DeFi stands for decentralized finance. It is almost similar to centralized finance, with the only difference being that it does not have traditional banks or institutions as mediators. DeFi relies on programmed code to decide how a protocol functions.
You have probably heard this term getting thrown around almost on a regular basis whenever someone talks about blockchain or “open finance”. It has become quite popular over the past few years, because of the amount of returns it has helped people make. Today, the total amount locked in DeFi (which means the amount that is being used on various applications/protocols within DeFi) is over $84B, an increase of over 1500% since September 2020.
Let us understand what DeFi is, and the various applications built within the ecosystem.
From Centralized Finance
Decentralized finance is quite different to centralized finance. Let’s take an example to understand this better. Let us suppose that you presently have a standing capital of $1000. Now, if you want to lend this capital to a potential borrower, you can do it several ways:
- You can lend it by yourself at a fixed interest rate to (perhaps) a friend, or
- You can go to a mediator who will further add more money to it and lend it to the borrower
In the latter case, there are chances that the mediator would like to add $1000 of their own money and then lend $2000 to the borrower at a fixed interest rate of 5%. The borrower will have to pay the money back in, say, 12 months. Thus, whatever money is made by lending is divided between you and the mediator. This mediator can be anyone from a bigger individual lender to a centralized bank.
When you put your $1000 in a bank, it keeps some of your money as reserve for liquidity and takes the other part of it and issues it as a loan to people who want one. Thus they make interest on the loan that they issue, and you earn interest by simply putting your money in a savings account. In a centralized world, all of this is being continuously managed by a bank. This bank has hundreds of thousands of employees, is governed by some rules, follows the regulations set out by the government and so on.
What if we replaced the bank and its employees with a piece of code that does exactly the same thing?
To Decentralized Finance
Let’s say a couple of programmers have teamed up and have written the basic code for an application that manages lending. The code has been written in such a way that instead of a human calculating the interest on how much your save assets can earn, the code does it on the basis of some mathematical formula. Furthermore, when the application lends some money to a borrower, they ask for collateral which they lock before transferring the borrowed assets. The application can further be programmed in a way that it is as secure as possible.
Thus, we have eliminated the need for any centralized human involving authority to help run the decentralized finance application. Most DeFi applications are nothing but protocols that are governed by their underlying code. Thus, you can lend, borrow, stake, earn, and do several other things that you would do in the case of centralized finance.
Where are the applications of DeFi?
Most of the applications in DeFi reside on a blockchain. They are usually deployed on the mainnet of the blockchain network. This gives them another added advantage of complete transparency and traceability. This ensures that if someone does commit any type of fraud, it becomes very easy to apprehend them.
There is an important that must be noted here. Most applications in DeFi are built on the Ethereum blockchain. This is because this blockchain offers several benefits over other networks in terms of the ease of creating applications/tokens and deploying them on the mainnet.
Some Common DeFi Applications
While the space itself is new, with major recognitions only coming in in the past few years, there are several different types of applications within DeFi that have managed to outcompete others.
Decentralized Exchanges (DEX)
As the name suggests, these are exchanges that do not rely on any intermediary to exchange cryptocurrencies. Rather, users are able to trade one token for another on these platforms with the help of code. DEXes are one of the most common applications within DeFi.
A lending/borrowing platform enables users to borrow/lend cryptocurrencies without having to rely on an intermediary. Some DEXes also offer both options on their platforms, and it is quite easy for anyone to do it.
These are the backbone of DeFi. As the name suggests, these are essentially coins that are pegged to a stable value such as that of a dollar. So, a stablecoin such as the USDT is denominated such that 1 USDT ~ 1 USDT.
Stablecoins are also cryptocurrencies, but they are not as volatile as others.
If you hold a certain type of token, then you can deposit it on yield farming applications and earn some interest. These applications are built for more advanced-level traders. Yield farming offers varying returns.
A popular protocol that offers yield farming is Aave.
This is used most frequently on DeFi lending/borrowing platforms. Users can supply liquidity of certain tokens to what are known as liquidity pools. Naturally, the more liquid these “pools” are, the more number of users can borrow from these pools and use the borrowed assets on other DeFi applications.
Most DEXes, such as Uniswap (and even most centralized exchanges such as Binance.
Another common application of DeFi is composability. It refers to the ability of users to create protocols on top of other protocols - this is especially easy because most DeFi applications are open-source.
Can I make money with DeFi?
Yes, you can. There are several ways such as liquidity providing and lending that can be used to earn money in DeFi. The only problem is that because of the complexity of newness of the space, there are chances that some aspects might be a bit hard to understand.