What is DeFi?

June 1, 2022
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Decentralized Finance (DeFi) is an alternative to the traditional world of finance. In traditional finance (TradFi), transactions involve banks, exchanges and custodians acting as central hubs for storing and recording ownership. Even though this is the system most people are used to, it has some weaknesses.

The biggest flaw with traditional finances is that everything has to pass through a central hub. DeFi, which stands for Decentralized Finance, solves this issue. As its name suggests, DeFi does away with the concept of centralized custodians and puts the power in the hands of the people.

How does DeFi Work?

Decentralized Finance (DeFi) hinges on cryptocurrencies and the blockchain. Before explaining the concept of DeFi, those two terms need to be explained.

A blockchain is basically a database. Unlike most databases that are stored on a central server, it is spread across many different ‘nodes’ that are located on different computers and servers. New data is always added to the blockchain in chronological order.

What makes it so useful is that it can’t be tampered with. Even if the data on one computer is tampered with, the rest of the network would notice an inconsistency and reject it. Since data is added chronologically, the blockchain forms a ledger of transactions that are fixed and cannot be modified retroactively.

Cryptocurrencies are digital currencies. There are many such currencies out there, the most famous of which is Bitcoin. Other than Bitcoin, there is also Ethereum, Litecoin, and Monero, to name a few popular ones. All transactions or exchanges of a cryptocurrency are recorded in a blockchain.

What it means is that people can exchange cryptocurrencies safely and securely without relying on a central entity like a bank. The blockchain securely records every transaction, and because it is tamper proof, all transactions are final.

Here are a few things you probably didn’t know about DeFi:

Smart Contracts Make Things Easy and Painless

In TradFi, the participants involved in a transaction have to sign off on everything, and multiple intermediaries are often present (for example, closing on a house purchase). Whether it’s a loan, exchange or a simple purchase, it involves a big hassle.

The advent of the Ethereum blockchain has introduced the concept of “smart contracts”. These are programs saved on the blockchain that execute automatically when certain conditions are met. They’re reliable and ensure that funds are transferred, and necessary information is recorded automatically without the use of a third-party escrow or intermediary.

You Get Better Return on Investment (ROI)

In traditional finance, investments tend to go through banks and stock exchanges. The institutions take a fee, causing you to lose out on ROI. Furthermore, it is a lot more manual,  requiring potentially phone calls, filling out forms and many delays as paperwork shuffles back and forth.

In DeFi, one can cut the middle-man out entirely and rely on smart contracts to enforce the investment or loan agreement. Depending on the lending protocol, a small fee may be charged, but since all activities happen on a blockchain, this transaction can be processed in a matter of minutes instead of days, potentially saving you time and money.

Stablecoins are Fixed to Real-World Prices

Many investors mistake decentralized lending as gambling on cryptocurrencies. And because they think most cryptocurrencies are extremely volatile, it makes decentralized lending risky as well.

However, that’s not the case. Stablecoins are a type of cryptocurrency that are linked to assets like Gold or the US Dollar. They attempt to match the value of the asset they are pegged to, and form the underlying pool of liquidity that powers decentralized lending.

The borrowers of stablecoins put up a lot more collateral in the form of cryptocurrency such as Ethereum and BTC than the amount of stablecoins they plan to borrow. This makes it so that even with large fluctuations in asset prices, there is usually more than enough collateral to pay back lenders in full.

In the big run up of Ethereum in May 2021 and subsequent rapid 50% crash that followed, there were no material liquidations of borrowers and not a single lender in Compound (one of the largest DeFi lending protocols) has suffered a loss because the blockchain allowed both borrowers and lenders to adjust their positions in real-time 24/7 to make sure loans were properly funded. As compared to traditional stock markets that are only open for a fraction of the day, and definitely not on weekends, some may say that DeFi lending is even better than the TradFi alternative.