What Is DeFi? A Simple Intro Guide

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Decentralized Finance (DeFi) is an integral part of a broader cryptocurrency ecosystem. Although the idea began with the launch of Ethereum in 2017, it was not until 2017 that most DeFi applications became available to users. The creation and notion of yield farming helped accelerate the adoption of DeFi in 2020.

DeFi implements in the world of cryptocurrency, services commonly provided by the traditional financial system. It aims to be more efficient in terms of transparency, security, and decentralization.

What is DeFi?

DeFi is a term used to define the diversity of decentralized protocols that offer financial services without relying on any centralized party. For instance, we have protocols that support the exchange, borrowing, lending, and insurance of digital assets.

DeFi protocols claim to provide transparency and control, and they’re built on blockchains such as Ethereum and Solana networks. Unlike the Bitcoin cryptocurrency network, Ethereum is programmable and allows other applications to be built on top of it.

DeFi protocols are winning user trust because of the inherent transparency built into them. Users are able to control their assets at any time, without the interference of a central party. 

Types of DeFi Applications

Although there are so many types of DeFi applications, this article discusses the most common ones such as decentralized exchanges (DEXes), stablecoins, lending platforms, and prediction markets.

Decentralized Exchange

A decentralized exchange (DEX) is a protocol that uses smart contracts to allow users to perform peer-to-peer token swaps without the interference of a third party. Unlike the centralized Exchange (CEX), DEXes allow clients to trade directly from their wallets without having to trust an exchange with their funds. Users are usually in total control of their funds and privacy.

Most DEXes feature an Automated Market Maker (AMM). This is a protocol that provides liquidity in the markets, by holding reserves of a token pair. Users typically provide liquidity to the AMM, which is in turn used to facilitate decentralized trading.

Stablecoins

Stablecoins are cryptocurrency tokens that hold a stable value. This means that the token’s price is not designed to fluctuate like other cryptocurrencies. For instance, some stablecoins are backed by the US Dollar, ensuring that one unit of the stablecoin is always equal to $1. 

Stablecoins are used for a variety of purposes in the DeFi ecosystem e.g., a store of value, trading, lending, etc. There are different types of stablecoins, including fiat-backed, cryptocurrency-backed, asset-backed, and non-collateralized versions. 

Fiat-backed stablecoins are typically backed by fiat currency reserves held by the issuing company. However, crypto-backed stablecoins are backed by other cryptocurrency and can be useful to track the price of a fiat currency. DAI is an example of a crypto-backed stablecoin.

Lastly, non-collateralized stablecoins, also called algorithmic stablecoins, are a risky breed of stablecoins often collateralized by debt, or other volatile cryptocurrencies that are used to control volatility. Most algorithmic stablecoin experiments have proved unsuccessful in large-scale adoption. A good example is the Terra (LUNA) backed TerraUST (UST) which lost its $1 peg and ultimately collapsed in May 2022.

Lending

For many people, the most important part of the DeFi ecosystem is a decentralized lending platform. Decentralized lending platforms are smart contracts that let you lend and borrow crypto assets at a fixed interest rate.

They offer what commercial banks offer through deposits and loans. However, the only difference is that there is no central party to make decisions on who participates in the whole process. On a DeFi lending platform, users typically borrow less money than the value of the collateral they pay in; meaning that it is overcollateralized.

Ethereum-based Maker was one of the first lending platforms to launch. Since then, other platforms such as Aave and Solend.

Prediction Markets

Prediction markets refer to DeFi applications where users place bets on the outcome of an event like sport, election, games, etc. Funds dedicated towards market predictions are typically stored in smart contracts, and released to winning parties as soon as predetermined conditions are met.

Is It Safe To Invest In DeFi?

Every investment comes at its own risk and DeFi is no different. The industry is still new and has had its fair share of challenges such as increased volatility and security breaches. With these challenges in mind, it is often best to invest only the amount you can afford to lose. Additionally, it is advisable to always do research first before making any investment into the DeFi space. 

Conclusion

DeFi is an attempt to improve existing financial systems by using blockchain to reduce intermediaries, introduce greater flexibility, and allow users to remain in full control of their assets. Although the space is relatively new, a number of applications are already live. Prospective investors must recognize the risks associated with using DeFi protocols and only invest an amount they can afford to lose.

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