DeFi stands for Decentralized Finance and it’s one of the hottest new trends in finance and cryptocurrency today. Learn about DeFi, and how it’ll change the financial products you interact with all the time, like loans, insurance, currency exchange, and more.
In the past few years, a new form of financial technology has emerged and is quickly becoming very popular: Decentralized Finance, or DeFi. This umbrella term covers things like exchanges, marketplaces, insurance, and more that operate in a decentralized manner. In the following paragraphs, we’ll explain DeFi in simple terms that you can easily understand.
So what exactly is DeFi?
The word “decentralized” is a powerful one, because it means not controlled by any single entity or person. A decentralized financial system doesn’t rely on an intermediary like a bank to make transactions or store assets. With the global shift from centralized systems to this more democratic model, we can expect many new ideas in decentralized finance (DeFi) to be invented that were never possible before.
Investing in DeFi requires an understanding of what it entails, or what its backbone is. Below are some basics on what you need to know about DeFi. The first thing you need to understand is how blockchain works. The advent of cryptocurrencies in 2008 with Bitcoin was the beginning of an entirely new paradigm for how people could store their wealth and transact with others. Cryptocurrencies are based on a decentralized ledger system where no one person or entity controls them – rather the ledger is stored in thousands or millions of copies that all check in with each other to ensure that they’re the same. This is the core of all cryptocurrencies – and it’s why they’re safe store of value. They are essentially unhackable, because a hacker would have to modify 51% of all of the ledgers to make the hack successful.
This is the core of the security of the blockchain – no one user can modify the entire blockchain since there are so many other copies of it. Legitimate transactions are placed on the ledger and stored immutably (or un-changeably) on the blockchain. Since the ledger is constantly updated with new transactions, your transaction is stored ultimately by all the users of the blockchain. This is the fundamental way that the blockchain works and this is the core of DeFi.
DeFi is more than Cryptocurrency
DeFi includes cryptocurrency, but so much more. In addition to covering cryptocurrency, DeFi allows for other assets to be placed on the blockchain. These can be as simple as a vote or opinion poll, to more complex assets like titles, deeds, insurance policies, or the inventory of a supply chain. Most of these financial tools are built on the Ethereum blockchain.
Dapps and Smart Contracts
The decentralized applications that run on the Ethereum blockchain are called “Dapps”. These Dapps allow users to create “smart contracts” that operate entirely autonomously once set up. Smart contracts are stored on the blockchain, and therefore cannot be changed once established. For example, imagine an insurance policy that automatically pays you when certain conditions are met. Or, imagine a trust fund that programmatically pays you if you hit certain life goals (ex. graduate from college). What about a loan that automatically releases the title to an asset once the loan is paid in full? These are just a few of the hundreds of interesting uses for this technology that are only just being explored.
So what constitutes a smart contract on a Dapp? Money legos are the constituent building blocks of Dapps. This is the idea that is central to building new DeFi tools – in essence it allows the modular DeFi protocols to be mixed and matched, or stacked on top of each other to create new, interesting applications, all in a permissionless manner. These money legos are the bricks from which Dapps are built. Smart contracts are then created within a Dapp and live on the blockchain. For this system to function, it requires a stable backbone to be useful, which was the purpose behind the creation of DAI.
What is DAI?
DAI is a stablecoin that is built on the Ethereum blockchain (ERC-20 token). This means that unlike Ethereum (ETH) which is subject to wild volatility in its value, DAI is constantly stable as its pegged to the US Dollar. It’s the cryptocurrency of choice for many Dapps.
How can I participate in DeFi?
There are already hundreds of Dapps that have been built and that have begun to get traction. Here are just a few of the categories:
- Decentralized Exchanges (DEX) – Ex. Uniswap and Kyber. These have no accounts, sign-up or ID verification. They are completely autonomous and free to use.
- Decentralized Money Markets or lending platforms allow users to borrow or lend cryptocurrency in an automated, decentralized way. For example, Oasis and Compound.
- Yield farming is something that holders of cryptocurrency can do to maximize the value of their holdings by generating returns (or yields) on the assets. There’s a whole rabbit-hole to explore here.
- Prediction Markets are essentially markets that allow users to place bets on certain predictions, for example, political elections. Ex. PrediQt and Omen.
There are significant risks to DeFi currently. It’s still early, and hackers are prevalent. Ensure that you’ve got all your bases covered if you’re developing smart contracts, and make sure that you’re only entering into smart contracts on reputable platforms. Some simple internet sleuthing will help you spot most of the bad actors. Until you really understand the ecosystem, be sure that you’re only playing with small amounts of money and only ever invest what you can afford to lose.
Why does DeFi matter?
There are currently 1.7 billion people that have been left behind by the financial system. They are “unbanked” which means that they have no banking relationship, or bank account and primarily deal in cash. DeFi could prove to be an avenue to giving these people access to banking services through their smart phone, and bypassing the current banking system entirely.
DeFi also is important because it’s an enabling technology for reducing fees, eliminating corruption, and driving efficiency into finance. The next few years will be very telling as to whether DeFi applications will have staying power, and the ability to go mainstream. It’s still the wild west in a large part, and it’s likely that great deals of money will be made, lost, and stolen. Be safe, but do take time to explore this valuable and interesting ecosystem.