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What is DeFi in simple words

DeFi is a relatively new concept in the cryptocurrency space. This English abbreviation stands for Decentralized Finance. Basically, the DeFi realm is the same services as classic finance. They are provided in cryptocurrencies and built on crypto protocols and smart contracts.

In the DeFi sphere, you can do the same actions as in CeFi (centralized finance), but faster and cheaper. It is so because they do not have an intermediary in the form of a bank, hedge fund, exchange, etc. Here everything is done by smart contracts that do not ask for food, can work around the clock and (almost) for free.

DeFi already has:

  • Decentralized exchanges where you can trade without an intermediary in the form of a broker: these are Uniswap, SushiSwap, PanCake, etc .;
  • Platforms for receiving money on loan (and giving money at interest) – Aave, Compound, etc.,
  • Platforms for profitable pharming (yearn.finance);
  • Services for creating your own stablecoins and managing monetary policy (MaderDAO);
  • Portfolio rebalancing services (TokenSets);
  • Risk hedging instruments (Nexus Mutual);

And many other features inherent in centralized finance.

A nice thing about DeFi is the fact that in such services, no one will ask you for a certificate of income, evaluate your credit history. And also look at your age and generally subjectively evaluate you before providing any service. And in many cases you will not even be asked for documents.

Market size in DeFi

In the DeFi sphere, market size or capitalization is not just the value of all DeFi tokens, but the value of tokens locked in smart contracts of protocols as collateral and tokens with voting rights.

All DeFi transactions require collateral. This is one of the main principles of DeFi: borrowers need to block (i.e. deposit) their funds in order to receive loans. Lenders also need to block their funds, which will be used to issue loans to borrowers. This is to minimize risks. For example, in order to receive a DAI stablecoin in the form of a loan in exchange for ETH (as in the Maker protocol), you need to deposit (block) in the form of ETH in a ratio of 1.7: 1. That is, for every dollar received in DAI, you need to deposit $ 1.7 in ETH. After the loan is repaid and the loan is paid off, the blocked ETH is returned to the user. The cost of a loan in the same Maker is 8.5% per annum. Compare with the cost of consumer loans in Russian banks.

The same applies to projects where you can lend cryptocurrency, and exchanges. Naturally, there the lender or trader places his funds into a smart contract, which will then be used in issuing a loan or in trading.

The sum of all blocked funds in DeFi is indicated by the abbreviation TVL (total value locked). TVL is the main metric by which you can judge the development of a particular DeFi project or the entire industry.

The main purpose

DeFi’s obvious goal is to provide access to finance to anyone. It doesn’t matter where you live, what kind of government you have, what is the rate of inflation in your country’s fiat (traditional) currency – you always have access to money. Here you contact the counterparty directly, without additional intermediaries in the form of banks, insurance companies, and so on. Often on the Internet, residents of countries with weak economies, underdeveloped financial institutions and high inflation rates are named as one of the main beneficiaries of DeFi. Indeed, in such countries it is much easier and more profitable, for example, to borrow money at 10% per annum than to go to a local bank and take out a loan at 150%.

However, not only underdeveloped countries will become DeFi users. Regions with strong economies will also have strong demand for DeFi services and services. For example, lending and receiving interest on your capital will be more profitable than in traditional finance. An example is the Gemini exchange by the Winklevoss brothers. There you can borrow your funds and receive a stablecoin yield of 7% per annum. It is unthinkable in Western banks, where the deposit rate is already around 1% per year (and European banks generally charge fees for keeping money on deposits).

DeFi Key Benefits

Decentralization and lack of external management. Yes, the same decentralization, which has already made everyone sore, and here it acts as the main advantage. There is no regulatory body of any kind, so here a smart contract acts as an arbiter and at the same time an executor. The rules of the game are known in advance, and the user can accept the rules for using this or that service or refuse it.

  • Transparency
    The source codes for DeFi applications and smart contracts are open, and anyone can view them for bugs and functionality.
  • Anonymity of transactions
    All transactions in the DeFi-sphere are anonymous (not to be confused with the anonymity of services, which may require the KYC procedure – Know Your Customer).
  • General availability
    To use DeFi, you just need to have a certain amount of coins on your crypto wallet and be connected to the Internet.
  • Ease of use
    DeFi has a flexible user experience. If the user does not like the interface of any application, he can use a third-party service or create his own interface.
  • DeFi constructor
    Another advantage of DeFi is interoperability, i.e. building new DeFi services on top of others. DeFi allows you to create new applications by combining previously created ones. For example, you can release new stablecoins in some DeFi services, create new landing protocols, new exchanges, etc. An example of this approach is the Yearn.Finance service, a decentralized finance lending protocol. It integrates multiple DeFi platforms to maximize the user’s return on investment. This service automatically rebalances the user’s portfolio in order to maximize the return on investment.

Scope of DeFi

Already, the field of application of DeFi services is very extensive, and in the future it will only expand, offering more and more new schemes and interesting solutions. Let’s take a quick look at some of the uses of DeFi.

  • Release of stablecoins
    Stablecoins are crypto coins, the value of which is rigidly tied to the underlying asset (for example, the US dollar). Among such platforms, one can distinguish MakerDAO (Dai stablecoin, and here ETH acts as collateral for Dai).
  • Non-custodial landing sites
    In the field of finance, a custodian is an organization that keeps depositors’ funds, at the expense of which it issues loans to other market participants. Banks are examples of such organizations. In the DeFi sphere, there is no custodian; all interaction between the borrower and the lender takes place through a smart contract. Among such sites, one can distinguish the same MakerDAO, Aave, Compound and others.
  • Decentralized exchanges
    Such exchanges (DEX) operate on the basis of blockchain and smart contracts. To trade on these exchanges, you do not need to go through the KYC procedure and disclose your identity. Among DEX-exchanges, Uniswap can be distinguished as one of the most successful and fastest growing. In addition to trading, this exchange also offers options for obtaining / providing loans.
  • Creation of synthetic assets
    Synthetic assets are those assets that are created on the basis of other instruments (stocks, options, futures, etc.). Their price changes exactly in line with the underlying asset. For example, there may be a synthetic asset for the S & P500 index futures. In this case, everyone who owns one such asset would make a profit or loss corresponding to the price of the S & P500 index futures. Synthetic crypto assets can be useful for hedging risks, for arbitrage operations, or simply trading such an asset in conditions of low liquidity of the underlying asset. In addition, “synths” are also interesting because you can trade them and profit from their operations without leaving the cryptosphere and without setting up an account on a classic exchange.

Disadvantages of DeFi

At the same time, the DeFi sphere is not without its shortcomings, which can now be called “childhood diseases”.

  • Low liquidity
    Still, it should be admitted that there is a lack of liquidity on the DEX exchanges and in the DeFi industry in general. That is, there is not a large enough volume of capital on exchanges, blocked in smart contracts. Low liquidity leads to slippage. There are situations when, as a result of sharp price movements, traders’ positions are closed not at their declared price, but at a less profitable one. In addition, the small capital in DeFi loans does not yet allow large amounts of loans, and lending is limited to a small loan size.
  • High volatility
    The entire crypto industry is still quite young, and by the standards of traditional finance, its age is ridiculous. It’s no joke, the world’s stock exchanges date back to the 16th century, while the main cryptocurrency – bitcoin. It is only 12 years old now. Of course, there is less money in the cryptosphere now than in traditional finance. This leads to the fact that crypto trading is more prone to emotional movements and higher volatility.
  • Hacking smart contracts
    Not all smart contracts are reliable, and not all teams that develop them are competent enough to anticipate all possible bugs and security aspects.

Profitable farming

In the DeFi environment, there is such a type of income as yield farming (profitable farming). It is a providing any service with its crypto assets, which are then sent to users in the form of loans. Providers receive a certain percentage or native service tokens for providing liquidity. Thus, any person who owns any cryptoasset can receive passive income with it, and not just keep it in his wallet according to the “buy and hold” strategy.

Profitable farming can, to some extent, be compared to staking coins in PoS protocols, because both there and there the user blocks his funds and keeps them in a pool. The longer his funds remain blocked, the more the user will earn. Technically, however, these processes are different. In staking, the reward is the commission on transactions on the network, while in pharming, profit is generated from interest income on loans.

Apparently, DeFi finance is just beginning to emerge in the economy. With their vast capabilities, there is no doubt that they have a long journey ahead of them. DeFi provides access to money for everyone, it is uncensored and has no central control body. All of this attracts people to DeFi, and the industry is showing high growth rates. With the flow of funds from classic finance to DeFi, growth will be explosive, and then many native coins will show their Xs. This primarily applies to ETH, since now the lion’s share of all DeFi works on the Ethereum blockchain. And, given the imminent transition to Ethereum 2.0, we can expect a multiple growth of ETH over time.

Disclaimer: This article is not investment advice. Assess the risks yourself before making any investment decisions.

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