Defi :Beginners guide to defi
What is defi?
Decentralized finance refers to an open,permissionless and interoperable alternative financial infrastructure built on top of the blockchain protocols such as Ethereum .Defi replicates existing financial services in a more open and transparent way. Defi does not rely on intermediaries and centralized institutions.Instead it is based on open protocols and decentralized applications(Dapps).
How does defi work?
Defi combines the blockchain technology,Ethereum and Smart contracts.
Defi involves a group of Decentralized Applications(Dapps).Agreements are enforced by smart contracts and transactions are executed in a secure and verifiable way.
building blocks of defi:
Defi uses a multi-layered architecture with each layer serving its unique purpose.These layers are hierarchical implying that they are only secure as the layers below them.
1.Settlement Layer(Layer 1):this consists of the blockchain and its native assets.For instance the Bitcoin blockchain with Bitcoins(btc).This serves as the foundation layer for storing ownership information securely.
2. AssetLayer (Layer 2):Consists of assets on top of the settlement layer.Usually referred to as tokens.For instance, ADA the native token of the cardano blockchain.
3.The protocol layer(Layer 3):Consists of standards for specific use cases e.g lending,decentralized exchanges,derivatives and asset management on the protocol.
4.Application layer(Layer 4):Consists of user-oriented application .Web browser/Mobile browser abstracts the smart contract interaction thus the protocols becomes easier to use.
5.The aggregation layer(Layer 5):An extension of the application layer.This ensures connection and interoperability to many applications and protocols.It gives users the ability to perform complex tasks through connecting to several protocols simultaneously.
Defi use cases
Defi is a vibrant segment of the blockchain industry that grew from $1BN in 2020 to $97BN in 2022.It can be quite complex wrapping your head around the abstract thought of defi but on exploration of its use cases defi can be well understood.
1.Decentralized exchanges(DEXs):They are the heart of defi. Centralized exchanges such as Binance,Coinbase,kraken etc are operated by single companies making their platform inherently centralized.This compromises security,trust and privacy.But on the other hand,DEXs are managed by developers and the execution handled by smart contracts.Smart contracts execute trades,hold liquidity,process withdrawals /deposits.
Most popular DEXs Uniswap,dYdX and PancakeSwap
2.Lending: Every lending platform consists of borrowers and lenders.Both of these parties interact via a liquidity pool
Lenders supply their assets(eg native tokens) and earn interest borrowers take out loans and pay the interest on their debts.The borrowers credit score will be adjusted by the smart contract based on behavior.
Popular lending protocols include Compound and Aave.
3.Derivatives: This is an advanced trading financial instrument that derives its value from another underlying asset such as currency,stock ,index or even cryptocurrency.Traders trade derivatives to protect themselves against market volatility.Derivatives have been in the past been inaccessible to developing countries .Defi, can give all traders around the world a chance to participate in derivatives market peer-peer.
Most popular Defi derivatives platform include Synthetix and bZx(Fulcrum)
4.Yield Farming:This is among the top uses of Defi. This is a passive income strategy that enables investors to earn crypto using their crypto assets.Essentially, an investor provide their cryptocurrency to a decentralized exchange so the DEX liquidity is optimal to serve the network.In return the investor earns rewards.
5.Insurance:Smart contract are vulnerable to security exploits resulting to huge losses.Even after thorough security audits,some exploits still do exist.A hacker can drain the liquidity pool.As a result,defi investors must use insurance protocols to protect their existing funds.
6. Stablecoins are another use case of defi .where their value is pegged to fiat currency such as USD .Since cryptocurrencies are volatile ,stablecoins are used as a hedge.
Challenges of defi
- Liquidity The defi market is not as big as the traditional finance.Lack of enough liquidity.The total value locked in defi lies at $97 BN
- Fluctuating transaction cost on Ethereum implying that trading can get really expensive.Last year transaction cost in Ethereum ie(gas fee) reached $60 for a transaction worth $100.
- High volatility on defi protocols that can lead to huge losses as there still lies uncertainties .After all this is new tech.
- Scalability Defi transactions require long periods of time for confirmation making it difficult to scale.
A new decentralized future is upon us where the horizons of digital money is expanding every single day.Even though we are on the quest of building a digital wall street with more open financial markets for every one ,traditional financial institutions won’t sit and watch but rather fight back as we have began seeing.
Reaching a perfected and balanced state will take many years and the timeline will also depend on how community is engaged.Disruptive technologies are now more than ever likely to shift into the real world giving us a chance to rewrite history.
“It doesn’t matter if you’re a hedge fund manager on Wall Street or if you’re one of the 1.7 billion people that don’t even have a bank account. With DeFi, you have complete access.” MakerDao CEO.