What is DeFi?

by | Mar 16, 2021

What is DeFi

DeFi stands for ‘Decentralized Finance’ and refers to a new capital market with a combination of various financial applications that are being developed on top of blockchain technology. 

The concept of DeFi first emerged with the launch of the Ethereum blockchain network – a decentralized computing program. 

Even though it was Bitcoin that sowed the seed of a truly digital currency facilitated by a distributed ledger. Thus allowing various entities to hold a copy of a history of transactions, replacing the need for a central authority. 

Ethereum, in a truly innovative way, leveraged distributed ledger technology in order to enable distributed computing through the means of smart contracts. Smart contracts are basically self-executing computer programs that are stored on blockchains and automatically execute when their pre-determined conditions are met.

These smart contracts, in essence, paved the path for creating and deploying trade, transactions, or contracts in a truly trustless and permissionless manner. Thus, opening a new gate for innovation and the rise of DeFi.

Cutting Out the Middlemen

DeFi, in essence, makes it possible for a use-case of broader access to financial instruments without the need for a gatekeeper or central authority. This is important because centralized systems and trusted intermediaries are still limited to a handful of developed nations and often show intentional and unintentional bias toward a certain segment of the society. At the same time, these gatekeepers and centralized financial institutions offer their users minuscule control over their finances. 

Bitcoin and all other digital-native assets stand out from legacy digital payment methods, ranging from PayPal and Visa. That’s because cryptocurrencies such as Bitcoin are known to remove the middlemen from transactions. In that way, Bitcoin made it possible for everyone to establish a truly trustless system where you don’t have to trust a value-leaching intermediary.

These value-leaching intermediaries, for long, acted as a rent-seeker in the financial sector. Perhaps, when paying with your credit card for a random purchase, a financial institution may monitor or flag your transaction, and even retain the authority to stop or pause it and record it in its private ledger. But with Bitcoin, such institutions are non-existent. 

Building on top of that trustless system, DeFi ecosystem expands the use of blockchain from a simple value transfer to complex financial application cases.

Now direct purchases aren’t the only transaction or contract which the big companies oversee; financial applications such as loans, crowdfunding, derivatives, betting, etc., are also in much control. Cutting out the middlemen from all types of transactions is one of the basic pros of DeFi. 

A Simple Definition of DeFi

In a purely ideological sense, DeFi can be defined as a form of movement that promotes decentralized networks and open-source software to make various types of financial services and products. The idea is to develop, operate financial DApps (Decentralized Applications) on top of a trustless and transparent framework, such as the permissionless blockchain and all types of peer-to-peer protocols. 

Three Most Considerable Functions of DeFi are; 

  1. Making monetary banking services
  2. Enabling advanced financial instruments such as DEX, derivatives, prediction markets, and tokenization platforms.
  3. Providing peer-to-peer or pooled lending and borrowing platforms.

DeFi & Ethereum

Given the advantage of first-mover, most DeFi applications so far are built on a single blockchain network, named Ethereum, the world’s second-largest cryptocurrency platform. Known to set itself apart from all other early-age blockchain projects, Ethereum implemented the idea of smart contracts on its platform. 

Thus leveraging the processing power of participants of its decentralized network to not only secure the network but also to execute code. That’s why the Ethereum network is called a synonym to a world computer. 

Now, let’s look at the major use cases of DeFi

Lending Platforms 

The Lending markets are one of the most popular use cases of DeFi, that connects borrowers to lenders of cryptocurrencies. One popular platform, known as Compound, permits you to borrow cryptocurrencies or give out loans. Lenders, in exchange for lending out their money, earn interest that is set algorithmically depending on the demand for borrowing.

DeFi lending as of now is only collateral-based, which means to take out a loan, you’ll need to put up collateral— most times, this could be ether, the token that powers Ethereum. That is useful in case you have invested in cryptocurrency and need some money without wanting to sell your crypto assets. One key point here is – DeFi lending platforms don’t ask for your identity or associated credit score to take a loan. Unlike how regular loans operate, DeFi loans don’t set a higher or lower interest rate depending upon your credit score.

Prediction Markets 

Prediction markets are one of the first mover DeFi applications that were built on the Ethereum network. A prediction market platform allows users to bet on specific events’ outcomes, somewhat like forex trade. 

All participants’ goal is to make money, and nothing else, though such prediction markets can sometimes predict outcomes much better than the usual conventional methods, like polling. Some centralized prediction markets with good track records include well-known names as Predictit and Intrade. DeFi can boost interest in prediction markets since centralized prediction markets are often disallowed or banned by governments.

Stablecoins 

The concept of stablecoins (especially, crypto-collateralized and uncollateralized stablecoins) can be said to be one of the important innovations born out of the DeFi space. Cryptocurrencies often experience sharp price fluctuations in-comparison to the equity market that leads to the need for stablecoins. Unlike all other forms of cryptocurrencies, stablecoins are pegged to fiat currency and don’t showcase volatility. 

However, fiat-collateralized stablecoins (for example, USDT & USDC) still rely on a centralized system or bank, thus negating the whole point of decentralization. Therefore, the need for truly decentralized stablecoins leads to the birth of multi-crypto-collateralized stablecoin such as DAI (a stablecoin launched by MakerDAO).

Conclusion

All being said, there’s no doubt that the whole DeFi ecosystem is still in very early stages. It would be interesting to see how it rolls out to the mainstream audience across the globe in the coming years. Hopefully, that day is not far, when every human being will be able to get access to basic financial services right from their smartphone. A world in which everyone can be their own bank. 

Written By Narender Charan

Head of Content Marketing @ HyperLinq. His love for Chai and mountains precedes everything. Often wonders about things like, "why $1 earned through leverage feels 100x better than $1 earned selling your time?"
Disclaimer

Posts on the HyperTrader blog and associated HyperLinq websites are for educational and informational purposes only. These posts should not be taken as financial advice, nor are they meant to be viewed as trading advice. HyperLinq Inc. or the authors take no responsibility for any damages or losses.

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