What is DeFi?
Last updated
Last updated
When reading news articles about Blockchain and Cryptocurrencies, you oftentimes see the “DeFi” term. Today in this article, we are going to deep dive into what is DeFi in a neat and tidy manner.
DeFi stands for Decentralized Finance. It is a “finance” as well but plays in a “decentralized” manner, which is one of the key features of Blockchain and Web 3.0. To be more specific, DeFi is an ecosystem and infrastructure of financial applications where every single person should be able to participate without any third parties’ monitoring and broking.
Now that you got a clear understanding of DeFi definition, let’s compare it with Traditional Finance, which is the traditional finance ecosystem.
Type | Traditional Finance | DeFi |
Regulators | Securities and Exchange Commission (SEC) of the US | Almost no regulators |
Brokers | Banks, Securities firms, Insurance companies, Realtors, Law firms, and much more | Blockchain Network |
Rights to exercise & Obligations to fulfill | Clearing House, Insurance, Collaterals, etc. | Automated with Smart Contracts |
DeFi’s ecosystem is hardly regulated by any authorities.
The traditional finance ecosystem has a lot of guidelines for contract methods and types to obey, and that results in a high level of costs. For this reason, it can be difficult to meet every single party’s needs and to develop many different kinds of financial instruments. On the other hand, DeFi can develop and create many customized (or personalized) products because it’s hardly regulated by any authorities.
The broker is now the Blockchain Network in DeFi, which had been Banks and Securities firms in the past.
Some say DeFi is a complete peer-to-peer financial ecosystem without any brokers, but that’s not the case. Strictly speaking, the Blockchain Network takes the broker’s role instead of banks or securities firms. In the traditional finance ecosystem, the brokers offer a few infrastructures for the two parties to communicate with and come to an agreement. It also tries to remove the counterparty risk to comply with investor protection policies. However, in DeFi, Blockchain Network takes this role. it has Distributed Ledger Technologies (DLT) as financial infrastructure, and miners and validators proves the validity of the contracts, then safely save the data in a distributed manner.
DeFi automates the rights and obligations to exercise and fulfill with Smart Contracts.
Many market participants rely on the intermediaries such as banks, securities firms, and insurance companies to reduce counterparty risk that may arise within the traditional finance ecosystem. Of course, such intermediaries can reduce the risk of peer-to-peer financial contracts, but in this process, the transaction parties incur some financial costs, including brokerage fees. In addition, the brokerage agencies can also go bankrupt at any time unexpectedly, and it’s highly likely to limit the types of financial products that can be mediated by the brokers. (Open one of your bank apps on your smartphone to see how many loans and deposit products are available for you to apply for. Surely, the number must be limited.)
However, in DeFi, the programming codes allow you to create and deploy as many financial contract terms as you would want, such as your desired conditions, rights to exercise, and obligations to fulfill. Once the programming codes have been deployed as a smart contract in a blockchain network, it’s now free to use and open to the public. The distributed smart contracts are safely saved on the blockchain, and the contracts allow both parties to sign and execute the contract without any help of third parties.
In the traditional finance ecosystem, most of the rights and obligations are manually exercised and fulfilled, which may result in many human errors. On the other hand, in DeFi, all rights and obligations are now automatically executed through smart contract codes. Examples include:
Josh, who has received a loan through a DeFi loan platform, automatically liquidates the entire collateral if the market value of the collateral existing in his wallet falls below $10,000.
Amber, who has provided loans through a DeFi loan platform, can be automatically repaid the $500,000 in principal onto her wallet when the loan expires on December 31.
As mentioned above, DeFi has a unique ability to enforce or automate financial contracts through smart contracts. The more intriguing thing is that there’s no longer a need for banks and securities firms in this process. DeFi with this characteristic can improve the business environments where many supervision and intermediation can increase financial costs and make personalized or customized products difficult to be viable. For more information on smart contracts, see the following articles:
What is a smart contract?So, what types of projects and platforms are there in DeFi Market? In fact, there are a vast variety of DeFi types that borrow a number of business models that exist within traditional finance. Let’s focus on the most trendy types.
DEX (Decentralized Exchange)
The most well-known type of DeFi to the public is DEX. Similar to the traditional stock exchanges and centralized crypto exchanges that allow the exchange of assets, DEX is a platform that enables the exchange or swap between a pair of cryptocurrency assets in a decentralized manner. There are many different types of DEX, such as orderbook-based and AMM (automated Market Makers) based.
In the case of stock exchanges and centralized crypto exchanges, the exchange itself operates its own server to broker every buyer and seller, while DEX differs that the exchange and swap processes take place within the blockchain network. (For certain DEXs, however, the ordering and concluding process is dualized, resulting in both centralized and decentralized characteristics.)
Lending Platform
Along with DEX, the lending platform is also one of the most representative types of DeFi. Let’s think about the business model of traditional banks. The bank essentially has a business model that takes interest gains as its main revenue stream from receiving funds from depositors and lending the surplus funds to borrowers.
Similarly, the DeFi lending platform also has a business model that receives crypto assets from depositors(or liquidity providers) and lends the surplus assets to borrowers. The interest gains from both parties become the main revenue stream of the blockchain network, and through this, it seeks to sustain the tokenomics by delivering the gains to miners or validators as their rewards.
Yield Farming
Yield Farming refers to an advanced investment technique that seeks to maximize profits by repeatedly using multiple DeFi platforms. The following is an example of Yield Farming.
100 ETH loan → 100 ETH deposit → 5 ETH interest accrual → (with 5 ETH collateral) 10 ETH additional loan → 10 ETH additional deposit → 5.5 ETH interest accrual → …
In fact, Yield Farming often combines the use of DeFi platforms and the Staking platforms. For this reason, it’s appropriate to regard Yield Farming as an act of maximizing profit by repeatedly making investments through a mixture of profitable platforms that exist in the blockchain environment.
Smart contract codes that enable DeFi are generally open sourced to the public. This makes it easy to form another DeFi platform that can be combined with the existing DeFi platform. DeFi is an area that is easier to grow than in the past because the distribution of smart contracts does not require any permission from authorities. The infinitely-possible ways to integrate DeFi is a characteristic that is referred to as the Money Lego!
The possibilities of DeFi, which is much easier to grow and expand than traditional finance, will be endless. A lot of investment institutions and developer groups have been discussing the availability of DeFi. Why don’t we keep an eye on this up-and-coming DeFi market?
