Module 6: The Basics of Decentralized Finance (DeFi)
Module 6 is all you need to know about the basics of decentralized finance. Here, we will examine how the DeFi system works, the benefits, and the limitations.
In section 1 of the Ardana academy, we covered the basics of money and blockchain technology. This section examines decentralised finance. In this module, we will first learn the basics of decentralised finance; what it is, how it works, it’s uses, advantages and disadvantages.
Various technologies and protocols are utilised to achieve the goal of decentralisation. A decentralised system, for example, might be made up of open source technologies, blockchain, and proprietary software. Smart contracts make these financial products possible, which automate the conditions of agreements between buyers and sellers or lenders and borrowers. In addition, DeFi solutions are designed to eliminate middlemen between transaction participants, regardless of the technology or platform used.
In the previous module, we learned that Ethereum gained traction with the boom of decentralised finance (DeFi) in 2020. Since then, decentralised applications have been created to automate financial services such as lending or borrowing without the need for a third party intermediary.
DeFi is a young industry with its infrastructure still under construction. Because of this, DeFi regulation and control are either non-existent or inadequate.
Why is DeFi so Important?
We learned the risks and challenges of having our personal and confidential data controlled by central authorities in the previous modules. Similarly, a traditional financial system is also centralised. Typically, a country's central monetary authority issues a national currency for use in trade and commerce. The supply and flow of money in the market is also dominated and controlled by these authorities. Customers put their money in banks and other financial institutions in the form of fixed deposits or recurring deposits, among other things, to make profits and greater returns.
This means, of course, that these authorities have complete access and control over all assets and funds, which increases the risk of manipulation. Of the enormous profits banks make by lending at higher interest rates or investing in the stock market, depositors receive only a very small share of the investment (profit). These authorities have the final say over the customers' investments, have complete access to their accounts, and there is also no transparency throughout the process.
An open and decentralised system, which is the core of decentralised finance, was required to tackle these issues.
What is Decentralised Finance (DeFi)?
Decentralised finance is abbreviated as Defi. It is an ecosystem of financial applications developed using blockchain technology. It handles transactions without the intervention of third parties. It implements a peer-to-peer network to create a decentralised environment where anyone can freely connect and manage their assets. Smart contracts are a part of DeFi. Smart contracts are self-executing and do not require intermediary oversight, and form the basis for decentralised finance. Overall, DeFi aims to create a transparent, open-source, permission-free and decentralised financial environment.
DeFi is more than just a concept. Although we are still in the early phases, many different protocols provide significant benefits that should not be overlooked. DeFi has a market capitalization of $148 billion, and Centralized Finance (CeFi)’s current market cap is $324 billion.
The use cases for DeFi are also very real. Today, there are working protocols that allow individuals to send money around the world, transfer currencies, earn returns on deposits, borrow or lend money - all in a decentralised manner.
While cryptocurrencies were introduced to create decentralised financial systems for commerce, DeFi was more about issuing money, payments, and storage. As a result, intermediaries such as banks are cut out, giving users complete control over their money. Moreover, decentralised finance goes a step further. It offers various other financial services such as loans, insurance, etc., on a decentralised blockchain platform that people can access all over the world.
Building DApps on a blockchain platform like Cardano and Ethereum (dapps can also be built on other blockchains) and implementing smart contracts for automation makes it possible to offer various financial services on a single network.
There are many advantages to D'Apps:
Since DeFi dApps are decentralised, there is no need for intermediaries or human intervention to ensure the highest security and integrity.
Since the business rules within smart contracts deployed through the blockchain platform are automated, these smart contracts execute themselves without the need for manual intervention.
All DeFi apps and their financial services are globally accessible to everyone around the world. Decentralised finance apps are generally based on permission-free, public blockchains that allow anyone to create and use apps. The dapp required to execute transactions on the blockchain interacts directly with the user's crypto wallet.
Since the blockchain is immutable and tamper-proof, DeFi apps naturally provide complete security throughout the financial process.
Decentralised lending and cross-border payments are just the beginning. Still, DeFi's greatest potential is to democratise access to finance in emerging markets and break down the barriers that traditional centralised financial institutions have erected. DeFi also promises that anyone with an internet connection can access any currency worldwide, earn returns on deposits, or get instant access to credit. In some emerging markets, even access to a stable USD-backed currency is revolutionary. Ultimately, DeFi will create a digital exchange ecosystem where money and value are transferred just as information and data are today, seamlessly in the background from point to point, with use cases not limited by infrastructure functionality.
A very prominent use case of DeFi is KYC (Know Your Customer) and AML (Anti-Money Laundering). In addition, blockchain-based DeFi solutions can be used to verify and authenticate transaction details to curb fraud and scams. DeFi is also used as an exchange for trading crypto derivatives such as Bitcoin futures. Crypto-derivatives are secondary contracts or financial instruments that derive their value from a primary underlying asset.
Other examples of DeFi's products include credit logs, payment logs, data analytics applications, and many more.
Why Has DeFi Become so Popular?
The financial sector has made significant progress in its services with the advent of blockchain technology. Blockchain has already boosted the cryptocurrency industry, and the emergence of Defi based on blockchain has further boosted the industry. The Total Value Locked (TVL) in Defi logs from Defi Pulse today stands at $26.57 billion. It is noticeable that Defi is continuously increasing its popularity globally. In a single year, it has grown more than 20 times. With this increasing popularity, Defi has become one of the hottest discussion topics in the crypto space.
What is the difference between DeFi and CeFi?
In centralised finance (CeFi), all trade orders are processed through a central exchange. A central authority controls the funds; users do not have a private key to access the wallets. Both decentralised and centralised finance offer services such as lending, borrowing, and payments. The difference is that DeFi is a decentralised platform, while CeFi is a centralised one.
When you compare Defi and CeFi, security is an essential point to consider. CeFi is vulnerable and prone to various risks, while DeFi provides an entirely secure transaction platform. In addition, Defi uses a features such as Proof-of-Work and Proof-of-Stake (PoS), which ensure that the system is safe and secure.
Also, DeFi is a permission-free network, while CeFi is a permission-required network. This means that in CeFi, certain operations can only be performed by the central authority, while in DeFi, there are no centrally authorised individuals.
When the two platforms are compared, DeFi is less expensive as the only costs incurred are the network fees, whereas, with CeFi, several intermediaries charge hefty fees.
How Does the DeFi System Work?
The decentralised financial system works with the help of three main components:
1. Blockchain technology
2. Decentralised application (DApps)
3. Smart contracts
The decentralised applications provide a platform to conduct financial transactions on the blockchain. With smart contracts, the transaction is executed between the two parties without any third-party intermediaries. Smart contracts aim to eliminate all intermediaries and central authorities involved.
A DeFi platform is developed to provide an automated, reliable and tamper-proof system. Decentralised applications equipped with these features automate the interaction with money in a variety of ways without the involvement of banks or intermediaries.
Recently, a new addition to the DeFi ecosystem was introduced: Yield Farming or Liquidity Mining. It is a way to reward users for providing liquidity in the DApps system. It involves lending cryptocurrency and earning interest on it, similar to a traditional bank lending system. Yield farming is implemented with two main goals: first, incentivise users to provide liquidity (liquidity refers to the ease with which an asset can be converted into cash or another asset) and distribute Defi app governance tokens fairly to protocol users.
What are the benefits of Defi?
With decentralisation comes stronger transparency. Since the distributed ledger, which contains information about all activities that have taken place on a blockchain network, is shared by all, the network's data is publicly viewable. In addition, the cryptographic principles underlying the blockchain guarantee that information is only recorded once its authenticity has been verified.
For customers, the transparency that DeFi applications provide can be a key advantage. It can improve due diligence and help people identify and avoid potential financial fraud and harmful business practices.
Through the clever use of cryptography and consensus algorithms such as proof-of-work, blockchain technology achieves true immutability. This guarantees that tampering with records stored on a blockchain network is virtually impossible. Combined with the features already discussed, this creates a level of security that is difficult or impossible to achieve by traditional means.
DeFi apps bring the inherent benefits of blockchain to the financial sector while striving to provide convenient interfaces to ensure a smooth user experience. In addition, the use of smart contracts like dApps provides an extra layer of protection against bad actors and fraudulent transactions.
Blockchain enables interoperability by connecting different blockchain systems and ensures seamless cross-chain transactions.
Blockchain's decentralised environment ensures that control is transferred from a central authority to a distributed network. Decentralisation offers its users the benefit of a trust-free environment, improves data reconciliation, and reduces vulnerabilities.
Blockchain allows its users to own their digital assets by giving them access and control over the private key.
What are the Limitations of DeFi
Much of the prominent discussion around decentralised finance these days largely focuses on the benefits of DeFi. However, it is important to get a balanced view of both the pros and cons of DeFi in order to properly assess its potential. In fact, most of the problems and risks associated with a DeFi project are primarily related to the technologies with which they are associated. Blockchain-related challenges are generally responsible for DeFi's drawbacks. Here is a snapshot of some of the critical setbacks you may experience when implementing DeFi:
DeFi projects are undoubtedly capable of enabling the financial inclusion of a wider population. However, DeFi projects encounter formidable difficulties in the scalability of the host blockchain from various perspectives. First of all, DeFi transactions take incredibly long periods of time to confirm.
At the same time, transactions on DeFi protocols can become very expensive during periods of congestion. Ethereum, for example, could process nearly 13 transactions per second at full capacity. In contrast, the centralised counterparts for DeFi could process thousands of transactions during that time period. The third-generation blockchain Cardano has already achieved a transaction rate of more than 250 transactions per second (TPS), compared to Ethereum's 13 TPS.
Concerns about uncertainty also shape the pros and cons of decentralised finance. For example, in the event of instability in a blockchain hosting a DeFi project, the project could automatically inherit the instability of the host blockchain. Currently, the Ethereum blockchain is going through several changes. For example, the mistakes made during the transition from PoW consensus to the new 2.0 PoS system could lead to platform issues.
Liquidity is also undoubtedly a critical factor in DeFi-based projects and blockchain protocols. As of October 2020, the total value tied up in DeFi projects is more than $12.5 billion. So, it's clear that the DeFi market is not as big as traditional financial systems. So it can be difficult to put your faith in a sector that is not as big as the usual financial sector.
Below is a table to help you quickly distinguish between DeFi and CeFi.
When combined with blockchain technology, DeFi has the potential to completely transform the global financial system. As more individuals use blockchain to conduct transactions and carry on their businesses, a big shift toward decentralised governance and decision-making is on the horizon.
Continue to the next module to learn about how defi can enable passive income!