A Detailed Guide to DeFi for Beginners

decentralized finance

The finance industry is one of the most critical and sensitive sectors today. With more and more people moving their finances from physical to digital forms, the finance industry is always looking for convenient and safe technologies that can be implemented to ease out the workflows and enhance safety.

Inspired by blockchain technology, decentralized finance, more popularly known as DeFi, is a new way to manage finances in a decentralized manner and entirely remove intermediaries’ need in the process. It is gaining a lot of traction due to its benefits and features. According to DeFi Pulse, the total value locked in DeFi was approximately USD 679 Million by the end of 2019. Today, however, the total value locked in DeFi is USD 12.45 Billion.

This article will answer all significant questions regarding DeFi, including:

  1. What is DeFi?
  2. What is the difference between DeFi and CeFi?
  3. What are the advantages of DeFi?
  4. How does DeFi work?
  5. What are the use cases of DeFi?
  6. What are some of the leading DeFi platforms?
  7. What’s next for DeFi?

Let’s begin by understanding the concept of DeFi in detail.

What is DeFi?

DeFi stands for Decentralized Finance. It is a form of finance that aims at removing intermediaries and creating a financial ecosystem that is:

  • transparent
  • open source
  • permissionless
  • not centralized

The decentralized finance system functions without a central authority, which implies that it is available to everyone. Hence, people can:

  • entirely control their assets
  • conduct peer-to-peer transaction and exchanges
  • use and create decentralized applications (dApps)

By removing financial intermediaries like exchanges, banks, or brokerages, DeFi uses blockchain technology to facilitate finances. With DeFi, people can:

  • borrow funds from each other
  • trade cryptocurrencies
  • insure against risks
  • earn high interests
  • speculate price movements on assets

With decentralized finance, people can gain many benefits. But to understand it better, we must know how it is different from centralized finance (CeFi).

What is the Difference between DeFi and CeFi?

CeFi stands for centralized finance. As the name suggests, it is a centralized financial structure.

There are many differences between DeFi and CeFi. To understand them in a better manner, let’s discuss them properly.

The significant difference between DeFi and CeFi is suggested clearly by the terms themselves. DeFi is decentralized, whereas CeFi is centralized. DeFi is a permissionless network, whereas CeFi is a permissioned network. This implies that in CeFi, specific actions can be performed only by authorized personnel, whereas in DeFi, there are no central authority figures.

DeFi is open-source, which implies that it encourages free collaboration. CeFi, however, isn’t opensource, which means that free collaboration isn’t facilitated, and all decisions are made by specific authorized figures. As DeFi is open-source, it is also censorship-resistant, whereas CeFi can be censored.

DeFi is cheaper as compared to CeFi because most of the expenses involve network fees only. However, CeFi is comparatively expensive as intermediaries charge hefty fees.

Defi is built on blockchain, whereas CeFi functions on old traditional methods.

Decentralized finance shifts transactions from traditional and centralized financial systems to P2P finance enabled by decentralized technologies built on blockchains like Ethereum and Stellar. Centralized finance involves several central authorities, institutions, and intermediaries, DeFi aims to remove with the help of smart contracts.

Thanks to the numerous promising advantages it offers, decentralized finance has become one of the most active sectors in the blockchain industry, with various use cases and a total locked value of over USD 12 Billion. Let’s take a look at its benefits.

What are the Advantages of DeFi?

Decentralized finance is facilitated by blockchain technology, which implies that it inherits the advantages of blockchain as well. Four significant benefits of DeFi are:

  1. Immutability
  2. Transparency
  3. Interoperability
  4. No Single Points of Failure

Let’s discuss them in detail.

Immutability

Immutability means “not susceptible to change.” As decentralized finance is supported by blockchain technology, all data is immutable, implying that it cannot be changed. As the information is tamperproof, it makes financial procedures and operations highly secure and conveniently auditable.

Transparency

DeFi offers transparency. As it functions on blockchain technology, all transactions, data, and codes on the blockchain are transparent to everyone. Such a level of transparency build trust among users, as everyone in the network can:

  • understand what kind of transactions are taking place.
  • view and understand the smart contract’s code and functionality.

Hence, transparency ensures:

  • high trust levels
  • security
  • auditability
  • authenticity

Interoperability

With decentralized finance, developers can freely:

  • build on top of existent protocols
  • customize interfaces
  • integrate third-party applications

Due to this kind of flexibility, DeFi protocols are often known as “Money Legos.” New decentralized finance applications can be built by combining other DeFi products. For example, Stablecoins, decentralized exchanges, and prediction markets can be combined to form entirely new and much more advanced marketplaces.

No Single Points of Failure

Decentralized finance is powered by blockchain technology, which implies that all information is stored on the blockchain and distributed among multiple nodes. Hence, all single points of failure are eliminated. As all data is spread across different nodes, it makes DeFi censorship-resistant and removes the possibility of a service’s potential shutdown.

Other than this, DeFi also enables:

  • autonomy as you are solely responsible for your assets and money in a DeFi network.
  • contract automation
  • quick transactions
  • low-cost transactions

Now that you have learned about the multiple benefits of DeFi, let’s take a look at how it works.

How does DeFi work?

Decentralized finance mainly works with the help of three components –

  1. Decentralized Applications (dApps)
  2. Blockchain Technology
  3. Smart Contracts

The decentralized applications perform financial operations on blockchains. Smart contracts remove the intermediaries or central authorities, which are generally required in the traditional forms of financial transactions. With smart contracts, transactions occur directly between two participants. Smart contract programs for DeFi protocols are run via open-source software by a network of developers and programmers. It decentralizes the financial processes by removing the need for central exchanges. Many dApps can connect and work together to create complex financial services.

A DeFi platform is built on the following features of blockchain technology:

  • reliable
  • tamper-proof
  • automated
  • can be programmed for cryptocurrency interaction

Decentralized applications (dApps) can be created with these characteristics to automatically interact with money in diverse ways without any intermediaries or banks. A decentralized finance ecosystem becomes more effective as:

  • more dApps are built
  • integration with each other increases

A recent innovation in the DeFi ecosystem is Yield Farming, which is also known as Liquidity Mining.

Yield Farming is a way to reward users for:

  • provisioning liquidity in a dApp’s ecosystem
  • providing other value-added services to a dApp

Yield Farming is often implemented with two primary goals in mind:

  • To incentivize users to deposit their liquidity and lock it into a DeFi application
  • Equitably distribute the DeFi app’s governance tokens to protocol users

Different DeFi protocols usually opt for other ways to approach Yield Farming, depending on their goals.

Now that you have a general idea of how DeFi works, let’s take a look at some of its use cases.

What are the use cases of DeFi?

There are multiple use cases of DeFi today. Decentralized finance can be implemented in multiple industries to bring out easy, quick, and convenient workflows. Here, we have listed seven use cases of decentralized finance:

  1. Data and Analytics
  2. Lending and Borrowing
  3. Insurance
  4. Identity
  5. Payments
  6. Stablecoins
  7. Exchanges and Marketplaces

Let’s discuss them in detail.

Data and Analytics

Decentralized Finance protocols enable efficient data analysis, discovery, and decision making around finances and risk management. It is possible because it works on blockchain, offering transparent access to all transaction data and network activity. Due to the growth of new DeFi dApp applications, numerous tools and dashboards have been developed to enable users to track the total value locked and compare platform risks.

For Example, Defi Pulse.

Insurance

Decentralized finance is still an emerging and developing concept. There are a few risks related to smart contract bugs that need to be attended to before implementing it in sensitive sectors like insurance. However, by implementing DeFi, the insurance industry can significantly benefit from enhanced transparency, authenticity, and security. There have been numerous innovative alternatives introduced to assist people in claiming insurance and protecting their assets.

For example, Nexus Manual – provides Smart Contract Cover to provide protection against unintended smart contract code usage.

Payments and Monetary Banking Services

Monetary use cases like payments and banking are the primary use case of decentralized finance and blockchain technology. As blockchain enables users to securely and directly exchange cryptocurrencies, without intermediaries, DeFi payments will create a payments and banking system that is more:

  • open
  • easy-to-use
  • accessible

DeFi payments can also help financial institutions to:

  • streamline market infrastructure
  • serve wholesale and retail customers in a better manner
  • reach out to people more systematically

With traditional payments and banking services, there are numerous intermediaries and middlemen involved. Hence, the processes become very tedious, time-consuming, and costly. With the use of DeFi payments:

  • peer-to-peer payments can be enabled, thus enabling direct payments.
  • smart contracts can automate processes, thus removing middle-men.
  • payments and banking services can become comparatively cheaper.
  • quick payments and processes can be ensured.

Stablecoins

Cryptocurrencies which are pegged with a stable asset like fiat currencies or gold are known as stablecoins. Created initially to stabilize the ever-changing prices of cryptocurrencies, stablecoins can be implemented in decentralized finance for:

  • lending
  • borrowing
  • central bank digital currency (CBDC)
  • remittances

Stablecoins can make blockchains feasible for payments as they hold on to a specific value rather than changing constantly. Typically, stablecoins are categorized into three types:

  • Crypto-Collateralized Stablecoin

    Stablecoins backed by crypto assets as collateral are known as Crypto-Collateralized Stablecoins. They are:

    • decentralized
    • trustlessly issued
    • pegged 1:1 against assets
  • Fiat-Collateralized Stablecoin

    Coins that store value in fiat currencies like Euros, USD, etc., are known as FiatCollateralized Stablecoins. They are usually redeemable at 1:1 with the fiat currency they are pegged to.

  • Non-Collateralized Stablecoin

    Stablecoins that are neither centralized nor over-collateralized with a crypto asset are known as Non-Collateralized Stablecoins. The system supplies more tokens with lower prices when demand increases and provides fewer tokens with higher prices when demand decreases, all according to its algorithm.

With traditional payments and banking services, there are numerous intermediaries and middlemen involved. Hence, the processes become very tedious, time-consuming, and costly. With the use of DeFi payments:

  • peer-to-peer payments can be enabled, thus enabling direct payments.
  • smart contracts can automate processes, thus removing middle-men.
  • payments and banking services can become comparatively cheaper.
  • quick payments and processes can be ensured.

Exchanges and Marketplaces

Decentralized exchanges involve peer-to-peer transactions between two stakeholders on the blockchain, without the involvement of any intermediaries or middlemen. Hence, they are very different from centralized exchanges. DeFi protocols support various online marketplaces to enable users to exchange products and services globally and directly (P2P).

Some advantages of implementing DeFi in exchanges and marketplaces are:

  • no sign-ups
  • no identity verification
  • no withdrawal fees

For Example, IDEX and Binance DEX.

Some types of market places focus on “Non-Fungible Tokens” (NFTs) exchange, which is also known as “crypto-collectibles.” For Example, OpenSea.

Some marketplaces also allow creating new marketplaces for voting on governance procedures.” For Example, District0X.

 

What are some of the leading DeFi platforms?

The cryptocurrency and blockchain industry is booming exponentially, and decentralized finance has a significant role to play in it. More and more DeFi platforms are being built to support multiple use cases and industries in order to bring enhanced transparency and security to the existing systems and workflows.

Here, we have listed and explained four leading DeFi platforms:

  • Uniswap
  • Maker
  • Compound
  • Aave

Let’s discuss them in detail.

 

Uniswap

Uniswap is a decentralized exchange platform built on the Ethereum network. Uniswap uses liquidity pools for token swaps without any limit orders.

On the Uniswap platform, users can:

  • swap any ERC-20 token
  • provide liquidity to protocols
  • earn fees while providing liquidity – all users who provide liquidity get a 0.3% fee, which is proportional to the quantity of liquidity they provide.
  • add liquidity to an existent pool
  • create their own liquidity pool – users only have to supply a token pair for markets to develop a liquidity pool on Uniswap.

Market makers set the exchange rates by using the “Constant Product Market Maker” mechanism of Uniswap. This mechanism is what makes Uniswap different from other decentralized exchanges. It is a pricing mechanism where a user can add any token to Uniswap by funding it with an ETH and ERC20 token being traded of equal value.

 

MakerDAO

Built on Ethereum, MakerDAO is a decentralized borrowing and lending platform. DAO stands for Decentralized Autonomous Organization, which is upheld by the MKR governance token holders. They can decide the protocol’s future by voting in favor of the proposals for platform changes or against them.

MKR holders govern the voting system of the protocol, and make decisions about changes to:

  • risk parameters
  • asset additions
  • stability fee levels

Maker produces DAI, which is a stablecoin used in the majority of significant DeFi projects. One can use Maker to:

  • create a vault
  • lock-in crypto collateral
  • produce DAI as a debt against their collateral

Both MKR and DAI are ERC-20 tokens. Maker also offers over-collateralized loans in DAI, upto 66% of the collateral’s value.

MKR serves as the platform’s collateral base, and all transaction fees on the platform are paid in MKR. It is burned according to DAI price fluctuations to retain its dollar peg and be used as a governance token.

 

Compound

The compound is an algorithmic money market protocol based on Ethereum. Compound enables users to:

  • lend assets to earn liquidity
  • take loans by collateralizing their own crypto

cTokens represent balances and can be used:

  • to earn interests
  • as collateral

Users can take over-collateralized loans and borrow up to 75% of their initial collateral with Compound. Undercollateralized loans/debts can be liquidated easily, and collateral can be added or removed conveniently.

The Compound protocol has been audited and formally verified. It also supports several assets. It was initially launched in September 2018 and implemented with an upgrade in May 2019. One year later, in May 2020, the platform became decentralized by providing governance capabilities to COMP token holders.

 

Aave

Built on Ethereum, Aave is an open-source and non-custodial protocol. It offers decentralized borrowing and lending services.

The protocol mints aTokens according to the supplied assets’ value when it is providing liquidity as a lender. You can begin to earn interest quickly as a lender on Aave and your aTokens increase in the process, which can be:

  • transferred
  • exchanged
  • deposited

The platform accepts various assets as collateral, and each type has different interest rates and liquidation penalties. Aave also has a Liquidity Reserve, which enables users to withdraw liquidity anytime freely.

Aave gained traction for “Flash Loans,” which are basically uncollateralized loans where lending, borrowing and repayment occur within one transaction. The platform has also undergone comprehensive external audits. It was launched initially as ETHLend in 2017, then changed to Aave in 2018, and the mainnet went live in 2020.

 

What’s next for DeFi?

Crypto is a digital offering that is all set to revolutionize every industry with its benefits. In the future, we can expect the majority of financial services to implement DeFi in their systems. Today, DeFi apps use collateral as a security mechanism for lending and borrowing activities. DeFi can become a significant source of revolution in the insurance industry as well.

Also, a significant shift towards “decentralized governance” and “decentralized decision making” is expected soon as more and more people are moving towards decentralized ways to conduct businesses and transactions.

If you wish to get a DeFi platform developed for your business, contact our blockchain experts.

Author’s Bio

Akash Takyar
Akash Takyar
CEO LeewayHertz
Akash Takyar is the founder and CEO at LeewayHertz. With the experience of building over 100+ platforms for startups and enterprise allows Akash to rapidly architect and design solutions that are scalable and beautiful.
Akash's ability to build enterprise-grade technology solutions has attracted over 30 Fortune 500 companies, including Siemens, 3M, P&G and Hershey’s. Akash is an early adopter of new technology, a passionate technology enthusiast, and an investor in AI and IoT startups.
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