Decentralized finance or deFi is a major component of blockchain innovation. It is significant for its role in shaping the existing financial system.
Join us as we explore the very fabrics of deFi here in this Monierate article.
What is Blockchain
Blockchain is the bedrock of the current crypto and deFi craze. It is also the foundation for a lot of other things. This includes digital identity and supply chain management.
The system has completely changed how we see finance, digital security, and data storage.
Before blockchain, institutions like banks, Google, and government agencies were in charge. They determined, controlled, and regulated important information systems. These systems are still very much existing and in use today.
However, there’s a powerful alternative which is the blockchain.
Blockchain serves as a digital platform upon which users can autonomously exchange and store data. It also presents a high level of security. Data is stored in a structure called a block - after being verified by multiple users. More data creates more blocks and the new blocks are added to the last available block, creating a chain.
The storage process is irreversible making no chance for deleting records.
Technically, with blockchain, you also don’t need the permission of an institution or authority. Its invention has led to the development of decentralized finance.
What is Decentralized Finance
Decentralized Finance, or deFi, is a new type of finance. It involves the application of blockchain, cryptocurrencies (which are blockchain-based assets), and appropriate software. Decentralized Finance allows for financial transactions without the involvement of central authorities.
How Decentralized Finance Differs from Traditional Finance
Think of what happens when you transfer money using your banking app. The bank you own an account with communicates with the NIBSS platform and your receiver’s bank. These government-controlled agencies and the systems they utilize have peculiar drawbacks.
One of these is the transaction cost. The involvement of financial institutions which are a third party to transactions creates costs. Also, most traditional transactions are reversible, adding to the cost incurred from using the system.
Another fundamental concern when it comes to centralized finance is the security of their networks. Systems in this setting comprise of single-point entry for operation and validation. There are certainly benefits and strong sides to this. At the same time, there are significant problems.
For example, there’s limited transparency, and the system is less resilient to vulnerability. Furthermore, important tasks are carried out by individuals or small teams. This increases the chance of error due to oversight.
It’s a completely different story with decentralized finance. Operations are run by several nodes. Countless users are involved in verifying transactions and actions. The entire record of data is available openly to the public or to network users.
Components of Decentralized Finance
Decentralized finance was born along with blockchain. It is embodied in the use and exchange of cryptocurrencies. That said, it is clear how these two digital structures are relevant to the topic.
But many other components come together to make up decentralized finance. In this section, we explain each one of them briefly.
1. Marketplace
Decentralized Exchanges:
Decentralized exchanges are to crypto what banks are to fiat. They serve as a place where users can go to purchase crypto. But they also appear like markets since you can buy from fellow individuals like yourself.
Decentralized Apps (dApps):
dApps or decentralized applications refer to application software that runs on blockchain. They can have any purpose. It could be facilitating finance, gaming, social media, or more. In 2022, a dAppRadar publication revealed that it tracked over 13,000 dApps. These software continue to increase exponentially. They do so as new use cases for digital tokens emerge and adoption soars.
2. Pricing
Oracles:
Oracles refer to computer programs that make external data available. They work to locate reliable sources of data, check their accuracy, and import them. Oracles bring in new and fresh data to an enclosed or internal system. Decentralized finance platforms (such as DEXs) use this to gather information like token prices.
3. Banking
Borrow/Lending Protocols:
Borrowing/lending was drafted from traditional finance into deFi. Here, it comprises three major components aside from the borrower and lender. These are smart contracts, liquidators, and oracles.
Smart contracts work to initiate the lending/borrowing process. Liquidators work to liquidate the loan. This only happens if the collateral value falls below a set threshold.
Lastly, the oracle communicates the price of assets to the smart contract.
Flash Loans:
Flash loans are a component of decentralized finance. They are unique uncollateralized loans that remain safe against borrower defaults. That’s because they function using smart contracts.
Lenders in the deFi ecosystem contribute to a liquidity pool that is open at all times. A borrower may request an amount of capital from a pool. They’ll access it without much ado. However, the entire process is crafted such that the borrowed funds are reverted to the liquidity pool if the borrower defaults on payments.
Interestingly, the loan and repayment process happens in one transaction.
4. Bridges and Synthetics
Wrapped Tokens and Bridges:
Wrapped tokens are digital assets or tokens operating on a non-native blockchain. They are born from two unique processes, wrapping and bridging.
Wrapping simply makes tokens suitable for a non-native blockchain. On the other hand, bridging helps with transferring tokens between blockchains.
Cryptocurrencies are designed to run on a specific blockchain. It is, therefore, unusual and even impossible to have tokens operate on a foreign blockchain. If this must be done, the token must be wrapped and bridged.
Stable coins:
Everyone living in this time and age knows what cryptocurrencies are. The more popular of these are Bitcoin and Ethereum. Their distant cousins, stable coins, offer less price volatility.
Stable coins are cryptocurrencies whose prices are tied to those of real-world currencies. They increase and reduce in value quite moderately.
It is not that stable coin prices do not fluctuate. Instead, the fluctuations in prices are far lower compared to those of regular crypto. This is precisely why these special coins are considered stable.
Synthetics:
Synthetics are a special kind of token. Like stable coins, the value of a synthetic is tied directly to those of an external asset. But they tend to manipulate the external asset’s value, rather than just imitate it.
Let’s explain. Two types of synthetics exist; leveraged and inverse tokens.
An inverse token will increase in price when its associated token decreases in price. On the other hand, a leveraged token will magnify the price of its external asset.
5. Governance
DAOS:
DAOs or Decentralized Autonomous Organizations are headless. There is no central executive or management figure. Instead, each member forms part of the management and has a fair right to decide what happens.
Each DAO rules over the management of a particular crypto token or community. Only individuals who currently own the DAO’s token can become members of this community.
Open Hedge Funds:
A deFi open hedge fund operates based on smart contracts and decentralized protocols. These funds foster transparency and trustlessness, underscoring their deFi nature.
6. Advanced / Smart Contract
Smart Contracts:
Smart contracts are digital agreements that work based on certain conditions. The contract is executed once the binding terms/conditions are met.
For instance, say two users are ready to transact in a peer-to-peer arrangement. A smart contract may be developed to reduce the need for trust in this transaction.
The terms for this contract could be something like:
Buyer and Seller agree on the payment amount and number of coins for that amount.
Buyer releases the money to an escrow.
Seller releases the coins to an escrow.
Once the smart contract registers the buyer and seller commitments, it executes the transaction. The contract itself proceeds to send the seller’s coins to the buyer. At the same time, the contract sends the buyer’s money to the seller.
Staking:
Staking in decentralized finance (deFi) is a token lock-up agreement that benefits the blockchain. Users lock their tokens for a pre-determined amount of time. These tokens aid with transaction validation, network security, and ecosystem governance. In return for staking, users earn new tokens.
EigenLayer:
EigenLayer enables an advanced staking option. Here, users can stake the same token on multiple decentralized applications (dApps). This form of staking takes advantage of Ethereum’s trust network to limit capital usage.
Yield Farming and Liquidity Mining:
Yield farming produces rewards for users who engage in deFi protocols. This could be through lending or staking. Liquidity mining is a sub-activity of yield farming. It specifically refers to providing liquidity.
Advantages and Disadvantages of Decentralized Finance
Advantages of Decentralized Finance
User Control: User control stands out as one of the most significant things about deFi. People literally have their money and other aspects of their finances under their control. For example, with deFi, you can withdraw or transfer funds at will. You don’t need to seek permission. Also, you don’t need to stand in long queues or wait out a public holiday before accessing financial services.
Heightened System Security: Security is everyone’s business. Users want to know that operating a platform is safe and secure. It is even more so with financial services. You can bet that you get heightened security with decentralized finance than with the traditional alternative. Seed phrases and private keys keep your account secure from hackers. These unique codes also protect you from the very providers of the exchange you utilise.
Disadvantages of Decentralized Finance
Standardization: Banks and related financial authorities have existed for a long time now. The system they operate allows them to achieve a high level of standardization. This is evident in the uniformity of payment procedures, channels, and even the shape of currency bills. Standardization enables uniformity and that leads to efficiency. It eliminates confusion as to what to do or when to do it.
Volatility: deFi tokens possess high volatility. For investors and traders, this presents a significant risk of loss. It also equally offers a chance of high and fast profit. Users should understand the risks of the deFi system before utilizing it.
Low Fees: Charges on crypto transactions are known as gas fees. These costs are meager compared to those on traditional bank networks. Users transacting on the Ethereum network, however, suffer significant gas charges. Sometimes, this charge is 20 times higher than those paid on other blockchains.
Conclusion
Anyone who has used traditional financial services will agree that deFi is much different. The expanse of options and controls available is simply impressive.
However, decentralized finance is still relatively new. It is, therefore, necessary for users to tread carefully. If we work together, we can achieve the positive growth of this emerging system.
