In the past, people have always used centralized finance (CeFi), in which a central authority regulates the flow of money. These central authorities hold the ability to change any policy to suit them, rendering people powerless. For instance, in many places, banks determine how much money you can move around or what currencies you can use.
The alternative to the censorship-resistant ways of Centralized Finance, is using Decentralized Finance (DeFi), in which there are no banks or ‘middlemen’, instead there are pieces of code that run and act as intermediaries and are available to anyone, censorship-resistant, and much cheaper than traditional/centralized finance.
Table of Contents
What is DeFi?
DeFi is an open and global financial system built for the internet age. It gives you an unparraleled level of control and visibility over your money. Additionaly, Defi offers users exposure to global markets and alternatives to their current CeFi banking options.
DeFi products essentially open up financial services to anyone with an internet connection. The markets are always open, and there are no centralized authorities to block payments or deny you access to anything.
So far, tens of billions of dollars worth of crypto have flowed through DeFi applications, and the number of networks and protocols is growing everyday. Defi is built on three main principles: Cryptography, blockchain, and smart contracts.
Cryptography: The mathematical and computational practice of encoding and decoding data
Blockchain: A system of recording information in a way that makes it difficult or impossible to change, hack or cheat the system
Smart Contract: Programs stored on a blockchain that run when predetermined conditions are met
One of the best ways to see the potential of DeFi is to understand some major problems that exist today with the traditional finance infrastructure:
- Age restrictions in setting up and accessing financial services
- KYC requirements — Instititutions get access to personal information ( lack of privacy )
- Governments and centralized institutions can close down markets at any time
- Monetary transfers and payments can be expensive to execute depending on the volume and can take days due to internal human processes
Pillars Of Decentralized Finance
Cryptocurrency Wallets
Cryptocurrency Wallets are locations for maintaining your private keys that allow you access to your digital assets. But your digital assets aren’t stored on the wallet, instead, a cryptocurrency wallet is the program that stores your private keys and allows you access to your coins stored on the blockchain.
Wallets contain a public key–the wallet address– needed to receive funds, and your private keys, which are needed to sign cryptocurrency transactions and access funds.
Wallets can grant you access to multiple assets or just a single coin, and they also come in various forms, including software, hardware, and centralized exchange wallets.
Self-hosted software wallets are a key component of DeFi, helping to facilitate various DeFi platform uses. Centralized exchange-based wallets, in contrast, govern your private keys for you, giving you less control but also less security responsibility. CEX-based wallets also don’t have access to the entire Defi market.
Accessing Decentralized Exchanges–DEXs– and other Decentralized Apps–dApps– requires having compatible wallets. Most of today’s DeFi self-custody software wallets will allow you to access all the dApps you need. The most popular DeFi wallets are MetaMask(EVM), Phantom(SPL), and Solflare(SPL). But, with Self-custody on-chain asset storage your responsible at large for the security of your funds.
In general, self-custody crypto wallets allow you full-control over your keys and assets but may present a steep learning curve for new users interacting with the market.
One thing to keep in mind is that you must have a portion of the native blockchain’s coin available in your wallet to pay transaction fees. In contrast, CEXs require you to pay transaction costs in your native fiat currency.
Defi Protocols
Defi Protocols are Decentralized Apps that deploy custom financial strategies, or primitives for use in the Defi market. The most common types of DeFi protocols are:
- Decentralized Exchanges (DEXs)
Decentralized exchanges (DEXs)
DEXs allow users to trade digital assets in a noncustodial way without the need for an intermediary or third-party service provider. Although they comprise only one element of the DeFi sector, DEXs have been a part of the overall crypto industry for years. They offer participants the ability to buy and sell digital currency without creating an account on an exchange–with a CEX-based wallet. DEXs let you hold assets away from a centralized platform while still allowing you to trade at will from your wallets via transactions involving blockchains.
DEXs are typically built on top of distinct blockchains, making their compatibility specific to the technology on which they are developed. DEXs built on the Solana blockchain, for example, facilitate the trading of assets built on its blockchain.
Automated market makers, a type of DEX, became prevalent in 2020. They use smart contracts and liquidity pools to facilitate the purchase and sale of crypto assets.
Liquidity Pools incentivize use by rewarding users for depositing funds and providing liquiduity to a DEX so users can make trades with low slippage. Popular Liquidity pairs include Stablecoin pairs and pairs consisting of the blockchain’s native coin paired with various stablecoins. DEXs have come a long way in terms of liquidity and accumulating a regular user base, which continues to grow. As DEXs become more scalable i.e., faster and more efficient, their trading volumes are expected to increase even more.
Yield Aggregators
Yield Aggregators serve as user-friendly interfaces for earning yields in the DeFi market through simplified, one-click deposit vaults. Essentially, they function as decentralized asset management platforms, harnessing yield potential from diverse DeFi protocols to maximize returns for users.
NFT marketplaces
Decentralized NFT marketplaces represent one of blockchain technology’s core use cases. The innovative contract platform for Solana is facilitating and effective for decentralized NFT marketplaces. Solana and other existing chains allow users to trade or exchange specific assets, such as non-fungible tokens (NFTs).
Lending and borrowing platforms
Lending and borrowing have become some of the most popular activities in DeFi. Lending protocols allow users to borrow funds while using their cryptocurrency as collateral. A huge part of the current financial systems in the world are based on borrowing and lending money. With the use of DeFi smart contracts, lenders can allow borrowers to use their funds while still keeping custody of them.
Decentralized finance has seen massive amounts of capital flow through its ecosystem, with lending solutions commanding billions of dollars in total value locked, or TVL( the amount of capital held locked in any protocol at a given time). Staking is a popular activity on lending and borrowing platforms.
DeFi staking involves locking crypto assets into a smart contract in exchange for rewards and generating passive income. The crypto assets able to be staked are fungible tokens or non-fungible tokens (NFTs), and the rewards usually correspond to earning more of what you’re already staking. Staking is a great way to incentivize cryptocurrency investors to hold on to their assets while earning high interest.
Oracles/prediction markets
Oracles (options) deliver real-world off-chain data to the blockchain via a third-party provider. Oracles have paved the way for the prediction markets on DeFi crypto platforms where users can place bets on the outcome of an event, ranging from elections to price movements, for which payouts get facilitated via a smart contract-governed automated process.
Use Cases Of Decentralized Finance
As the industry continues to grow, we should expect a lot of improvements and newly built tools which will have more use cases. For now, let’s get to know the basic and common use cases of DeFi.
Payments and stablecoins
First off, it is essential to understand the bridge between DeFi and CeFi in terms of certain types of crypto. In recent years, protocols have dedicated themselves to producing stablecoins– cryptocurrencies tied to the value of Fiat currencies. For example, $DAI, $USDT, $USDC, etc. are all stablecoins because their values derive from the United States Dollar(USD).
For DeFi to qualify as a financial system –comprising of transactions and contracts– there must be a stable unit of account or asset. Stablecoins are essentially a store of value.
Participants must be able to expect that the value of the asset will remain relatively stable. This is where stablecoins come in.
Stablecoins bring stability to the DeFi market, where it’s common to yield farm and expose yourself to volatile assets. Considering the fact that fiat-pegged stablecoins are tied to a fiat currency, such as the U.S. dollar or the euro, they don’t exhibit nearly as much volatility as cryptocurrencies and therefore are desirable for commerce and trading.
Additionally, stablecoins allow companies operating in Web3 to pay contractors and employees without worrying about the price movements of their funds/assets.
Derivatives, Margin and leverage Protocols
Derivatives protocols with leverage features Protocols take the decentralized finance market to the next level by allowing users to borrow cryptocurrencies on margin using other crypto as collateral.
Additionally, developers can program smart contracts to include leverage that can exponentially ramp up the user’s returns- with high levels of risk. Using these DeFi components also increases the risk exposure for the user because the systems are often based on algorithms meaning there is no human intervention if there is a problem.
Yield Farming
Yield farming involves staking, or locking up your cryptocurrency on multiple platforms in exchange for interest or more cryptocurrency tokens. It has become very mainstream in the crypto space.
Yield farmers maximize returns by lending and borrowing crypto on DeFi platforms and earning various cryptocurrencies for their services. Yield farmers can increase their yield output by employing more complex tactics. For example, shifting cryptos between multiple loan platforms to optimize gains.
It’s a simple concept that has existed for as long as banks have. Yield farming is just a digital version of lending with interest for profit to investors.
Yield farmers have earned returns in the form of Annual Percentage Yields (APY) and some, have made life-changing money leveraging on this. Some popular protocols that support yield farming include Aave, Compound, Curve Finance, Uniswap, and Beefy Finance.
While it’s possible to earn high returns with yield farming, it is also incredibly risky. A lot can happen while you’re interacting with various protocols, and your cryptocurrency is locked up, as evidenced by the many rapid price swings in the crypto markets.
DeFi Risks
Fluctuating transaction rates, high token volatility, regulations, code bugs, and hacks are some risks to consider in decentralized Finance. For all its promise, the decentralized finance space remains a nascent market still experiencing growing pains. DeFi is yet to reach wide-scale adoption, and for it to do so, blockchains must become more scalable. Blockchain infrastructure remains in its early form, much of which is clunky to use for developers and market participants alike.
DeFi has grown significantly. Given its youth and innovation, the legal details around DeFi have likely not yet fully materialized. Governments across the globe may aim to fit DeFi into their current regulatory guidelines, or they may construct new laws about the sector. Conversely, DeFi and its users may already be subject to specific regulations.
In terms of adoption, it is uncertain how exactly things will pan out in the future. One potential outcome might include traditional finance adopting aspects of DeFi while retaining elements of centralization rather than DeFi completely replacing mainstream financial options. However, any entirely decentralized solutions may continue to operate outside mainstream finance.
In general, its important to remember the smaller a token’s market capitalization is, the riskier it is as an investment. Therefore, look at the liquidity of tokens before committing your funds. Ensure you know how long a DeFi protocol has been in operation and how much money it has in total deposits before you invest. To make it clear, there is no DeFi protocol without risk, but the above considerations can help you to evaluate the investment risk before you put your money into any protocol.
Conclusion
From taking out the middleman to turning artworks and video clips into digital assets with monetary value, DeFi’s future looks bright. It is a promising ecosystem with the potential as far-reaching, even though it’s still in the infancy of its capabilities.
Investors have more independence, which allows them to deploy various strategies to grow the monetary value of their assets in creative ways that seem impossible in the traditional financial system. However, DeFi also carries big implications for the big data sector as it matures to enable new ways to commodify data and has a long road ahead, especially when it comes to uptake by the general public.
To learn more, visit the Streamflow blog