In the business world of cryptocurrency, there is a domain that is attracting more attention every day: DeFi or Decentralized Finance. In this article you will find out all the information that you need about DeFi and know it can help you save money when you make financial transactions online.
DeFi is the abbreviation for “decentralized finance”, a term used for describing a financial system that does not rely on central financial intermediaries, but instead it is based on blockchain technology. DeFi refers to financial transactions that use smart contracts that do not require intermediaries, such as a bank or a lawyer.
DeFi – the financial revolution is happening right now
Decentralized financing (DeFi) is a movement that seeks to replace traditional financial intermediaries by placing financial services on the blockchain platform. DeFi extends the use of the blockchain technology from simple value transfer to complex financial transactions. Direct purchases, financial applications such as loans, insurance, crowdfunding, derivatives, betting and other transactions can be achieved without any intermediaries by using DeFi.
DeFi advocates believe that smart contracts will form the basis of future financial infrastructure, based on the premise that banks, brokers and other financial institutions will be taken out of service, replaced by a new generation of robust and transparent services based on blockchain technology.
Instead of simply decentralizing transactions – as in the case of Bitcoin – DeFi aims to decentralize the entire financial industry. This is done through smart contracts, which are fragments of computer code that allow complex transfers and agreements to be made on the blockchain platform, without the need for a central authority.
What are the most popular DeFi applications
Most DeFi applications are created through Ethereum, the world’s second largest cryptocurrency platform, by using smart contracts which automatically execute transactions if certain conditions are met. Ethereum programming languages, such as Solidity, are specifically designed to create and implement such smart contracts.
The most popular types of DeFi applications include:
- Decentralized Exchange Offices (DEX) – Online exchanges help users exchange currencies for other currencies, whether it’s US dollars for Bitcoin or Ether for DAI. DEXs connect users directly so that they can trade cryptocurrencies without any intermediary. With the help of decentralized applications (dApps) it is possible to trade cryptocurrencies on decentralized exchanges (DEXS), such as Uniswap. These are entirely peer-to-peer.
- Stablecoins – Cryptocurrencies face higher price fluctuations than fiat currencies. Stablecoins bind cryptocurrencies to non-cryptocurrencies, such as the US dollar, to keep the price under control. As the name suggests, stablecoins aim to bring “stability” to prices.
- Loan platforms – These platforms use smart contracts to replace intermediaries, such as banks. Lending markets are a popular form of DeFi, which connects borrowers with cryptocurrency lenders. A popular platform, Compound, allows users to borrow cryptocurrencies or offer their own loans. DeFi loans enable users to lend their cryptocurrency to someone else and earn interest on the loan. Compound sets interest rates algorithmically, so if there is a higher demand for a cryptocurrency loan, interest rates will increase. The DeFi loan is based on guarantees, which means that in order to make a loan, a user has to provide a guarantee, often Ether cryptocurrency.
- Wrapped Bitcoins (WBTC) are a way to send Bitcoin to the Ethereum network so that Bitcoin can be used directly in the Ethereum DeFi system. WBTCs allow users to earn interest on Bitcoin, which they borrow through the decentralized lending platforms described above.
- Prediction markets allow users to bet on the outcome of future events, such as elections. The purpose of DeFi prediction markets is to provide the same functionality, but without intermediaries.
In addition to the DeFi applications described above, the following concepts regarding DeFi have been developed:
- Yield farming: users scan different DeFi tokens for higher yield opportunities;
- Liquidity mining: DeFi applications attract users to their platform by giving them free tokens;
- Composition: DeFi applications are open source, the code behind them is public. Therefore, these applications can be used to “compose” new applications;
- Lego Money: DeFi applications are like Lego games, they can be similarly assembled as “lego money” to build new financial products. For example, you could buy a stable currency, such as DAI, and then borrow it from Compound to earn interest, all using your smartphone.
How to make money using DeFi
Using Ethereum-based loan applications, as mentioned above, users can generate “passive income” by borrowing money and generating interest on loans.
Here are 4 ways to generate income with DeFi:
- Lending money using DeFi – Lending money is one of the most common financial activities in DeFi, because many of the early DeFi platforms specialized in lending protocols. How does it work? You lend your digital assets to a platform by locking them into a smart contract. Borrowers can then access your assets as loans and pay back interest to the platform. Smart contracts distribute the interest to lenders in proportion to what they lock in.
- Staking money using DeFi – Staking is the process of locking in digital assets into a smart contract. Many DeFi platforms use staking as a great method to open what is essentially a savings account on the blockchain. Like a savings account, your balance will accrue additional income in the form of the same type of tokens used on the blockchain.
- Become a liquidity provider (LP) – Many popular Decentralized Exchange Offices (DEXs) use automated market maker (AMM) protocols that create liquidity pools made up of equal value of token pairs. These liquidity pools are public, which means that anyone can provide liquidity to these pools by locking in equal values of particular token pairs. By becoming a liquidity provider (LP), you can earn a share of the swap fee or commission that is proportional to your share of the liquidity pool.
- Yield Farming – Yield Farming has the potential to generate profit, allowing users to put their cryptographic assets into operation, through various loans, and then generating financial results. Liquidity providers usually get a specific token when providing liquidity to pools, which represents their share. When redeeming these LP tokens, they will receive back their stake plus any share of fees earned.
Using one or more of these 4 methods, you can use your digital assets to earn passive income with the help of DeFi. By providing capital and liquidity, in return you can earn incentives, and the best part is that you can do it all by yourself, without any intermediary. All your money stays right where they belong.
What are the benefits of DeFi?
Decentralized financing gives users the flexibility to do business and trade anytime, anywhere with a simple internet connection. The most immediate benefits of DeFi are instant or extremely fast transfers and drastically reduced fees and charges. With fewer intermediaries taking part in the financial cards, users enjoy additional benefits that are not found in the traditional financial industry. For example, DeFi loan protocols typically offer much higher interest rates on deposits, as well as lower fees and more favorable terms for loans and lines of credit.
DeFi offers the opportunity to provide equitable access to financial services. There are millions of people who do not have access to financial services due to isolation, lack of money, political oppression, etc.
Another advantage of DeFi is the extremely high yield trading, allowing investors to borrow and lend their cryptocurrencies at much higher interest rates than traditional banking.
How DeFi gained user trust during the pandemic
In August 2021, the value of DeFi transactions increased by 3 billion dollars. The largest decentralized DeFi exchange is Uniswap. During a very short period of time, Uniswap has become the market leader due to its technology of automation of transactions through smart contracts based on a simple and innovative model that ensures liquidity.
Uniswap surpassed Coinbase Pro in terms of trading volume. But why do people use Uniswap? The main reasons are: there can be no false payment orders, no false volume, the commissions are extremely low and the liquidity is very high. Last but not least, you do not have to register with your identity card, because the KYC procedures (Know Your Customer) are not necessary, since everything is done peer-to-peer through an open-source software that works automatically.
Amid the COVID-19 pandemic, mistrust in traditional financial institutions has grown. The need for an alternative to financial instruments (loans, exchanges, deposits) using a technology that does not depend on banks and regulators has increased. The legislative gap of regulating cryptocurrency exchanges has created an opportunity for a new type of market maker to emerge.
Conclusions about DeFi and how it can help you
Many financial institutions are beginning to accept DeFi and are now looking for different ways to be a part of this independent financial system. For example, 75 of the world’s largest banks are testing blockchain technology in order to speed up payments as part of the Interbank Information Network, run by JP Morgan, ANZ and the Royal Bank of Canada.
In the previous years, there were many DEXs (decentralized exchanges), but the major problem was always liquidity. This problem was solved by using DeFi applications. Above all benefits, DeFi services offer users the opportunity to buy, sell, borrow and deposit money without the need for a central company or institution governed by regulators.
With the development of DeFi, an important step is being taken towards a new, more liberalized and decentralized financial system of the future.