If you’re new to cryptocurrencies, you’ve certainly heard the word “DeFi” (Decentralized Finance) used to describe a number of different protocols and assets.
To begin, it’s crucial to note that DeFi is a relatively new word that is only now gaining traction. This means that DeFi, an abbreviation for decentralized finance, lacks a precise definition. Rather, it is an attempt to characterize what a specific class of cryptocurrencies is now seeking to achieve.
Having saying that, DeFi cryptocurrencies are beginning to share several characteristics.
Most DeFi projects are software protocols that run on top of another cryptocurrency – typically Ethereum or Cosmos – and employ a combination of that protocol’s crypto asset (along with their own and maybe others) to automate a financial function.
The cryptocurrency DAI is an excellent illustration of this in action.
Simply said, DAI allows users to “lock” bitcoin in an Ethereum blockchain smart contract, where the funds are utilized as collateral to generate new assets that power its lending business.
DeFi initiatives, like DAI, can also include a “governance token,” a crypto asset that allows users to influence project development or earn money from the service.
Proponents of DeFi cryptocurrencies say that this means they may be used as “capital assets” in the same way that stocks and bonds can. As a result, although Bitcoin may function as pure money or store of value, these new crypto assets seek to provide exposure to the value of the service offered.
Please keep in mind that the above is our best attempt to summarize the state of the industry’s cutting-edge.
As usual, use caution while examining projects and methods, and this may be especially true for projects at the cutting edge of technology.
How does Decentralized Finance function?
As previously stated, DeFi protocols provide a service by combining crypto assets.
Proponents say that by doing so, these services may provide advantages over those provided by banks and other centralized financial institutions.
These services can be described as follows:
Automated: Users may be able to utilize DeFi services 24 hours a day, seven days a week, without the lengthy approval processes imposed by traditional financial institutions.
Open: Users may be able to engage in service-related decisions. (This may include the option to vote on rate adjustments, for example.)
Permissionless: Users cannot be refused access to DeFi services arbitrarily or due to unfair regulation, and they may be able to fork a project if necessary or wanted.
Trustless: Users may not have to rely on a central institution for access to the service, instead trusting that the software will function as described by the code.
Please keep in mind that you should always double-check the code of such protocols to ensure that it functions as it should.
What are DeFi protocols?
As the number of DeFi protocols grows, it’s important to understand the many types of challenges that these efforts are seeking to solve.
The goal of this section is to categorize the numerous categories into which prominent projects belong, which may be useful for constructing and diversifying your crypto portfolio.
Borrowing and lending
DeFi cryptocurrencies that focus on lending may enable users to take out a loan via software, eliminating the requirement for a trusted third party.
These projects, which are powered by code rather than paper contracts, may automate the maintenance margins and interest rates required in lending. This, among other things, provides for automated liquidation if balances fall below a certain collateral ratio.
While each loan protocol has its own quirks, they all function in the same way. For example, there are two kinds of users: those that lend their tokens to the system and provide liquidity to it, and those who borrow it.
Someone who wants to lend cryptocurrency would transmit the tokens to a protocol-controlled address and earn interest based on the quantity lent.
Borrowers, on the other hand, put cryptocurrency as collateral. They can then borrow cryptocurrency as a proportion of the listed value.
If the protocols function properly, consumers will be able to readily borrow cryptocurrency, and holders would be able to receive a return on their investments.
Aave, Compound, and yEarn are some lending protocols.
Exchanges that are decentralized
Decentralized exchanges (DEXs) may enable users to swap crypto assets without the need for a middleman, allowing for genuine peer-to-peer cryptocurrency trading.
Users of the protocol are often able to instantaneously exchange cryptocurrencies without the requirement for an order book. Instead, the conversion rate might be programmed into the network.
The concept is that DEXs can provide access to trade pairs even when the underlying asset’s activity is too low for larger exchanges.
Another significant advantage of a DEX is that user funds are not handled by centralized parties. Instead, they are kept in personal wallets, which increases the anonymity of users who use DEXs.
Uniswap, 0x, and Kyber Network are examples of decentralized exchanges.
Derivatives
Derivatives markets are places where buyers and sellers trade contracts based on an asset’s predicted future worth. Cryptocurrencies, future event outcomes, and real-world stocks and bonds are all examples of assets.
Users can exchange real-world assets such as equities, currencies, and precious metals in the form of tokens on Ethereum using protocols such as Synthetix.
Other protocols, such as Augur or Gnosis, allow users to bet on the result of events. Augur allows users to generate and trade “shares” that represent a fraction of the value of events such as election results or sports results.
Finally, protocols such as dYdX allow users to exchange margin tokens, giving traders exposure to leverage short or long bets in a variety of marketplaces.
DeFi Protocol Evaluation
Finally, the advent of DeFi has given rise to new metrics that claim to provide insight into their performance. Please keep in mind that these indicators are as fresh as the crypto assets themselves.
The “Total Value Locked” statistic proposed by data aggregator DeFi Pulse is a developing DeFi standard. More than $4.5 billion had been invested in DeFi protocols as of August 2020.
The statistic seeks to demonstrate how much value in cryptocurrencies is locked in a protocol’s contracts. However, because this indicator is based on the fiat value of the stored assets, it is feasible that it will climb significantly without any change in the underlying protocol utilization.
Another new statistic is “on-chain cash flow,” which tries to illustrate the amount of money paid to users who own tokens that power DeFi protocols on a daily basis.
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