8 min read
02 Mar
02Mar

Decentralized finance (DeFi) offers financial instruments without relying on intermediaries such as brokerages, exchanges, or banks by using smart contracts on a blockchain. DeFi platforms allow people to lend or borrow funds from others, speculate on price movements on assets using derivatives, trade cryptocurrencies, insure against risks, and earn interest in savings-like accounts.

DeFi uses a layered architecture and highly composable building blocks. Some applications promote high interest rates but are subject to high risk. 

Decentralized finance - also known as DeFi - is at the forefront of much of the innovation happening in the financial world today. Built using blockchain technology it allows consumers to access many of the same services as in the traditional financial system but with more transparency and accessibility.And as the financial landscape changes, it will create even more services. Using smart contracts and the underlying DeFi architecture, you can borrow money, invest, buy insurance and more.But how does DeFi actually work? Keep reading to find out the central characteristics of decentralized finance, its uses, and its risks.

Content

  • What Is DeFi (Decentralized Finance)?
  • How Does DeFi Differ From Traditional Finance?
  • How Is DeFi Built?
  • What Can You Do With DeFi Today?
  • Ethereum and DeFi
  • Ethereum applications
  • How to Build DeFi
  • Is It Safe to Use?
  • Conclusions

What Is DeFi (Decentralized Finance)?

DeFi is an alternative financial system created using blockchain technology.

DeFi is an open-source alternative to the traditional financial system, providing more transparency and accessibility. 

DeFi allows consumers to do many of the same things as with the traditional financial system but in a more transparent way. It operates primarily using smart contracts, which are automated agreements that self-execute once certain conditions have been met.

How Does DeFi Differ From Traditional Finance?

In many ways, DeFi replicates traditional financial systems.DeFi allows you to do many of the same activities as with traditional financial system, including:

  • Investing
  • Sending money
  • Borrowing
  • Lending
  • Saving

While DeFi and traditional finance have plenty of the same functions, it all happens entirely differently.

  • Transparency

Decentralized finance is generally transparent.

  • Permissionless

Another difference between DeFi and the traditional financial system is the lack of permission to both create and participate.But because DeFi has no such regulations, anyone can join the space and create apps and financial startups.

  • Operating Hours

Most traditional financial companies open only during certain times of the day.But DeFi doesn't abide by operating hours.That's not to say there are no advantages to the traditional financial system. 

How Is DeFi Built?

Decentralized finance is built on a multi-layered architecture known as a “software stack.” Each layer builds on the others. This creates the system on which all DeFi transactions operate.Here are the five components of DeFi's architecture:

  • Settlement: This first layer forms the foundation that the rest of DeFi builds upon. This layer is made up of the blockchain and its native protocol asset (primarily either Bitcoin or Ethereum).
  • Assets: This second layer holds all the cryptocurrencies and other assets of DeFi. This includes NFTs - or non-fungible tokens, explained later in this article.
  • Protocol: The standards (protocols) for various tasks and activities make up this layer. Protocols are implemented through smart contracts and are specific to each of the different activities of DeFi, such as crypto exchanges, debt markets and derivatives.
  • Application:
  • Aggregation: This top layer expands the application layer.
The Five Layers of DeFiSource: Federal Reserve Bank of St. Louis

The Five Layers of DeFi Source: Federal Reserve Bank of St. Louis 

What Can You Do With DeFi Today?

As decentralized finance becomes increasingly popular and versatile, the list of things you can do with it continues to grow.

  • Send Money

One of the first features that made DeFi attractive is the ability to send money anywhere in the world immediately and affordably.

  • Store Money

Just as you would use a traditional bank to store your money, DeFi allows you to store your own currency using a crypto wallet.

D'CENT Biometric Wallet
D'CENT Biometric Wallet

D’CENT Wallet is created by IoTrust (Korea), a company founded by security experts with over 15 years of security know-how and engineering experience in developing deeply embedded security solutions based on secure-chip technology (SE and TEE). D’CENT Wallet aims to protect users’ digital assets by combining software and hardware security solutions. Users have the choice of using the Biometric Wallet, Card type Wallet, or the Software Wallet.


  • Borrow and Lend

DeFi makes borrowing and lending easier and more accessible.Unlike borrowing in the traditional financial system, borrowing with DeFi doesn't require you to disclose your identity or be subject to a credit check.

DeFi also works well for those who may have a hard time borrowing in a traditional setting.

  • Trade Cryptocurrencies

One of the very cornerstones of DeFi — and what many people know it for — is the ability to buy and sell cryptocurrencies. Centralized crypto exchanges act similarly to traditional stock trading platforms. There's a central power, and you must disclose your identity and deposit assets, often by connecting your bank account.

  • Trade Tokens

Cryptocurrencies aren't the only things you can trade on DeFi.You can purchase tokenized versions of traditional stocks, exchange-traded funds (ETFs) and other financial assets.For example, you could buy a tokenized version of Tesla stock.

Or buy (and sell) NFTs, digital assets that represent real assets.

  • Crowdfunding

Just like you can use the traditional financial system to crowdfund for your ideas, you can use decentralized finance to do the same.

  • Buy Insurance

Another feature of DeFi is the ability to buy insurance. According to Ethereum's website, DeFi insurance is more affordable, automated, transparent and quicker to pay out. Types of insurance coverages in the works by the company Etherisc provide protection for flight delays, hurricanes, crypto wallet theft, death or illness, and more.

Ethereum and DeFi

Bitcoin and its blockchain technology were the first on the market.

Ethereum's blockchain technology is easier to use than Bitcoin's.The Ethereum project is currently in the process of creating Ethereum 2.0, which is a set of upgrades designed to make Ethereum technology and DeFi more scalable, secure and sustainable. 

Ethereum applications

Most decentralized finance applications are built on top of Ethereum, the world’s second-largest cryptocurrency platform, which sets itself apart from the Bitcoin platform in that it’s easier to use to build other types of decentralized applications beyond simple transactions. These more complex financial use cases were even highlighted by Ethereum creator Vitalik Buterin back in 2013 in the original Ethereum white paper.

That’s because of Ethereum’s platform for smart contracts – which automatically execute transactions if certain conditions are met – offers much more flexibility. Ethereum programming languages, such as Solidity, are specifically designed for creating and deploying such smart contracts.

For example, say a user wants his or her money to be sent to a friend next Tuesday, but only if the temperature climbs above 90 degrees Fahrenheit according to weather.com. Such rules can be written in a smart contract.With smart contracts at the core, dozens of DeFi applications are operating on Ethereum, some of which are explored below. Ethereum 2.0, a coming upgrade to Ethereum’s underlying network, could give these apps a boost by chipping away at Ethereum’s scalability issues.

The most popular types of DeFi applications include:

  • Decentralized exchanges (DEXs): Online exchanges help users exchange currencies for other currencies, whether U.S. dollars for bitcoin or ether for DAI. DEXs are a hot type of exchange, which connects users directly so they can trade cryptocurrencies with one another without trusting an intermediary with their money.
  • Stablecoins: A cryptocurrency that's tied to an asset outside of cryptocurrency (the dollar or euro, for example) to stabilize the price.
  • Lending platforms: These platforms use smart contracts to replace intermediaries such as banks that manage lending in the middle.
  • "Wrapped" bitcoins (WBTC): A way of sending bitcoin to the Ethereum network so the bitcoin can be used directly in Ethereum's DeFi system. WBTCs allow users to earn interest on the bitcoin they lend out via the decentralized lending platforms described above.
  • Prediction markets: Markets for betting on the outcome of future events, such as elections. The goal of DeFi versions of prediction markets is to offer the same functionality but without intermediaries.

In addition to these apps, new DeFi concepts have sprung up around them:

  • Yield farming: For knowledgeable traders who are willing to take on risk, there's yield farming, where users scan through various DeFi tokens in search of opportunities for larger returns.
  • Liquidity mining: When DeFi applications entice users to their platform by giving them free tokens. This has been the buzziest form of yield farming yet.
  • Composability: DeFi apps are open source, meaning the code behind them is public for anyone to view. As such, these apps can be used to "compose" new apps with the code as building blocks.
  • Money legos: Putting the concept "composability" another way, DeFi apps are like Legos, the toy blocks children click together to construct buildings, vehicles and so on. DeFi apps can be similarly snapped together like "money legos" to build new financial products.

How to Build DeFi

One of the central characteristics of decentralized finance is that anyone can participate.

  1. Install Truffle and Ganache.
  2. Create an ERC20 token.
  3. Compile the ERC20 token.
  4. Deploy the ERC20 token.
  5. Create a FarmToken smart contract.

Visit Ethereum's website for a more in-depth guide to creating and launching a DeFi project. 

Is It Safe to Use?

It's important to note that while DeFi is becoming increasingly popular and has more uses than ever before, it still comes with plenty of risks.

First, unlike the traditional financial system, DeFi isn't heavily regulated. Traditional banks follow regulations to protect customers. And if you store your money in a bank and the bank goes out of business, FDIC insurance kicks in to protect your money.

A second risk of decentralized finance comes with the technology.

Third, DeFi investments come with plenty of risk of losing your money.

Benefits Of Defi

  • DeFi is permissionless. It lacks many of the gatekeepers that exist in the traditional financial system, so anyone can participate.
  • Defi is transparent. Anyone can analyze and audit the code because blockchain is an open-source technology.
  • DeFi reduces time and cost. Many of the transactions that you do in the traditional financial system can be done more quickly and affordably using DeFi.
  • There's less room for human error. It runs off automated technology rather than individuals.

Risks And Downsides Of Defi

  • There can be bugs in the technology. And because smart contracts are automated, it's difficult to repair these bugs later.
  • Cryptocurrency and tokens are volatile investments. If you rely entirely on DeFi for investing, you risk your entire portfolio.
  • It isn't regulated like the traditional financial system is. As a result, consumers have fewer protections.
  • There's more room for fraud. According to the Securities and Exchange Commission (SEC), there's been an increase in scams and fraud cases surrounding digital assets.

Conclusions

  • DeFi offers financial instruments without relying on intermediaries (brokerages, exchanges, banks) by using smart contracts on a blockchain. DeFi allow people to lend, borrow funds from others, speculate on price movements on assets using derivatives, trade crypto, insure against risks, and earn interest in savings accounts.
  • DeFi is an open-source alternative to the traditional financial system, providing more transparency and accessibility.
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