DeFi explained. A beginner’s guide to Decentralized Finance.
The cryptocurrency and blockchain industry provides several unique fields where initiatives and businesses create solutions for diverse use cases. Decentralized finance, sometimes known as DeFi, has been one of the most significant and prosperous of such blockchain-based innovations. With the use of secure oracle networks, like Chainlink and blockchains with built-in smart contract functionality, DeFi encompasses a wide range of decentralized apps that disintermediate traditional financial services and open up entirely new economic primitives.
DeFi builds on the merits of cryptocurrencies by introducing new features and providing several of the services of the traditional financial sector in a way that is governed by the wider populace rather than a single business or group of entities. DeFi uses open-source code, thereby giving anyone the chance to expand on already-existing apps in an unrestricted, modular way. DeFi applications now also offer participants access to saving, investing, trading, market-making, and more through a variety of use cases.
DeFi vs CeFi
Financial institutions allow you to save, borrow, earn interest, send transactions, etc with your money. Commercial banks have a long, successful track record of offering insurance and having safety precautions set up to deter and guard against theft. Although, such establishments thus also hold control over your assets to a degree. From banking hours to time-consuming transactions everything requires a detailed back-end settlement. Commercial banks additionally require particular customer information and identification credentials for participation.
DeFi is a market segment that offers financial services and products to anybody with an internet connection and it runs independently from banks and other third-party businesses. Since the decentralized financial market is always active, transactions happen in close to real-time and cannot be stopped by an intermediary. Cryptocurrency is available for storage everywhere, including on desktops, hardware wallets, and other locations. Decentralized finance aims to employ cryptographic technologies to address numerous problems with the established financial markets. Decentralized banking has the potential to revolutionize the financial landscape, especially for the 2 billion unbanked people who, for various reasons, lack access to traditional financial services.
DeFi solutions are built on several blockchains, with the ecosystems consisting of members interacting peer-to-peer (P2P) and the processes controlled by smart contracts and distributed ledger technology. These outcomes are not restricted by geographical boundaries, and participation does not call for identification documents. DeFi does away with middlemen and makes decentralized banking viable, which was previously not possible because transactions had to be approved by outside parties. DeFi aims to establish an unrestricted, permissionless, and open financial market. The goal of much of the technology in the DeFi sector is to enhance the functioning of the current financial system, which might enhance user experience.
Components of decentralized finance(DeFi):
Decentralized exchanges (DEXs)
With DEXs, consumers exchange digital assets in a non-custodial setting without the need for a middleman. DEXs have been a part of the larger crypto economy for a while. They allow users to purchase and sell digital money without having to register for an exchange account. DEXs allow you to store assets away from a centralized platform while also simultaneously enabling on-the-fly trading. Since DEXs are frequently built on top of different blockchains, their compatibility depends on the platform on which they were created. In terms of liquidity and building a loyal user base that is still expanding, DEXs have made great strides. Trading volumes for DEXs are anticipated to rise even more as they become more scalable, or quicker and more effective.
Aggregators & wallets
Users connect with the DeFi market through various aggregator interfaces. They are essentially decentralized systems for asset management that automatically switch users’ crypto assets between several yield-generating platforms to maximize returns. Digital assets are stored and traded through wallets. Wallets can be found in a variety of formats, including software, hardware, and exchange wallets. Depending on the wallet, self-hosted wallets—wallets for which you manage your private keys—can be a crucial part of DeFi, facilitating a variety of platform uses. Contrarily, exchange-based wallets manage your private keys on your behalf, providing you with less security responsibility but also less control.
Decentralized Marketplaces
Blockchain technology’s primary use case is decentralized markets. They give peer-to-peer networks their name by enabling users to transact with one another in an unreliable manner, i.e., without the need for a middleman. The leading blockchain allowing decentralized marketplaces is the Ethereum smart contract platform, but numerous others let users sell or exchange particular assets, including nonfungible tokens (NFTs).
Oracles or the prediction markets
Oracles use a third-party operator to send real-world off-chain data to the blockchain. Oracles paved the way for financial services on DeFi crypto platforms where users can wager on the outcome of an event, ranging from elections to price fluctuations, with payouts paid via an automated process managed by smart contracts.
Layer 1 Protocols
Layer 1 stands for the blockchain that the programmers decide to construct. The DeFi applications and protocols are implemented there. Ethereum is the primary layer-1 solution for decentralized finance. Polkadot (DOT), Tezos (XTZ), Solana (SOL), BNB, and Cosmos (ATOM) are a few competitors. As the DeFi market develops, these solutions will unavoidably interact with one another. There are various possible advantages to having DeFi sector solutions run on different blockchains. Based on the performance of rival blockchains, blockchains may be compelled to increase speed and decrease costs, creating a competitive climate that may lead to enhanced functionality.
DeFi 1.0 to DeFi 2.0
To provide clients with new and exciting possibilities on the road to financial freedom, DeFi 2.0 is an improved version of the present DeFi idea that strives to address weaknesses while expanding on strengths. DeFi 2.0 protocols build on the fact that the first generation of DeFi products successfully bootstrapped the industry by developing a foundational user base and the fundamental DeFi primitives that current and future manufacturers can now use to create the next wave of DeFi apps.DeFi 2.0 research got started when users and projects became aware of DeFi’s limitations, which prompted them to find workable solutions. Every time a problem has been solved, the market has seen a tiny uptick, which is precisely what the market wants. Features of DeFi 2.0 are:
Layer one & Layer two
For DeFi users, especially new users, the Ethereum network has proven to be a substantial obstacle. Unfortunately, the majority of customers have not been able to use DeFi due to pricey gas fees and protracted wait times. DeFi, on the other hand, provides a wide range of opportunities, which makes it quite alluring.
Yield Farming
Another significant DeFi innovation, as a result, was born. Yield farming or the practice of employing liquidity provider (LP) tokens to bootstrap liquidity for new DeFi protocols, has become the norm. The idea behind yield farming is simple. Users that use the AMM protocol to offer liquidity for an exchange pair earn an LP token in return, and stake the LP token for rewards in the project’s native token. Helping users earn yields is the most straightforward way to address the liquidity issue or to draw more customers and capital into the DeFi market. The liquidity issue was partially solved by third-party liquidity providers on AMM protocols, which allowed any independent individual with enough money to provide liquidity for a token pair. Additionally, if there isn’t enough liquidity, the slippage brought on by swaps deters users from participating in the environment of a DeFi protocol. Without consumer involvement in token transactions, insufficient fee volume is generated to encourage third-party actors to pool their tokens and provide liquidity.
With the introduction of yield farming, new DeFi protocols were able to bootstrap substantial sums of liquidity to begin and maintain operations while minimizing slippage for users entering their ecosystem. Although yield farming has shown to be a successful strategy for raising initial capital for DeFi initiatives, there are long-term hazards involved. Furthermore, despite its efficiency, it does not entirely resolve the liquidity issue on its own because of the unique limitations of long-term yield farming enterprises. Since it is vital and healthy, the majority of DeFi projects must engage in yield farming activities and bootstrap liquidity. To avoid unfavorable, long-term effects, project teams must exercise caution when it comes to their token supply and long-term yield farming strategies.
Centralization via DAOs
Apart from coming to DeFi to make money, people also come to DeFi to pursue freedom and self-reliance. However, a group still maintains control over a significant number of DeFi protocols, which causes DeFi consumers to lose faith. DeFi projects often give priority to the decentralized aspect to address this problem. The popularity of the DAO, which lets anyone vote on a project’s development, has skyrocketed recently. Deposited assets will be able to be exploited to their fullest extent with the help of DeFi 2.0. The approach for trading LP tokens for bonds minimizes the frequency of farm-and-dump scenarios while simultaneously providing long-term liquidity, as shown by Olympus DAO. This helps to create a sustainable cash flow. Therefore, keeping a healthy financial flow enables initiatives to grow more sustainably and draw in new backers.
Conclusion
DeFi is growing quite quickly. The sector’s TVL, or Total Value Locked, has climbed consistently over time. The fact that most of DeFi’s resources are static and underutilized, however, is one of its biggest issues. There are currently many more lenders than borrowers, as seen by the low utilization ratio of DeFi protocols. AMM draws a lot of TVL and serves as DeFi’s “Liquidity Pool,” yet the majority of it is not used. This is so because AMM’s design prevents liquidity concentration. Numerous initiatives, including Olympus DAO and Abracadabra, have begun to make the necessary efforts to address the aforementioned issues, and they are progressively emerging as the driving force behind the Capital Efficiency branch’s upcoming wave.
One thing is certain: DeFi 2.0 news is another indication of the DeFi space’s ongoing development, regardless of whether you view it as a generational shift in decentralized finance or just a fancy term.
More importantly, the types of projects that make up the DeFi 2.0 movement demonstrate that we have already moved past the bootstrapping phase, which is possibly the most important stage of that evolution. With that out of the way, DeFi 2.0 projects are now equipped with the resources needed to continue advancing decentralized finance. When it comes to creating protocols—the “money lego”—that maximize revenue, capital efficiency, decentralization, and everything else, developers are getting creative. Tradeoffs do exist, however, some are yet to be seen.
Will be covering DeFi in detail in the coming posts. Stay tuned to master this unconventional finance ecosystem.