Decentralized Finance or DEFI
DEFI or decentralized finance, although, has captured only 5% of the cryptocurrency market but has shown massive growth from 4 Billion $ to 93 Billion $ in just 3 years. To understand DEFI we first need to know what centralized finance means and what are the irregularities present currently in the CEFI system.
CEFI, or Centralized Finance is the ecosystem that we currently have which contains many players such as banks, stock markets, insurance companies, and various other financial institutions. We realized the need for a decentralized financial system after the 2008 financial crisis for the following reasons:
- All services rely on a central authority
- Since these have heavy regulations or are governed by individuals, thus they are prone to mismanagement, fraud, and corruption.
Hence came the idea for DEFI.
DEFI is an ecosystem in creation that will be governed by none and will be processed using programs. This would be completely decentralized and would remove irregularities present in the current financial system. These would be using decentralized money like certain cryptocurrencies. These cryptocurrencies will be programed for automated services for which we would have to build decentralized exchanges, decentralized lending services, decentralized insurance companies, and other organizations.
Now we all have heard about Bitcoin, so what’s the difference between Bitcoin and DEFI.
Bitcoin is one of the forms of currency that we could end up using in the DEFI ecosystem. Think about it this way,
Bitcoin is the Dollars, Rupees, Euros, and Pounds that we have, whereas the DEFI will also contain banks, stock markets, insurance companies, financial institutions, and many more. DEFI is the power set, whereas Bitcoin is one of the subsets of DEFI.
Components required to build a DEFI ecosystem-
- Decentralized Infrastructure
- Decentralized Money
- Decentralized Exchange or DEX
- Decentralized Money Market
- Decentralized Insurance
We require a platform to build and deploy DEFI services, which can be done using a platform called Ethereum.
Ethereum is a DIY platform for writing DEFI programs called Dapps. Using Ethereum we can write automated codes, also called smart contracts used for creating any financial service for a DEFI environment. This means rules are determined by investors who build the app and in the form of votes they decide the rules to be put in service and depending on those rules only these Ethereum-deployed programs work and the control over these apps is lost; ie these programs become immutable.
Any DEFI infrastructure built would lay waste if we did not have decentralized money, and it is also the most critical and toughest part of creating a DEFI ecosystem.
Although we have many decentralized cryptocurrencies such as Bitcoin, Ether (Ethereum’s currency) however, they have many problems. Bitcoin is although decentralized but has only basic programmable functions and is also not compatible with the Ethereum platform, whereas Ether even though being compatible and programmable has very high volatility due to which it is not the suitable choice to be used as currency since for a strong DEFI financial system we require a more stable currency to operate within this system.
Hence we use Stable Coin. The Stable Coin is a cryptocurrency pegged to the value of a real-world asset such as the US Dollar. However, for DEFI we require money that doesn’t use a flat money reserve for maintaining stability as it would mean having a virtual central authority governing the cryptocurrency.
Thus we use Dai-stable coins, which are a cryptocurrency pegged to the value of the US Dollar i.e. 1Dai=1$. You might be thinking that what differentiates Dai from Stable coins. Dai is not backed by US Dollar reserves; rather it is backed by crypto collaterals that can be used publicly on the Ethereum blockchain. Dai is over collateralized, which means effectively that 1 $ worth of Ether locked in deposits could buy me 66 cents worth of Dai, and if I wanted, my ether back then I would pay Dai and the ether would get released. If we do not have Ether as collateral then we can buy Dai on exchange.
Since Dai is over centralized, even if ether’s price becomes extremely volatile, the value of locked Ether backing the Dai circulation would be of 100% value or more.
Dai also uses the Smart Contract on the Ethereum platform; thus Dai is a truly trustless & decentralized Stable Coin that cannot be shut down or censored and perfect form of money for DEFI Services.
Decentralized Exchange or DEX-:
Exchanges apply according to a set of rules or smart contracts to buy, sell or trade cryptocurrencies.
When we trade in DEX, we require no exchange operator, no sign-ups, no identity verification & no withdrawal fees. Rules enforced by smart contracts execute trades, secure and handle necessary funds.
Unlike CEFI, no need to deposit funds into an exchange account before conducting trade, thus preventing exchange hacking.
Decentralized Money Markets-:
These are the services that connect borrowers with lenders.
The compound is an Ethereum-based app for borrowing and lending Dai, which effectively means that we can lend our crypto and earn interest on it. Compound connects borrowers and lenders, enforces terms of loan and distributes interests.
The process of earning interest on crypto has become popular and is also called yield farming.
It is a DEFI platform with people who are willing to take insurance & people who are willing to insure in return for a premium. Here everything happens autonomously without any insurance company or agent in the middle.
DEFI services work in conjunction with each other which makes it easier to mix and match different services and hence these services are also called Money Lego.
Here I have demonstrated a DEFI service :
Risks associated with DEFI system-:
- DEFI is still in its infancy
- Hackers have found creative ways to exploit loopholes in the existing system.
- Some services still can be only partially centralized or the system is decentralized only as its central components.
- No KYC is done as there is not an account that collects information on one’s trading.
- DEFI has lots of risks due to lack of regulations.
Hence DEFI is in it’s early stage & in coming years we may get to know whether it enters the mainstream of finance.