What is DeFi and how does it work?
The Definition of Defi
Decentralized finance (DeFi) is the practice of conducting financial transactions (such as buying, selling, borrowing, and lending) directly among individuals, rather than via intermediaries (such as banks, exchanges, or brokerages).
More than that, DeFi heralds a transition away from placing one's faith in centralized institutions and toward placing one's faith in code-based peer-to-peer networks.
The Benefits of DeFi
In contrast to TradFi, there are various advantages to using DeFi (traditional finance, such as banks). DeFi is:
The Risks of DeFi
When you have a lot of power, you also have a lot of responsibility. Risks in DeFi include:
How DeFi works
In the existing conventional monetary system, if you want to create a bank account or get a loan, you are required to go via a centralized institution such as a bank. This is the case even if you don't want to do either of those things.
The bank will only allow you to create an account if they are able to verify your identification.
They may opt to lend you money if they are able to determine that you are trustworthy with your financial obligations.
In both instances, the bank is in charge of making decisions.
Your access to such services may be limited or you may be denied access entirely if the institution believes that you do not have the necessary identity or that you do not have a "creditworthy" reputation.
DeFi dispenses with the traditional banking system in favor of a collection of decentralized apps (dApps) driven by smart contracts.
The Meaning of The Term "Dapp."
A decentralized application is abbreviated as a "dApp." Typical web applications, such as Twitter, are hosted on servers that a single company owns. On the other hand, decentralized applications (dApps) in cryptocurrency are hosted on public blockchain networks. Since these networks are open-source, they are not managed by a single entity.
DApps are decentralized applications that are self-sufficient and often include a number of smart contracts.
What Is a Smart Contract?
When certain criteria are satisfied, computer programs known as "smart contracts" can automatically carry out the terms of an agreement, including a loan, a trade, a purchase, and other types of transactions, all without the need for authorization of a third party.
The phrases "if/when...then..." are encoded into blockchain code, enabling smart contracts to carry out their terms automatically. The smart contract will be triggered and the subsequent action in the agreement will be carried out if a given occurrence takes place.
Oracles are DeFi components that supply data from the real world to blockchains. Smart contracts are components of DeFi that draw information from blockchains using oracles.
Let's imagine, for instance, that you make the decision to borrow money using a decentralized lending platform such as Maker. You will get a loan from the platform in the form of token Dai, which is its stablecoin. The platform will then place your crypto collateral, such as Ethereum, into a smart contract.
The smart contract will have the conditions of the loan pre-programmed into it, including the interest rate, the period of the loan, and other such details. When the loan's due date comes and goes, the smart contract will sell your ETH to cover the principal and any accrued interest.
On the other hand, in the event that you are punctual with the repayment of the loan, the smart contract will return your ETH to you.
In conventional banking, each of these procedures would have to be carried out by a live bank teller or loan officer, and the whole process would likely take several days or perhaps a few weeks.
Everything takes place very instantaneously and without the involvement of any middlemen when DeFi and smart contracts are used.
Step-by-step example of DeFi
Getting a Crypto-Backed loan through Aave
One of the most widely used distributed financial intermediary protocols now in existence is called Aave. Aave is a decentralized platform for lending and borrowing money. On the site, you have the ability to get a loan using cryptocurrency as collateral without even having to provide your name or email address.
When you already have ether (ETH) stored in your cryptocurrency wallet, it will be much simpler for you to borrow stablecoins and other cryptocurrencies against it.
1. In the first step, use the WalletConnect service to link your Blockchain.com wallet to Aave: Scan the QR code using the mobile app for your Blockchain.com Wallet, after which you will be prompted to approve the connection. Click "Connect Wallet," then "WalletConnect."
2. After that, you will need to deposit some ETH into the Aave platform. This ETH will act as the collateral for the loan, which means it will be the asset used to secure the loan. You may use more than a dozen different cryptocurrencies to secure your deposits on the Aave platform.
3. If you make a deposit of ETH, the smart contract will allow you to borrow up to sixty percent of the value of that ETH in stablecoins such as USD Tether (USDT) and USD Coin (USDC), as well as other cryptocurrencies.
4. Aave will keep your loan open and continue to collect interest as long as the value of your loan is less than sixty percent of the value of your collateral. If the value of your loan exceeds the threshold of 60%, the smart contract will automatically sell, or liquidate, your cryptocurrency to repay the debt.
5. The last step in paying off the loan is for the borrower to settle the principal amount and any accrued interest. As soon as the clearing process for that transaction is complete, the user will be able to remove all of their collateral from the Aave platform.
Throughout the procedure, the only costs you pay are those that go toward supporting the Ethereum network. You won't be subjected to additional costs or a time-consuming approval procedure when using the Aave platform.
Examples of DeFi
The crypto community is continuously doing research into the many various ways that DeFi protocols might be used. The following are some examples of popular applications:
Decentralized exchanges, often known as DEXes, are online markets that allow users to purchase and sell cryptocurrencies without having to provide their cash to a third party, as is the case with centralized exchanges. Uniswap is now the most widely used decentralized exchange.
You may trade between hundreds of different cryptocurrencies using this website with only a few clicks.
Lending and borrowing platforms
These are websites that allow users to lend or borrow crypto assets using other types of cryptocurrency as collateral. Aave is now one of the most widely used platforms for lending and borrowing money.
Tools for compliance and Know-Your-Transaction (also known as KYT).
These are technologies that assist cryptocurrency firms in meeting regulatory compliance obligations, such as those pertaining to anti-money laundering (AML) and fighting the financing of terrorism (CFT). One well-known instance of a compliance tool is known as Chainalysis KYT.
DeFi FAQ
Can anyone be denied access to DeFi?
No, cryptographic networks do not need authorization to use; rather, they are open to anybody who has access to the Internet. This is one of the properties that distinguish cryptography.
Is DeFi trustworthy?
Users of a cryptocurrency depend on a code to act as the banker, broker, and lender on their behalf. Anyone has the ability to examine open-source software and ensure that it functions properly by testing it.
Having said that, a smart contract's quality depends on its underlying code. Users have suffered losses of millions of dollars as a result of a few high-profile breaches that have occurred in the cryptocurrency field. Before utilizing any cryptocurrency product or service, it is essential to do your own independent research.
How do prices stay current in DeFi if no one manages them?
DeFi protocols use oracles in order to guarantee that the prices of cryptocurrencies shown on the blockchain are always correct. Oracles may be thought of as "crypto price feeds" since they provide the blockchain with real-time data on the pricing of cryptocurrencies.
To lay the groundwork for a loan, an example would be for an oracle to inform a cryptocurrency network about the current price of Ethereum or Bitcoin at any given time. This is another instance of a DeFi component taking the place of the work that a third party would normally undertake in a conventional system, which the third party would likely charge for.
By relying on decentralized crypto networks and smart contracts rather than centralized intermediaries, DeFi protocols can provide monetary services that are accessible to everyone who has an Internet connection – twenty-four hours a day, seven days a week.
