What Is DeFi and How Does DeFi Work?

TL;DR

• DeFi (Decentralized Finance) is a use-case of blockchain technology that lets you handle your finances without relying on centralized entities like banks.
• It enables you to make high-speed transactions, get instant loans, and even stake your assets to earn passive income.
• While centralized payment methods have a banking server aiding in fund relay, everything in DeFi is decentralized. All actions are automated and executed on a blockchain.
• Its use cases include loaning and lending, derivatives trading, P2P transfers, investing in stablecoins, yield farming, staking, etc.
• DeFi has all traditional finance use cases covered. Additionally, it is transparent and offers better returns than CeFi, etc.

Introduction

Are you tired of seeing your online payments perpetually stuck due to server issues? Or are you simply unwilling to put up with the 2 to 3-day payment reversal timeline in case of a failed payment?

Or do you simply need a loan without haggling with the provider in person? Regardless of what your financial requirement is, DeFi has you sorted.

Yet, the question remains: what is DeFi, and how does it even work?

Decentralised Finance: An Explainer

Short story: DeFi is the future of finance.

Long story: DeFi is a particular use-case of blockchain and decentralisation that lets you explore the financial world’s basic and complex offerings without relying on centralised, hackable, and changeable entities. 

Now that’s a bit harsh! Let us mellow it down. What is Defi in plain English, and how does it differ from traditional banking/centralised financial products or services?

What is CeFi? Centralised Finance

Simply put, CeFi or Centralized finance is like every other standard banking service we use— including cash withdrawals, credit lines, mobile payments, and more. And while everything looks hunky-dory for now, have you ever imagined what happens if the bank—managing your funds— goes bankrupt. Nothing against centralised financial bodies but have you ever heard of RECESSION.

P.S. Invest in DeFi Coin Sets via Mudrex. It consists of tokens representing the top decentralised finance projects. 

DeFi vs CeFi: The Difference

With DeFi, you can reimagine everything else in a heartbeat. Sending payments in under a second, getting an instantly verified flash loan in virtually no time, getting a good yield with the assets locked, and whatnot. You name it, and DeFi has it.

There is a catch, though!

To explore DeFi, you would need to be a part of a blockchain (decentralised ecosystem) with token economics incentivising the inhabitants. Much like the real world, where fiat is the incentive!

CeFi, on the other hand, lets you get started instantly. You can simply open a bank account or a Demat and start using the services. The infrastructure is all there, up and running. 

Advantages and Disadvantages of Decentralized Finance

Now that you have explored a few aspects of DeFi and even managed to look at it from the CeFi lens, here is a quick ‘Pros and Cons’referesher to help you decide:

Advantages of DeFi

• All real-world CeFi use-cases are covered.
• Transparent and open.
• Some DeFi protocols offer better annual yields than the standard savings account.
• No central authority
• Can work with other crypto products/offerings like NFTs and DAOs

Disadvantages of DeFi

• Lacks regulations.
• Customer protection ethos aren’t clearly defined.
• Smart contract bugs can be exploited.
• The concept of collateralisation can be a tad disheartening.
• Requires a lot of privacy checks.

How does DeFi work?

Unlike the established financial institutions, DeFi is a comparatively novel concept. Yet, the question remains: how do we envision and implement DeFi. 

Centralised payment methods have a base with banking servers helping with fund relay. In Defi, everything happens inside a blockchain with specific protocols (software modules for blockchain) sitting atop the ecosystem, specifically to render an automated form of financial service— using the ecosystem’s native crypto. 

Use Cases of Decentralized Finance

Set of protocols sitting on top of a standard blockchain: sounds simple, right. Let us now spare some thought as to how these protocols actually work:

1. Loaning and lending

As mentioned, DeFi takes any existing financial service and aims to improve it. And loaning seems to be the most obvious one. Unlike standard borrowing, where you rely on trusted parties, often a bank or NBFC, DeFi simplifies borrowing by having set codes (smart contracts) do the job for you.

Instead of paper contracts, DeFi lets you experience smart contracts where the interest rates, time of repayment, maintenance margins for the collateral, and other details are predefined and encoded. And this approach has a highly underrated benefit for the loan provider:

If the collateral value drops below a certain threshold, the smart contracts can trigger a liquidation to avoid deeper losses. Sounds intuitive!

But then, who lends the sum if no centralised parties are involved. The answer is the ‘User’. In DeFi, both lender and lendee are the standard blockchain users— with contracts (smart ones) signed between them. The process of lending and borrowing takes place as per the pre-assigned protocols. 

Lenders either send money to specific addresses or collate them across lending pools (with smart contracts taking care of the interest-earning part). Borrowers are often required to post collateral (often as some form of crypto or stablecoins) to borrow the amount needed from the lender or the pool in a given ratio (the ratio is also determined by the smart contracts underscoring the DeFi protocol).

As you can see, borrowers can loan, and lenders can earn interests directly, without the need for intermediaries. 

If you are looking for examples, Yearn Finance happens to be one such ecosystem. 

2. Derivatives

No, we aren’t talking about the equity market here. Or are we?. 

DeFi-based derivative solutions allow users to exchange (buy or sell) contracts that relate to the future value of any asset (something that the concept of derivates talks about). These assets can be standard cryptocurrencies or real-world bonds, or equities. 

Synthetix happens to be one such ecosystem, where real-world stocks or other assets can be traded in their tokenised forms— within a decentralised realm. 

3. P2P transfers

Even though standard blockchain networks can initiate P2P fund transfers without dedicated smart protocols, having a DeFi layer built atop makes the process safer and more secure. This use-case concerns sending direct crypto-based payments without relying on centralised servers. 

And even though these transactions are currently taxed, the speed and reliability outweigh the financial obligations. 

While these are some of the centralised financial offerings made better with DeFi, here are the ubiquitous decentralised financial use-cases made possible within blockchain ecosystems:

• Stablecoins

If you have been following crypto, you would have heard about stablecoins recently. Primarily cryptos pegged to fiat, another crypto, or even an asset— stablecoins are the fiat currencies within a blockchain. They are used to procure loans and move assets over a decentralised network.

• Yield farming

Do you know why banks are popular? Due to the liquidity, they offer, which in turn means the easy availability of the concerned currency in case the user needs it. DeFi, despite being all secure and decentralised, has had some issues with liquidity. And that is due to its restricted adoption.

Yield farming is a use case where blockchain participants voluntarily lock their assets up in liquidity pools to make the process of lending, borrowing and staking more liquid. There are incentives for participating in yield farming and generating liquidity, which can be a good passive income generator.

• Staking

Arguably the simplest DeFi use-case, staking concerns participating in the network governance (for making decisions in a decentralised network) by delegating assets. Remember the upcoming Ethereum 2.0. People are already locking up their ETH in staking pools to get validator rights and earn staking rewards if and when the merge comes into effect.

What is the Future of DeFi?

The use-cases associated with DeFi are certainly next-level. Yet, these aren’t the reasons why you should plan a shift from a centralised setup to a decentralised one. Here are the reasons that make DeFi worth your time:

1. Round the Clock: Works 24 x 7
2. Automated: No need for manual control
3. Open: Decision-making is transparent 
4. Permissionless: No service denials 
5. Trustless: Software-based fund relays

And that is what the future of DeFi looks like in the least possible words. Eventually, it will work towards assisting traditional CeFi institutions with better speed and transparency whilst aiming to cut down on hidden charges thing and wait times. 

Are there any Challenges?

At present, DeFi suffers from the issue of restricted adoption. And that’s not the only challenge it has been facing. Here are more:

1. Overreliance on algorithmic stablecoins (Ones with no collateral and all code)
2. Prone to hacks due to buggy smart contracts
3. A massive drop in valuation due to the bearish market sentiments
4. Liquidity issues due to hastened panic selling and withdrawals

What are some of the Most Promising DeFi Projects?

2022 hasn’t been the best year for DeFi. Terra crashed through the ground. USDT or Tether came perilously close to de-pegging, and Solend—one of Solana’s most reputed protocols tried thwarting the ethos of decentralisation.

All of that did change the DeFi scenario to an immeasurable extent, making the following projects rise to the occasion:

1. Ethereum: Still manages to hold on to the top position with 63.80% of DeFi TVL (Total Value Locked), as per market value.

2. BSC or Binance Smart Chain: With close to 408 powerful DeFi protocols, BSC comprises 8.41% of the entire decentralised finance market in terms of total value locked.

3. Tron: Recently, Tron warded off a de-pegging scare relevant to the USDD coin by shooting the ecosystem’s over-collateralization quotient to over 250%. Despite the hiccups, Tron manages third place, with 5.50% TVL locked.      

Here is a detailed blog on DeFi tokens.

Wrap-Up

DeFi is finance’s date to the big date— the era of decentralisation. As innovative as it sounds, the bearish market sentiments have significantly dented DeFi use-cases and protocols, with stablecoins taking the most hit. 

Also, with protocols like Solend bypassing the ethos of decentralisation to safeguard user interests shows that the current crop of smart contracts isn’t as top-notch as we would like them to be. Therefore, for DeFi to thrive and work hand-in-hand with the existing financial setup, we need better use-cases and certainly the best-in-class smart contracts— explicitly for keeping hackers, bugs, and bad actors at bay. 

FAQs

1. How is DeFi different from Bitcoin?

While Bitcoin is the first-ever crypto-focused blockchain project and a full-fledged ecosystem with BTC as the native token, DeFi is one of the more relevant use-cases of Blockchain. One is a blockchain, while the other is a blockchain-driven technology.

2. What is a DeFi example?

Any blockchain-specific project or protocol that helps you procure financial benefits— either as a loan, assets for trading, or a form of payment, without having to rely on anything centralised, is a DeFi example. Crypto project Synthetix, which we previously talked about, is a popular example. 

3. Is DeFi a good investment?

DeFi is one of the fastest-growing verticals in the crypto space. Investing in DeFi projects after thorough research could be a good idea. Focus on protocols they use, true decentralization, and how they can impact financial services. You can invest in DeFi through the DeFi 10 Coin Set too.

4. Is Ethereum a DeFi?

Ethereum is an open-source blockchain with smart-contract functionality. The smart-contract functionality allows the development of multiple protocols on top of the Ethereum blockchain. While Ethereum may not be the same as DeFi, most DeFi applications are built on it.

5. What is DeFi Staking?

Holding certain cryptos in specific pools (more like decentralised projects) to earn rewards and decision-making abilities is known as staking. Staking in DeFi is a passive income generator— if done correctly.

6. What is DeFi Wallet

DeFi wallet is the safest way to manage and store crypto assets(cryptocurrencies, NFTs, etc.) They are secured via high-end encryption techniques and private keys. Anyone can send you crypto through your public key, and you can access the wallet through your private key(password).