediaries. They power DApps (decentralized applications) and protocols, many of which were built through Ethereum, and now via Layer 1 Blockchains.
Under decentralized finance, you can’t have your assets frozen by the bank or be limited by political and economic barriers. This system puts complete control in your hand as a user, eliminates human error, reduces transaction time, and increases access to financial services. All you need is a device and an internet connection.
Various Applications of Decentralized Finance (DeFi)
Let’s look into some of the popular concepts that characterize the industry.
Decentralized Exchanges (DEXs)
A decentralized exchange is a platform that is used to trade different currencies (fiat, crypto, and tokens). They show real-time market price fluctuations and infographics and connect users without the involvement of intermediaries. Example of DEXs include popular platforms like Uniswap and Pancakeswap.
You can actually borrow using DeFi with no bank charges and low-interest rates. Smart contracts set the Terms & Conditions, stipulating the deadline and interest received by the investor, eliminating the need for a third party.
Users can also earn rewards by lending crypto assets to a DEX. This procedure is called “liquidity miming” or “yield farming”. The DEX may use it as a means to start up a platform or raise capital for a project, and rewards usually come from trading fees. Compound and Aave are notable and reputable samples of decentralized lending platforms in the DeFi market.
Decentralized Prediction Market (DPM)
These are platforms where users can buy shares used to bet on future events rather than products or services. DPMs works similarly to the traditional prediction markets but use smart contracts to eliminate the need for third parties or a single operator that connects users. Instead, quadratic voting is employed to allow market participants to allocate votes toward a mutual contract.
You can buy shares of a wide range of events from sports, and weather forecasts, to anything really. If you are a risk lover or a crypto enthusiast with a bit of spice, then companies such as Gnosis, and Augur are top centralized prediction markets platforms where you can get started.
Fair warning though, be careful as you navigate this aspect of DeFi and take ample time to understand how the markets operate before you begin to trade. It is called the “Wild West” of the DeFi-verse for a reason.
Automated Market Maker (AMM)
Automated market maker is a smart contract that lets anybody create a market or exchange by automating the process of providing liquidity, allowing anyone to be a liquid provider as long as they fulfill the requirements in the smart contract. Basically, AMM is what powers all decentralized exchanges (DEXs).
AMM is a plus because it boosts liquidity which aids trading activities. High liquidity reduces the chance and effect of slippage and results in less volatility in the market prices of digital assets. Uniswap is ahead when it comes to automated market maker technology.
Decentralized Insurance Platform (DIP)
With security concerns like smart contract bugs, hacker attacks, fraud, wallet compromise, and transaction malfunctions on the rise, you should know that there are platforms that provide insurance services to protect your digital assets and lower the risk of these cyber hazards. They provide insurance collateral protection, smart contract cover, and protection for crypto wallets among other things. If you need another layer of protection, you should check out platforms like Nexus Mutual and InsurAce Protocol.
Decentralized Applications (DApps)
DApps are like regular applications that are operated on the blockchain. They are smart contract-based protocols and applications that are not under any central authority.
Unlike regular apps, DApps is a permissionless system that operates on a peer-to-peer (P2P) network like a blockchain. DApps are built on DeFi protocols to serve as an interface to execute the concepts. DEXs, DPMs, decentralized lending platforms, marketplaces, and crypto gaming platforms are popular examples to note.
Asset Management Tools
This category of DeFi involves protocols for investors that may not be so knowledgeable about the market. They provide the necessary data and suite of market tools that do not require the expertise or sometimes, input of the investor. An example of asset management tools is TokenSets, which offers strategies, and non-custodial asset management tools that work automatically without the need to manually interact.
In the wake of the enduring market downturn, the recent FTX debacle, and other crypto-related events that have left the crypto market with a lot of negative market sentiment and FUD, it is important to reiterate that the financial revolution is larger than just cryptocurrencies. The blockchain technology that powers all of these web3 applications isn’t going anywhere and will expand to add new sectors, principles, and processes as time unfolds.