Decentralized Finance (DeFi) or Open Finance is the movement that allows users to utilize financial services without the need to rely on middlemen (centralized entities) like banks or brokerages. These financial services are provided via Decentralized Applications (D-apps), the majority of which are deployed on the Ethereum platform.
For DeFi D-apps to work, collateral locked into smart contracts is usually required. The cumulative collateral locked in DeFi D-apps is often referred to as the Total Value Locked, which serves as a growth indicator of the DeFi ecosystem.
What differentiates these DeFi D-apps from traditional banks?
- At their core, the operations of these businesses are not managed by an institution and its employees — instead, the rules are written in code (or smart contract, as mentioned above).
- The code is transparent on the blockchain for anyone to audit.
- D-apps are designed to be global from day one.
- “Permissionless” to create, “permissionless” to participate — anyone can create DeFi apps, and anyone can use them.
- Flexible user experience.
- Interoperable — new DeFi applications can be built or composed by combining other DeFi products like Lego pieces.
De-Fi key categories
1. Stablecoins. A building block of decentralized finance. Stablecoins are tokens designed to stay at a fixed value, even when the price of cryptos changes, and backed by a reserve asset.
2. Decentralized lending and borrowing. Traditional financial systems require users to have bank accounts to utilize their services, a luxury that 1.7 billion people currently don’t have. Borrowing from banks comes with other restrictions, such as having a good credit score and having sufficient collateral to convince the banks that one is credit-worthy and able to repay a loan.
Decentralized lending and borrowing remove this barrier, allowing anyone to collateralize their digital assets and use this to obtain loans. One can also earn a yield on their assets and participate in the lending market by contributing to lending pools and earning interest on these assets. With decentralized lending and borrowing, there is no need for a bank account or checking for creditworthiness.
3. Collateralization. Provide digital assets to collateralize your decentralized loans, providing the lender some recourse in the event of default.
4. Decentralized Exchanges. To exchange cryptocurrencies, people can use exchanges such as Coinbase or Binance. Exchanges like these are centralized exchanges, they are both the intermediaries and custodians of the traded assets. Meaning users of these exchanges do not have complete control of their assets, putting their assets at risk if the exchanges get hacked and are unable to repay their obligations.
Decentralized exchanges aim to solve this issue by allowing users to exchange cryptocurrencies without giving up custody of their coins. By not storing any funds on centralized exchanges, users do not need to trust the exchanges to stay solvent.
5. Fund Management. Fund management is the process of overseeing your assets and managing their cash flow to generate a return on your investment. There are two types of fund management — active and passive fund management.
6. Insurance — Risk management. Insurance is a risk management strategy in which an individual receives financial protection or reimbursement against losses from an insurance company in the event of an unfortunate incident. It is common for individuals to purchase insurance on cars, homes, health, and life.
7. Decentralized Identity. Identities are used in the context of smart contracts for things like assessing your creditworthiness for a decentralized loan.
8. Composability. Snapping together DeFi functions that do different things, much like software libraries. For example, if one contract takes in crypto and generates interest, the second contract could automatically reinvest that interest.
9. Derivatives.
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