Blockchain Blog 12: Decentralize Finance (DeFi)

Aakash S


We started these 28 Blogs on Blockchain and Cryptocurrency by knowing about the barter system which existed thousands of years ago. We closely looked at how we transformed ourselves from a barter system to digital currencies. Then we talked about how our economic system kept on changing in order to stand along with modern-day innovations and technologies. We introduced ourselves to blockchain and why it is considered a hope for the coming time. Maybe everything that we talked about was just to understand the revolutionary implementation of one particular application of blockchain, Decentralize Finance, or DeFi.

So before knowing about DeFi, let us talk about the Centralized Finance system which we are using in our economic system since the currencies were first introduced.

Centralized Finance

Almost every aspect of lending, banking, and trading is governed by centralized systems and government bodies. Banks act as a third-party intermediary that can approve or deny transactions and withdrawals. The New York Stock Exchange (NYSE) controls what assets are able to be purchased in the U.S., and can delist and discipline companies for not following their guidelines. Regulatory bodies such as the Federal Reserve, U.S. Treasury, the Internal Revenue Service (IRS), and the Securities and Exchange Commission (SEC) impose guidelines and rules for centralized financial institutions to follow. These intermediary groups reduce the ease of access to capital and financial services to the public space.

So what is Decentralized Finance (DeFi)?

Decentralized Finance (DeFi) is an ecosystem of financial applications that challenge the idea of central governing bodies controlling financial services. It is a movement of decentralization across the world that aims to create open-source, transparent, and consentless financial service systems that are available to anyone across the world without the need for central oversight or authority. DeFi apps and services are built upon public blockchains such as Ethereum. They can reproduce existing centralized financial services and even offer new innovative services created with DeFi systems in mind

So why see DeFi as an option for a Centralised Financing system. We already talked about the drawbacks of the current financial system in Blockchain to Eliminate Poverty?

So what are the benefits of DeFi?

Some of the benefits to using Decentralized Financial systems are:
Ease of access to financial services to individuals, areas, or countries that are isolated from current financial systems. This can include access to banking and loans. DeFi is built using blockchain technology such as Ethereum. These applications built upon public blockchains provide a level of transparency that traditional financial services do not employ. Traditional financial systems rely on institutions (banks, credit card companies, etc) to act as intermediaries during transactions. Courts and other regulators are relied upon to settle financial disputes. DeFi applications do not need any 3rd party entities to settle transactions or disputes. Agreements are made in the form of smart contracts which cannot be altered. This removal of third-party oversight in financial transactions reduces the overall cost of providing and using these services and allows for a more fluid financial system.

DeFi and Smart Contracts

Smart contracts are self-executing contracts with the conditions of the agreement between buyer and seller directly written into lines of code. This code and agreement cannot be altered once created and is accessible on public blockchains such as Ethereum. Anyone can view them and verify the smart contract, and transactions are always traceable and irreversible. Smart contracts are the foundation behind decentralized finance. They encode the specific terms, agreements, and activities of different decentralized applications (DApps). These programs go beyond simply sending and receiving funds. An example of this could be found in a loan between two parties. Smart contracts would be created that encode the specific details regarding the loan, and they cannot be altered once created. If certain conditions are not met by the borrower, their collateral could be liquidated. These agreements are enforced by the coding behind smart contracts, and not by third-party institutions such as banks.

DeFi Lending and Borrowing

In traditional financial systems, you may consider putting money into a savings account and could qualify for a 0.5% interest rate on your savings. The bank can then lend that money to another customer at a 3% interest rate, take 2.5% of the rate for themselves, and leave the 0.5% interest for the savings account owner. In DeFi, users are able to lend out investments directly, cutting out the middleman and earning the full 3% interest return on their money. Borrowing and lending DApps such as Compound and Aave allow you to deposit your crypto to use it as collateral and borrow against it. You can also opt to deposit your crypto to lend out and earn passive income/interest on your investment. Smart contracts are used to ensure the security of the funds and automatically match borrowers with lenders, and actively adjust interest rates based on supply and demand.

Liquidity Pools

A liquidity pool is a collection of capital locked away in a smart contract. These pools of liquidity (money) are used to facilitate decentralized lending, trading, and other DApps used in the DeFi ecosystem. Instead of central institutions providing capital for loans, smart contracts are used to distribute and collect capital for borrowers and lenders. All activities on liquidity pools are governed by smart contract code, removing the risk of human error and intervention when dealing with large funds.

Yield Farming

Smart contracts allow for investors to invest their capital in liquidity pools without the need of 3rd party oversight. As depositors invest their funds in these pools, they are often eligible for rewards based on the amount locked in the pool and the duration of the deposit. Yield farming is the process that investors profit off of the interest gained from investing in liquidity pools. Users who deposit funds into liquidity pools are called liquidity providers. These pools power applications and marketplaces that lend, borrow, or exchange tokens. Usage of these applications incurs fees, which are paid out to liquidity providers (LPs) based on their share of the pool.

Decentralized and Centralized Marketplace

How do centralized exchanges (CEXs) work?

With typically centralized exchanges, money is deposited into an account and is used to purchase cryptocurrency. When crypto is purchased and stored on a centralized exchange, you give up a sense of control of it. You can still trade, sell, or withdraw the currency, but you cannot spend it on the blockchain. You do not own the private keys to crypto purchased/stored on a centralized exchange. When you withdraw crypto, you are essentially asking the exchange to authorize a transaction on your behalf. When trades are initiated they do not occur on-chain. The exchange distributes funds to users in its own database.

Many centralized exchanges have streamlined their operations, resulting in faster trades and ease of use. While many centralized exchanges are reputable with positive histories, there is a level of risk. Exchanges can deny withdrawals at any moment for any reason, meaning that there could be times that you cannot send your crypto off the exchange. There is also the risk of exchanges shutting down without warning, or data breaches that could result in hackers draining exchange funds. This risk is mitigated by only using reputable exchanges that have proven themselves over time.

Decentralized Marketplaces (DEXs)

Many would consider decentralized exchanges to be some of the most important DeFi applications created. Decentralized exchanges are platforms that imitate the function of typically centralized exchanges. One of the biggest differences is that the backend of DEXs exists solely on a blockchain. Centralized exchanges take custody of your funds/coins and require a level of trust that the exchange will honor your transaction. DEXs do not take custody of funds/coins as trades are completed directly from user to user

How do decentralized exchanges work?

DEXs are powered through the use of smart contracts which are coding programmed into a blockchain that defines the terms of a transaction. Orders are executed and processed without requiring users to sacrifice custody of their funds at any point, unlike centralized exchanges.

Most popular DEXs are centered around assets on a single blockchain such as Ethereum, but there are cross-chain DEXs in development. Transactions are P2P (peer to peer) and direct without any intermediaries. Some DEXs utilize liquidity pools to provide trading pairs and liquidity for certain markets, removing the need for actual buyers/sellers.

Benefits of DEXs

No KYC: KYC/AML (Know Your Customer and Anti-Money Laundering) is a requirement that you must provide identity documentation and proof of address to CEXs to access and use them. This is a privacy concern for users as the security of these personal information databases comes into question. DEXs do not require your personal information in order to use them. No counterparty risk: One of the main incentives to using a DEX is that users remain in control of their funds. There is no central database that could be at risk of data breaches. Access to unlisted assets: Centralized exchanges choose what tokens are available on their platforms. DEXs provide the opportunity to invest in unlisted assets without barriers to entry

Drawbacks of DEXs

No direct link to bank/debit cards: DEXs only work with cryptocurrencies and are not able to directly interact and exchange with fiat (USD/EURO). You must already have cryptocurrency to use a DEX. Convenience: DEXs are not as user-friendly and intuitive to use compared to centralized exchanges. Centralized platforms display real-time trades and order books that are unaffected by block times. No customer service: If you forget your password on a CEX, you can reset it anytime. There are no customer services on DEXs. If you forget/lose your private keys, your money is lost and cannot be retrieved. Trading volume and liquidity: CEXs have much more trading volume and liquidity than DEXs. Liquidity is how easy you can to buy or sell assets at a fair and practical price. In a liquid market, bids (buyer prices) and asks (seller prices) have little difference in price. In an illiquid market, there is a large difference between bids and ask prices. This can also be an issue with supply and demand, as DEXs are still niche marketplaces. Fees: Fees are not always higher when using a DEX, but they can raise during high network activity times and network congestion.