Okay so you know DeFi stands for Decentralized Finance.
You probably also know that by decentralized it means that no entity, such as a third party or an intermediary, has control.
But how does it all work?
Decentralization is described as the process by which the activities of an organization, especially those relating to planning and decision-making, are distributed or delegated outside of an authoritative central location or group.
Thanks to decentralization, the assets of platforms like Bitcoin eliminate the intermediaries of transactions.
The advantages of a decentralized currency such as bitcoin include:
- Permissions – which means that users do not need the authority of third parties such as banks and governments to use the money. It’s free and open for use worldwide.
- Bitcoin is immune to seizures
- Using a computational algorithm called proof of work (PoW), no one is able to block or censor your operations
- P2P transactions are very cheap also, much less than central payment networks like PayPal, Visa or MasterCard
SEE ALSO: Understanding DeFi Prediction Markets And Why They’re Always Right
By decentralizing money, third-party institutions such as banks, governments, etc. cannot make rules and earn income by exchanging money.
DeFi brings benefits to financial applications which include:
In DeFi, the above financial aspects are decentralized using smart contracts programmed on blockchains like Etherem and Solana, designed to create a wide range of decentralized applications in addition to currency.
Smart contracts automatically execute transactions if certain conditions are met.
While bitcoin only supports sending transactions, a platform like Ethereum based on smart contracts can add conditions to a transaction.
For example, a user wants to send money to a friend next Tuesday, but only if the temperature exceeds 90 degrees Fahrenheit according to weather.com. Such rules can be written in a smart contract.
Based on the above, DeFi applications can be designed to offer different solutions to meet different financial needs based on pre-programmed conditions. No one is therefore needed to check whether the conditions are met.
Smart contracts have spawned a creative trend across the world with many solutions coming day by day.
Here are 4 of DeFi’s most popular apps:
Decentralized exchanges (DEX)
A decentralized exchange is a peer-to-peer (P2P) marketplace that connects buyers and sellers of cryptocurrencies. Unlike centralized exchange platforms like Coinbase and Binance, users have full custody of their funds on DEXs since they own their private keys.
In the absence of a central authority, DEXs use smart contracts that automatically execute under defined conditions and record every transaction on the blockchain.
Examples of popular DEXs include Uniswap, Curve, PancakeSwap, and Sushiswap which allow users to trade crypto.
These platforms connect lenders and borrowers using smart contracts essentially replacing middlemen like banks that handle loans as middlemen.
Popular lending platforms include Aave and Compound.
On Compound, users can borrow cryptocurrencies or offer their own loans. Users can also earn interest by lending their money. The compound sets interest rates algorithmically, so if there is a higher demand to borrow a cryptocurrency, the interest rates will be pushed higher.
DeFi loan is collateral-based, which means that in order to take out a loan, a user must provide collateral – often ETHER, the token that powers Ethereum. It also means that users do not disclose their identity or associated credit rating to take out a loan, which is the normal way non-DeFi loans work.
Another way to generate “passive income” on some of the mentioned lending platforms includes yield farming. This has the potential for even greater returns, but with greater risk. It allows users to take advantage of the ready aspect of DeFi to put their crypto assets to work by generating the best possible returns.
Stablecoins are tokens that fuel the DeFi economy by providing a stable medium of exchange.
Popular stablecoins include USDC and USDT. They are crypto assets whose value is generally indexed to the value of a dollar, offering a stable solution for example to earn interest rather than one whose value fluctuates.
These DeFi applications allow users to bet on the outcome of an event.
One of the most popular predictions was, “Will Donald Trump win the 2020 presidential election?” “
In the world of finance, participants trade with contracts whose payout will vary depending on the outcome of a future event. Prediction markets make the outcome of this future event negotiable.
While the goal of participants in prediction markets is to make money, sometimes these markets can predict outcomes better than conventional methods like surveys.
Examples of DeFi applications in this category include Gnosis, Polymarket, Augur, and PlotX.
DeFi is a new financial technology, experimental and not without problems, especially in terms of security or scalability. Many efforts are underway to improve the technology, and in particular since DeFi has attracted the interest of large institutional players.
A recent report from Chaialysis indicated that institutional players drive most of the activity on DeFi, and not necessarily independent users.
When it comes to scalability, where different projects face the challenge of exposing their service to a larger user base due to slow and expensive transactions, different solutions have emerged:
- Ethereum, the main DeFi platform, is moving to Ethereum 2.0, where it will use a concept called sharding which involves breaking up the underlying database into smaller chunks that are more manageable for individual users.
- THElevel 2 solutions like Polygon sidechain which offers cheaper and faster transactions for DeFi applications along Ethereum
- The emergence of high performance smart contract blockchains like Solana
Many believe that various DeFi projects have the potential to attract hordes of new users by making financial applications more inclusive and open to those who traditionally do not have access to such platforms.
RECOMMENDED READING: Celo Partners With Leading DeFi Projects In $ 100 Million Initiative To Bring DeFi To Developing Countries
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