Understanding DeFi — The Future of Finance
The finance industry has grown exponentially over the years with the growth of technology. Decentralized Finance(DeFi) is a new financial system that aims to be trust-free, open to everyone, permissionless and doesn’t require middlemen like banks. To achieve this, DeFi uses Blockchain technology and smart contracts. Currently, most DeFi projects are built on the Ethereum blockchain(and its Layer 2 chains) due to its high security, robust programming language and strong developer ecosystem.
How it started?
One of the first DeFi projects was MakerDAO, founded in 2015. It allowed users to lock in ETH as collateral and generate DAI. DAI is a stablecoin that is algorithmically pegged to the US dollar such that 1 DAI always equals 1 USD. DAI can also be used for savings on MakerDAO’s oasis platform. This recreates traditional finance’s ability to lend and borrow assets.
How is DeFi better than Traditional Finance(TradFi) or Centralized Finance(CeFi)?
Traditional finance consists of the traditional banks that you come across in your everyday life and Centralized finance consists of any system that has its orders routed through a single exchange system.
Some examples of TradFi — Bank of America, Wells Fargo, JP Morgan Chase
Some examples of CeFi — Coinbase, Nexo, BlockFi, Celcius
Some examples of DeFi — Aave, Compound, Uniswap
Unlike banks, DeFi protocols are permissionless, secure and anonymous. Anyone with enough collateral can take a loan with DeFi. While banks regulate the interest percentage on loans and savings to match with their agenda, DeFi protocols offer interest percentages based on supply and demand.
In most countries with unstable economies, the banks close up often due to losses, taking the users funds along with them. Both traditional banks and CeFi companies suffer from Hacks, Bad loans, Inside jobs and Rug pull.
As of writing this blog, the most popular DeFi protocols are AAVE and Compound with over 26.8 billion US dollars worth of Total Value Locked(TVL) in AAVE and over 19 billion USD of TVL in Compound.
How does DeFi Work?
DeFi mainly works by creating money markets for specific tokens like ETH, DAI, USDC, USDT, LINK, etc. Users supply tokens to these money markets and earn interest on their savings.
When a user deposits their token, they receive an alternate token that is equivalent to the supplied token + interest. For example, Compound provides CETH tokens when ETH is deposited. The CETH tokens are just like any other ERC20 tokens and can be transferred between different wallets. CETH is required to withdraw the underlying ETH locked in the money market. The exchange rate between ETH and CETH tokens will keep increasing with each block. Thus, when you exchange your CETH for ETH at a later time, you’ll get the total deposited ETH and the interest on top of it.
To borrow money from a DeFi protocol, collateral must be placed. Currently, all loans are overcollateralized. The borrower must supply tokens worth more than the actual loan. Every token deposited as collateral has a collateral factor that determines how much you can borrow. For example, ETH and DAI have a 75% collateral factor on Compound. This means that, for every ETH that is collateralized, you can borrow 0.75 ETH.
The big question now is, why would someone take a loan when they can just liquidate their funds and get money? People generally take loans to avoid/delay paying their capital gains taxes or they don’t want to sell their tokens. There is a limit on how much can be borrowed. This limit depends on the amount of funds in the money market and the quality of your collateral.
The borrowed funds should always be less than the collateral times the collateral factor.
Borrowed Amount < Collateral * Collateral Factor
If this condition fails, the collateral will be automatically liquidated and the protocol will repay the difference to the borrower.
The interest rates for lenders and borrowers are determined by the ratio between supply and the borrowed tokens in a particular market. The interests are calculated in every block, thus it is always a variable. Protocols like AAVE offers a stable APY in the short term but changes over the long term based on supply and demand.
Risks in DeFi
The major risk in DeFi comes from poorly written smart contracts. A poorly written smart contract can be susceptible to hacks where the money market can lose all its funds. The other risks with DeFi are the volatility of cryptocurrencies and the quickly changing APYs.
DeFi is hugely disrupting traditional finance. The permissionless, open and censorship-resistant nature of DeFi is crucial in the present condition where government policies and traditional banks are not built to serve the common people. I’m incredibly bullish on DeFi. Always DYOR.
I have been developing on Ethereum for a while now and have been investing in various cryptocurrencies as well. I mostly work with smart contracts and solidity programming. If you have a fun project in mind and want to collaborate with a solidity developer, hit me up :)
You can find me on Twitter where I post about blockchain development and crypto in general.
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