DeFi: What is DeFi, How Does It Work & Major Defi Protocols

The launch of Bitcoin in 2009 gave birth to robust blockchain technology. The cryptocurrency and blockchain space features several niches in which organisations and projects create solutions for different use cases. 

The full form of DeFi is Decentralised Finance sector, is one such niche. With DeFi, you can carry out most of the things banks support — lend, borrow, earn interest, trade derivatives, buy insurance, trade assets, etc. But it is faster and does not need a third party or any paperwork. 

It does sound interesting. Hence crypto enthusiasts must be aware of all the vital aspects. This article illustrates those aspects. Read through the end to gain insight.

What is DeFi?

Decentralised finance or DeFi is an umbrella term for different financial applications in blockchain or cryptocurrency geared towards disrupting financial intermediaries. It is based on secure distributed ledgers. 

DeFi aims to create a permissionless, transparent and open-source financial service ecosystem which operates without any central authority and is available to everyone. Users will have total control over their assets and interact with this ecosystem via P2P (peer-to-peer) and DApps (decentralised applications).

Working of DeFi

Decentralised finance is primarily based on Ethereum and is all about code. It uses smart contracts and cryptos to offer services which do not require intermediaries. 

Financial institutions play the role of guarantors of transactions in today’s financial world. A smart contract replaces these financial institutions in a transaction in decentralised finance. 

A smart contract can hold funds and refund or send them depending on several conditions. When live, a smart contract always runs as programmed, and no one can alter it.  The following illustration clarifies:

Suppose a contract that is engineered to offer an allowance can be programmed to send money from Account X to Account Y every Friday. For that matter, it will only do so as long as Account X contains the required funds. No one can change the contract and add Account Z as a recipient to steal funds.

Also, contracts are public for any individual to audit and inspect, implying bad contracts will quickly come under community scrutiny.

DeFi vs traditional finance

DeFi is an emerging system aiming to revolutionise the traditional finance segment. It boasts the ability to be a financial tool outside of regulatory and government control. This makes it potent enough to disrupt traditional finance. Given below is a comparison between DeFi and traditional finance:

Some major DeFi protocols

• Sushiswap
• Maker (MKR)
• Balancer
• AAVE
• Uniswap
• yEarn
• Synthetix
• Compound
• PieDAO
• mStable
• Uma
• 0x Protocol
• Ren Protocol
• Numerai
• Project Serum
• Curve

What are Decentralised exchanges (DEXs), and how to use them?

Decentralised exchanges or DEXs refer to peer-to-peer marketplaces where crypto traders directly make transactions without the need for a trusted intermediary to hold the money. These directly connect users, and with the help of smart contracts, the trades directly take place between user wallets.

Usually, DeFi exchanges do not provide custodial wallets, and users connect to these platforms via a Web3 enabled application or browser extension like Binance Chain Wallet, Coinbase Wallet, MetaMask, etc. 

After connecting to the platform with the wallet, you can begin exchanging cryptocurrencies via plain, easy-to-use user interfaces that a majority of the DeFi exchanges offer.

Decentralised marketplaces

Decentralised marketplaces refer to trustless networks that are built on blockchain technology and enable investors to trade without the involvement of middlemen. They enable individuals to transact and interact on a global, self-executing, permission-less platform.

At its core, a decentralized marketplace matches sellers and buyers of services and goods. Instead of a person, a smart contract or program controls a majority of the vital functions like releasing funds and executing trades.

Use cases for DeFi

Listed below are some of the key DeFi use cases:

• Synthetic assets and derivatives – Allows the formation of tokenised derivatives with added security
• Infrastructure development – Provides the tools to compile, integrate and develop blockchain solutions
• Asset management – Allows selling, purchasing, staking, earning interest on and transferring digital assets
• Compliance and KYT – Provides KYT (Know-Your-Transaction), which tracks transaction behaviours in place of user identity
• Risk management and analytics – Helps analyse data for reduction and assessment of risk
• Payment solutions – Provides safer, more transparent and faster solutions in comparison to the legacy payment systems
• DAOs (Decentralized Autonomous Organizations) – These are decentralised administrative entities which manage the core financial operations.
• Digital identity – Provides portable self-sovereign identity which is private and secured
• Insurance – Offers secured audits, automated insurance claims and cuts down paperwork
• P2P lending and borrowing – Ensures P2P borrowing and lending with low risks and high-interest rates

DeFi Risks

Given below are some of the risks of DeFi:

• Threat of hackers – All the potential use cases of DeFi rely on software systems which are vulnerable to hackers.
• Collateralisation – Almost every DeFi lending transaction needs collateral equal to a minimum of 100% of the loan’s valuation, if not more. These significantly limit who is eligible for several types of DeFi loans.
• No consumer protection – The absence of rules and regulations implies that users have little recourse in case a transaction goes foul.

Future of DeFi

DeFi bears the potential to revolutionise the financial sector when concerns regarding privacy and data security are increasing. But first, it must address issues related to liquidity, regulations, scalability and security.

There was less than $20 billion worth of value that was locked in different DeFi products as of November 2020.  A majority of these were on Ethereum. It was worth over $260 billion by the next year, with Binance Smart Chain alone contributing $19 billion. If this trend goes on and the decentralised finance maximalists are right, it can be just the start of a monstrous DeFi wave.

DeFi has gained significant momentum over the years. Crypto enthusiasts looking forward to them must keep in mind all the above-mentioned vital aspects. Also, they must ensure to carry out extensive research before interacting with DeFi applications due to the considerable risk involved.