It basically stands for Decentralized Finance, so instead of a bank or government controlling the flow of money which is Centralized Finance, in Defi, there are no banks or government thus no censorship and rules are defined in code.
Defi consists of 3 things:
- Smart Contracts
Decentralized finance is made up of five pillars these are:
- Stable coins
- Lending & Borrowing
- Decentralized Exchanges
- Margin Trading
Stable coins are basically cryptocurrency tokens/coins pegged to a dollar in the physical world, meaning when you buy a stable coin from a decentralized/centralized exchange a dollar is minted in the physical world to back it, which in turn brings stability to the asset.
Examples of popular stable coins:
- USDC was created by Coinbase.
- BUSD was created by the biggest centralized exchange in the world, Binance.
- Tether or USDT was created by Reese Collins
- DAI created by MakerDAO
Lending & Borrowing
Our physical financial system is built on lending and borrowing, and because Defi aims to replace Cefi, lending and borrowing do exist but with some rules.
A simple example in the real world is when you borrow from a bank, you provide collateral for security so that if you default on your loan and the bank can sell the asset and at least get back close or all of the amount borrowed, it can be a car or house.
In Defi it's different, since there is no bank, you borrow from a pool of funds provided by lenders part of the network who expect to get a profit from lending their assets. To enable that crypto/Defi loans are overcollateralized meaning in the case of a bank you can get a loan of $1.5 million dollars collateralized by an asset of the same or lesser value than that but in Defi, you will have to collateralize an asset may be close to $2.5 million to get the $1.5 million dollar asset, that is ~66% more.
You might be thinking why would I borrow then, it doesn't make sense. Most of the time borrowers provide volatile assets like Ethereum, and to get a stable coin, in our previous example they put down $2.5 million of Ethereum and get $1.5 million of USDC, they can use that for emergencies or trading and within that time Ethereum's price could go up by 10%, that means the Ethereum they collateralized is now worth $2.75 million, the person could pay back the loan of $1.5 million and get back their Ethereum that is worth $2.75 million so they make a profit. So what happens if the price of Ethereum goes down, well in that case the smart contract (which is literally code) liquidates the collateralized Ethereum to give back the money to the lenders with interest thus the over-collateralization.
The good thing about Defi loans they don't have a fixed time limit like banks do.
Some great lending and borrowing platforms include:
Decentralized Exchanges (DEX)
These are exchanges run by code, they only change when the code changes meaning no government can shut it down or an organization. They allow traders to exchange tokens or coins example exchange Ethereum with Tether.
DEXs are really cool because you can trade coins/tokens at any time provided there is a liquidity pool for them. What is a liquidity pool? it's a crowdsourced pool of cryptocurrency/token pairs like ETH/USDC, that allows other people to trade that asset.
More on liquidity pools in the next article.
You can easily make money from such exchanges with strategies like Arbitrage Trading, which is trading that exploits the tiny differences in price between identical assets in two or more markets.
Examples of the biggest DEX's include:
Some of the advantages of DEXs over CEXs is:
- You control your wallet, unlike in CEXs like Coinbase where you share a wallet
- DEXs can't be shut down as they are decentralized and run by code(code is the law in Defi) unlike CEXs like Binance that shutdown trading on assets during mass-selloffs.
- Minimal transaction charges
- You can trade any limit unlike CEXs
- No need to provide KYC(know your customer) info such as picture, national id, or passport in order to use them.
Insurance is a means of protection from financial loss. It is a form of risk management, primarily used to hedge against the risk of a contingent or uncertain loss.
This sector also exists in Defi where you can protect both your coins/tokens/NFTs to physical assets like a farm/house and even hurricane insurance.
Some platforms that exist to facilitate this include:
Margin trading refers to the process whereby individual investors can invest more than they can afford to, an example I can have $20 dollars and I want to invest in Ethereum, $ETH, which at the time of this writing costs around ~$4300, the platform can allow you to trade with 10x your amount, so that means I put my $20 dollars but with 10x leverage, I am basically trading with $200 dollars, so if the price of Ethereum goes up by 4% I make 40% and vice-versa.
An example of a platform that allows margin trading is Perpetual Protocol that allows up to 10x leverage.
- Because code is the law, there are instances where the smart contracts deployed contained bugs that hackers exploit and get away with millions of dollars example a Defi platform called PancakeBunny, the flash loan(basically is a loan with zero collateral that you have to pay back within 10 seconds) feature got exploited, with the hacker getting away with $45 million, this ended up tanking its token.
- Some developers create Defi platforms to make away with people's money, what is known as a Rug pull. An example a developer can add specific instructions to the smart contract to prevent users from selling their token/coin after an exchange with a valuable token.
This leads to a lack of trust for newbies getting into Defi because of the bad reputation.
How can you prevent this?
- Defi is mostly open-source, meaning developers expose their whitepapers, smart contracts, and code to the world for other developers to fork or even track bugs, this gives newbies to go through to better make confident decisions.
- There are audit firms some paid or open-source that audit Defi platforms' smart contracts, grade their security, and expose their findings publicly, this also helps to make confident decisions.
- Avoiding un-audited platforms.
- Check the total value locked(TVL) within the platform and take note of how many addresses control liquidity in a specific coin/token pair, the more the better. You can get such info from analytic platforms like Dune Analytics.
There are other sectors that make up the Defi such as gambling, an example is Sportx that allows users to socially bet on football, soccer, tennis and so much more.
Stay tuned for more articles on the Defi category, if you have any questions join my Discord server.