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Decentralized Finance For Absolute Beginners

What Is Defi and How Does It Work?

I feel :

The decentralised financial system is very strongly poised to replace our traditional banking and financial system by offering better platforms for consumers to invest, lend , borrow and earn using the digital currency , in-fact this open and global financial system built for the modern internet age is an alternative to a system that’s opaque, tightly controlled, and held together by decades-old infrastructure and processes.

Defi world gained popularity mostly 2020, since 2015 with advent of MakerDAO, it has risen extremely fast & is seeing total value locked rise from $100M to $15B+ collateral in less than 24 months, in only crypto lending space , Defi suite of financial products has got more than 60 billions value being locked which are being traded on various DeFi exchanges and centralized exchanges, this show how swiftly it is preparing to compete with our ailing banking and financial system. Fiat currency are losing its charm and its value is diminishing extremely fast, causing the increase of deadly inflation rate .

Defi Total Value Locked : Source Defi Pulse

The biggest alternative to the BFSI system is here in the form of Decentralized finance, so today we will explore the what & why of DeFi and also will cover the opportunity & use case which Defi offers .

What is Defi ?

DeFi which is expanded as Decentralized Finance is a complete financial ecosystem or an umbrella that offers the suite of financial products and services, like , lending, borrowing , fixed income, insurance etc, making it available for masses on a public decentralized blockchain network , without any authority of any middleman.

Defi In Short:

  • DeFi consists of Dapps and peer-to-peer protocols developed on decentralized blockchain networks that require no access rights for easy lending, borrowing, or trading of financial tools
  • The DeFi ecosystem is made up of multiple decentralized, non-custodial financial products.
  • They function using dex(decentralized exchanges), lending protocols and synthetic derivatives.
  • Currently most of Defi Apps makes use of Ethereum blockchain but many alternative public networks are emerging like Polygon, Binance smart chain, Solana, Cardano, that promises superior speed, scalability, security, and lower costs

In layman terms :

Defi is nothing but the amalgamation of traditional banking services with blockchain technology

How Does DeFi Work ?

Defi comprises of various financial instruments like

  • Lending
  • Decentralized Exchanges
  • Derivatives
  • Payments
  • Assets
  • Market Predictions

These all instruments makes use of digital token and smart contracts to facilitate various financial services which don’t required intermediaries, in our traditional banking system, there are these central and private banks who act as the powerful custodian of your fiat money , which allows them to dictate terms against our likings, In Defi , this custodians are completely eliminated via smart contract software.

A smart contract is a type of Ethereum account that can hold funds and can send/refund them based on certain rules. No one can alter that smart contract when it’s live — it will always run as programmed.

These smart contracts are public and open to be audited, which ensures that any bad contracts can be easily identified by the community and can be scrutinised.

The DefI ecosystem does have a decentralized community of technical members, for example Ethereum blockchain network over which DefI’s are hosted has the Ethereum community who can read code.

This open-source based community helps keep developers in check, but this need will diminish over time as smart contracts become easier to read and other ways to prove trustworthiness of code are developed.

Now that we have some basic understanding how Defi functions it is imperative to understand what actually makes DefI stand out. IT is their projects or to say their DefI protocols which makes it unique as a fintech platform. To further understand the DefI working mechanism let’s discuss few of the DefI project

DefI Protocols Worth Understanding

Defi systems can be categorized into following :

Lending Protocol:

  • Maker
  • Aave
  • Compound

These lending Defi protocols allows user to borrow cryptocurrency as a loan depending upon the user repaying capacity, apart from lending user can simply lock their cryptos to Defi exchanges or Centralized crypto exchanges to earn some passive income

To Learn more about Crypto lending : like Staking & Yield Farming

please read my previous articles below:

Dex: Decentralized Exchanges :

Apart from lending , there are decentralized exchange projects like

  • UniSwap
  • SushiSwap
  • PancakeSwap

Decentralized exchanges are exchanges that operate without an intermediary. They are not as popular as their centralized counterparts.

To know more about Dex, please read my article on the same

These exchanges allow users to trade any native token, for example Ethereum ERC-20 token, as a liquidity provider to earn money for providing liquidity to the concerned token’s market.

Let’s go more deep by taking UniSwap as an example:

UniSwap offers three core functionalities:

  • Swapping tokens
  • Adding liquidity
  • Removing liquidity.

How Swapping Tokens Works ?

  • Users are required to create an account on Metamask/or connect their wallet to the UniSwap Dex.
  • Once a Metamask account is created, users can select tokens they own in their wallet to swap for the desired type of cryptocurrency, which are supported by the given DEX

How To Add Adding liquidity?

  • To provide liquidity, users deposit an equivalent value of tokens into the. token’s associated exchange contract
  • Once you have tokens for liquidity, you can add them to a “Liquidity pool” on the UniSwap or any Dex interface.
  • Users who locks in their token for liquidity gets rewarded with a fee as calculated by the exchange

Synthetic Assets:

Third type of DefI projects is synthetic assets, for example synthetix’s tokenized stocks or Makers decentralized stablecoins like DAI.

A synthetic asset is simply a tokenized derivative that mimics the value of another asset.

For Example :

Synthetix : is a one such Defi platform that lets users create and exchange synthetic versions of assets like gold, silver, cryptocurrencies and traditional currencies like the Euro. The synthetic assets are backed by excess collateral locked into the Synthetix contracts.

Apart from these 3 there are protocol which supports:

Market Predictions:

These market prediction Defi platforms allow users to make future predictions of some events like sports bettings or politics to predictions on stock prices and more.

DeFi systems open these markets for participation. The concept of decentralized prediction markets has long been touted as a possibility through smart contracts.

Example of Market Prediction Protocol:

Augur: It is a decentralized prediction market platform that utilizes the collective prediction of the mass population . The DeFi platform August uses Ethereum to harness the “Wisdom of the Crowd” to create real-time predictive data.

The maiden version of Augur was released in 2015 and its mainnet was released in 2018.

How does Augur work?

Augur offers you two primary functionalities:

Market creation:

Users can form the Augur market by spending some amount of Ethereum. When creating a market, users need to set the taker fees and maker fees, which should be low enough to incentivize people to bid and high enough to cover the Ethereum cost.

Trading Events Shares:

Now any users can be a part of the created Augur market, to transact against the predictions of listed market event occurrence . Traders can make money by buying positions at a low cost and selling them when the price goes up. People who predict an event correctly will also receive rewards when the market closes.

Augur has the native reputation token : $REP which is an ERC-20 token to be used on the Augur platform to create and trade predictions, As the name suggests, $REP represents token holders’ reputation in the market. For any action that requires tokens, users stake their reputation.

What Makes Defi Protocols Truly Decentralized & Unique?

The Defi has the following key attributes which makes it a Decentralized platform for the financial world

Non Custodials:

Unlike Centralized exchanges or traditional BFSI’s , DeFi protocols never take your crypto assets associated with your wallet into their custody , with DeFi protocols you always have full custody over your cryptocurrency.

Decentralized:

Defi protocols are decentralized because there is no single authority from the Defi platform creator team, who controls the Defi platforms. It encourages the practice of community spread across multiple locations , to have control over the smart contracts . The creators vote themselves out of power as soon as possible and let the community users vote on the future of the concerned Defi network.

Highly transparent:

Defi promotes the highest level of transparency in the way they function allowing a greater level of openness and accessibility to one and all . Being built on top of a blockchain, Defi protocols transactions are available to the public audit. The real beauty is that all the transactions associated with the public ledger are anonymous, consisting of only numerical addresses.

Permissionless:

An internet connection is all you need to access these Defi services

Censorship Proof:

No central party is able to reverse the order of transactions and turn off the service

Programmable:

Developers can create and intertwine financial services at a very very low cost

High Efficiency:

Open Defi financial services are powered and driven by software without any human dependency, which cuts down any operational issues and cost making the system more automated and efficient .

What Are The Drawbacks Associated With Defi System?

These are few of the prominent drawbacks which needs to be considered on the part of the Defi users

Smart Contract Security Risk :

Smart contracts, which acts as the pillar in the Defi blockchain system, are prone to manipulation, these smart contract software are open source which can be peeped into by the investing users, before they go onto invest. Defi smart contracts are generally handed over to their party agency for security audit and bug tracking, but still the smart contract bugs can be escaped due to human involvement, this is risky and can lead to software level tech failure.

Bad Users With Malafide Intent:

There have been some major instances in the past , like in Sep 2020, the KuCoin exchange confirmed $150 million worth of bitcoin and ERC-20 tokens being transferred from its hot wallets . When they audited this transaction with blockchain intelligence software Elliptic they found that the exchange had actually lost about $281 million.

These types of incidents though not very common , can pop up and due to the decentralized nature of Such Dex , such bad actors can fowl play and still escape from getting their funds freeze.

Sole User Accountability :

Considering that DeFi isn’t free of risks and issues, it’s still not responsible for your mistakes.

DeFi transfers responsibility from intermediaries to users

Since DeFi’s do not have any custody of the user tokens, if any mishappening happens with the same, user is solely responsible for loss of their digital asset and mind it, is next to impossible to recover as there is no central system in place which would have kept some trace of the same and done something

Over-collateralization:

Defi lending business suffers from over-collateralization and it occurs when the value of the staked asset (by borrower) is prohibitively high as compared to the loan amount itself.

DeFi projects have high collateralization in order to counter the removal of obstacles such as credit ratings.

Time to Sum Up :

With Some Stats From, Defi World & With Defi Vs Traditional Finance Comparison:

  • Top Defi lending projects like Aave & Compound remains the dominant player in this lending space & have seen a total value locked increase from $100M to $15B+ collateral in less than 24 months.
  • Aave leads the game with total deposits deposits, as of June 2021, Aave has also flipped total value borrowed, now dominating lending in both deposits and outstanding borrow ,

Refer the image below:

Source: GlassNode Insights

As on date , here are the Top 15 Defi Projects in various categories based on total locked value .

Source: defi Pulse

Defi Vs Traditional Finance: (Simplified Visual Representation)

Before i take a leave i would like to leave you all with the simple comparison between Defi ’s and Traditional Financial system,

Time To Sign-Off With Food For Thought:

“Defi ecosystem has grown exponentially since 2020, and has now more than 100 billion value locked in the system. This shows that the power is now in the hands of the user and the wealth creation is truly going to be democratized for the larger good of humanity. If you are willing to be patient and to get the required education you can leverage the power of this DeFi to shape your life for financial freedom”

What’s Next?

  • We will uncover how user can practically setup their wallet to avail crypto lending facility on the DEX platform , like UniSwap

Thanks for being there with me and inspiring me as always …

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@pramodAIML

@pramodAIML

Passionate Blogger & Tech Entrepreneur | Founder of FinTech Startup | Write about AIML, DevOps, Product Mgmt & Crypto