What is DeFi?

2021-03-05 | CryptoCurrency.ong

DeFi stands for Decentralized finance. DeFi is a public financial infrastructure / system based on digital devices, procedures, smart contracts and decentralized applications (DApps), mainly in the Ethereum blockchain.

The essence of DeFi

DeFi's aim is to provide tangible, everyday financial services on a blockchain basis, leveraging the potential of technology. Following the release of Bitcoin in 2009, the only purpose of various blockchain systems was to allow the movement and transfer of a single cryptocurrency. Satoshi Nakamoto's work was capable of much more, however, as it happened in the Ethereum system.

The essence of DeFi is to allow complex financial transactions between several actors through smart contracts; lending is a great example of this. It is, in fact, much more than “just” moving a digital device, a cryptocurrency, since each DeFi lending project works with liquidity pools that are charged by the users, who receive interest, i.e. a commission for their contribution. The interest rate is determined by the system, but not arbitrarily: it is continuously adjusted to the current rates of supply and demand. A decentralized exchange (DEX) operates on a similar principle, with the difference that the goal here is not to take out borrowing, but to take advantage of changes in exchange rates. Here, too, liquidity reservoirs need to be replenished for users to create trading opportunities in the system.

The most popular types of DeFi applications are the following:

• decentralized exchanges (DEXs): these are online exchanges that 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: it is a cryptocurrency that is tied to an asset outside of cryptocurrency (fiat currencies like the dollar or euro) to stabilize the price
• lending platforms: these platforms use smart contracts to replace intermediaries such as banks. One popular platform, for example, is Compound - they allow users to borrow cryptocurrencies or offer their own loans. Their users can make money off of interest for lending out their money. compound sets the interest rates algorithmically, so if there’s higher demand to borrow a cryptocurrency, the interest rates will be pushed higher.
  
• "wrapped" bitcoins (WBTC): this is 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.
  
• prediction markets:  prediction markets are markets for betting on the outcome of future events, such as presidential elections in different countries. The goal of of prediction markets in the DeFi ecosystem is to offer the same functionality but without intermediaries.
  

New DeFi concepts that have emerged due to the DeFi apps

• yield farming: this is for knowledgeable traders who are not afraid of taking risks. Here, users scan through various DeFi tokens in search of opportunities for larger returns.
• liquidity mining: this happens when DeFi applications entice users to their platform by giving them free tokens. This has been the hottest form of yield farming so far.
• composability: DeFi apps are open source, i.e. the code inside of them can be viewed and modified by anyone. Therefore, these apps can be used to "create" new apps with the code as its building blocks.
• money legos: DeFi apps work like legos, the toy blocks children click together to construct buildings and other objects. DeFi apps can be similarly snapped together like "money legos" to build new financial products.

Is investing in DeFi safe?

No, it’s still risky, although many believe DeFi is the future of finance and that investing in the disruptive technology early could lead to massive gains. As DeFi has increased in activity and popularity through 2020, many DeFi applications, such as meme coin YAM, have crashed and burned, sending the market capitalization from $60 million to $0 in approximately 35 minutes. Other DeFi projects, including Hotdog and Pizza, faced the same fate, and many investors lost a lot of money.