What is DeFi or Decentralized Finance? If you’ve never heard of it, you should; if you do, chances are you still need to get more understanding about how it actually works. We are here to help you demystify this world-changing, trust-building form of finance.
In this article, we will explain to you what exactly DeFi means and some DeFi terms you need to understand before taking part in this financial system.
What is DeFi?
DeFi stands for Decentralized Finance, a term given to financial services that have no central authority or intermediaries. Decentralized Finance takes components of traditional finance and decentralizes them by removing middlemen and replacing them with smart contracts.
More simply, DeFi is labelled as open finance, in which people will have open access to no matter where you are in the world and no matter what your background is.
The Components of DeFi
The first thing we need is an infrastructure for programming and running decentralized services to build a decentralized financial system. And Ethereum is exactly what we need. Ethereum is a Blockchain-based software platform for writing decentralized programs (we usually call them decentralized apps or Dapps for short). We can code automated programs, or also smart contracts, by the use of Ethereum so that we can manage any financial service we would like to build in a decentralized way. This indicates that we decide the regulations as to how a particular service can operate, and if we enforce those regulations on the Ethereum platform, they are permanent, and we no longer have power over them. We will begin to develop our decentralized financial infrastructure when we have a program in place like Ethereum for building decentralized applications.
Obviously, money plays an important role in any financial system. We certainly couldn’t say Bitcoin and Ether are stable when we look at the high volatility of them. If we’re desiring to create trustful financial services that people will want to use we’ll need a more stable currency to work within this framework, and that’s why we need Stablecoins. Stablecoin is a cryptocurrency that is pegged to an asset. We have different classes of assets, and the two most popular ones that people use are the US dollar and gold.
People might want to use a stablecoin for the use of DeFi that does not employ fiat money reserves to retain a peg, as this would require some form of centralized control. And now DAI will be brought into play. DAI is a decentralized cryptocurrency, designed to be worth exactly $1. In order to maintain its fixed pegged to the US dollar, DAI needs a system. So that’s, where MakerDAO comes in. MakerDAO is the protocol that stabilizes the DAI stablecoin to ensure that one DAI is always 1 USD, meaning the protocol ensures that there isn’t too much die or too little die in circulation.
DAI is over collateralized, which means you can borrow 66 cents worth of DAI if you lock up $1 worth of Ether in a deposit. If you need your Ether back, just repay the DAI you loaned and the Ether will be released. Since DAI is over collateralized, even though the price of Ether becomes highly volatile, it is highly likely that the value of the locked Ether supporting the DAI in circulation will still hold at 100% or more. This makes DAI a completely trustless and decentralized stable coin that can not be closed down or blocked, so other DeFi services are a great form of currency.
Now that our decentralized financial system has stable decentralized money, it’s time to create some additional services. The first application of DeFi is decentralized exchanges, which are a type of cryptocurrency exchange that conducts without the need of a middleman. With DEXs, trade can occur between users, allowing one another to buy and sell cryptocurrencies in a faithless environment through an automated process. Assets traded under decentralized exchanges are never held in an escrow or by third-party people, so these exchanges can reduce the risk of theft from hacking of exchanges.
But the range of decentralized financial services doesn’t stop there. Let’s move on to decentralized money markets services that connect borrowers with lenders. Through lending them, lenders can gain interest on their crypto assets, whereas borrowers can obtain liquidity without selling their assets off. Borrowers have to over-collateralize their loans by providing assets more valuable than the loan value.
Why is DeFi important?
To understand why we need DeFi, let’s take a look at the world we are living in right now. When it comes to finance, maybe the typical financial experience for an end-user in today’s world is dealing with a standard selection of a few commercial banks no matter which country he is living in. People just put away their money in their savings account and practically earn nothing on those savings. In fact, they don’t trust that traditional banking, and they know that they might not have better interests, but this financial system is, unfortunately, the only option for them, and thus it gradually becomes a standard.
However, with DeFi, you can bring all the services you expect from your traditional banks or even services that you traditional banks don’t offer to an all-in-one platform where you can access anything you want and trade any types of assets you wish.
As DeFi doesn’t require intermediaries like a bank or lawyer, you can earn interest and make trades without worrying about any middlemen involved. It is more interesting when you are in a programmable network where there’s no counterparty or third party holding your funds at the end of the day.
The above information is the brief summary of DeFi and there are tons of applications you can explore to fulfil your purpose. As you can see, DeFi can allow for efficient, limitless, creation, and expansion of a whole new global financial universe in the future.