Defi 101
What is DeFi
DeFi, is the abbreviation for Decentralized Finances based on cryptocurrencies or a blockchain that aims to eliminate financial intermediaries. DeFi is inspired by blockchain, a technology that supports digital currency bitcoin. Blockchain allows multiple organizations to store a copy of transaction history, ensuring that it is not controlled by a single, intermediate source. This is important because centralized systems and human gatekeepers can minimize and make things worse while giving users more direct control over their finances. DeFi is unique in that it expands blockchain use in addition to easy asset transfers to complex financial applications.
Bitcoin and many other digital goods differ from traditional digital payment methods such as Visa and PayPal because they exclude all transactions. If you pay for coffee in a cafe with a credit card, the financial institution stays between you and the business, controls the transaction and reserves the right to suspend or suspend it and record it in its register. Those institutions are no longer compatible with bitcoin.
Large firms have more than just direct purchases; also regulate finance applications including loans, insurance, rebates, receipts, bets, and more. One of DeFi’s main advantages is that it eliminates mediators of all types of transactions. The DeFi concept was once known as “open finance” before it became known as “Decentralized finance.”
Decentralized Finance uses technology with the objective to disintermediate all the centralized models and provide the services to anyone, regardless of race, age, or cultural identity. DeFi services and applications are usually based on public block chains, and can replicate existing products built on standard technical standards or provide novel services designed for the DeFi environment. DeFi programs, on the other hand, give users more control over their money by offering wallets and trading options designed for individuals and not institutions.
DeFi vs. Traditional finance
The debate over traditional funding is always controversial.
There is a big difference between the two.
- DeFi in a public blockchain acts as a reliable source of distributed revenue, controlling all financial transactions; On the other hand, public administration, which includes regulations and licensed financial institutions, serves as a source of trust, which governs all activities of traditional finance.
- DeFi is gaining partial popularity because it is more open and transparent than traditional finance. As there are no particular entry barriers, anyone with basic programming skills can contribute to the development of financial services and tools in addition to public blockchain.
- The traditional financial system, on the other hand, has found it difficult to accept this new practice due to high entry barriers. The need to obtain the necessary licenses and authorization from regulators hindered the development of traditional financial systems.
What makes up DeFi
DeFi components are similar to those in the current financial environment in that they require stable finance and a range of different utility cases. Stablecoins and services such as crypto exchanges and loan services are examples of DeFi items. Smart contracts provide a framework for DeFi applications to operate as they incorporate the terms and conditions required for these services to operate. The smart contract code, for example, includes custom code that specifies the specific terms and conditions of each individual loan. The deposit can be closed if certain terms or conditions are not met. All of this is done by code and not by bank or other organization by hand.
The software stack contains all the components of a distributed financial system. The components of each layer are designed to achieve a specific purpose in building a DeFi system. Stability is a distinguishing feature of the stack because the components from each section can be combined to create a DeFi application.
Defi Stack is composed of following 4 Layers:-
Settlement layer: It is also known as Layer 0 because it serves as the base layer for every transaction made. It includes a public blockchain and digital currency or cryptocurrency. This money, which may or may not be sold on the public market, is used to pay for transactions in DeFi applications. Ethereum and its natural token ether (ETH), traded in crypto trading, are an example of a settlement. Types of token goods, such as the US dollar, or digital tokens of real-world assets, may be used in the payment platform. A real estate token, for example, could represent ownership of a piece of land.
Protocol Layer: DeFi agreements are interoperable, which means they can be used by many businesses to create an app or application at the same time. The protocol layer provides DeFi natural credit. Synthetix, a trading platform available based on Ethereum, is an example of DeFi protocol. It is used to make digital duplication of real-world objects.
Application Layer: As the name suggests, it is a layer of the app where the customer-facing programs reside. These applications deliver basic agreements to simple customer-focused services. The most common applications in the digital financial system, such as chemical exchanges and lending services, reside in this layer.
Aggregation Layer: This layer connects multiple applications from the previous layer to provide service to investors. They may, for example, be able to make money transfers between different financial products in order to increase profits. Such trading practices will require a lot of documentation and proper connectivity. The technology-based structure, on the other hand, should be a smooth investment platform, allowing traders to quickly switch between different providers. In the realm of integration, borrowing and lending are two examples of services. Other examples include banking services and cryptocurrency wallets.
Decentralized exchanges (DEXs)
Users can trade currencies for other currencies using online exchanges, such as US dollars for bitcoin or ether for DAI. DEXs are a popular sort of exchange that links users directly so they can trade cryptocurrencies without entrusting their funds to an intermediary. There are more than 35 distributed exchanges based on various blockchains, and the market continues to grow. The largest trading volume of any DEX is Uniswap, based on the Ethereum blockchain. On May 5, 2021, it unveiled its V3 to Ethereum mainnet.
PancakeSwap and SushiSwap are both Binance Smart Chain forks based on Uniswap. QuickSwap and Umbria Network are based on Polygon (the Ethereum rating solution), with the first being a Uniswap fork and the last being a SushiSwap fork. IDEX is now available on Ethereum and Binance Smart Chain, and Polkadot is on its way.
DeFi Aggregators/Wallet
DeFi aggregator puts trading from multiple financial platforms (DeFi) together in one place, saving customers time and improving cryptocurrency trading performance. DeFi, as the name implies, is distributed across multiple blockchains, including Ethereum and Binance Smart Chain.
The ecosystem system of independent financial systems exists within each blockchain. While having a different set of protocols has the advantage of separating assets and obtaining the best interest rates from crypto loans, efficiency and ease of use are disrupted as financial data disperses over several contracts. DeFi mergers are thriving in this area.DeFi mergers collect the best prices from DEX, loan services, and payment pools and integrate them into one place so that users can grow their business. After that, the user has to use smart contracts to make each transaction manually.Although this method is not sufficient for unconventional cryptocurrency trading, it is very restrictive for people who want to do complex trading strategies.
Aggregators not only offer lower prices, but some DeFi aggregators also offer a unique, easy-to-use way to test and integrate trading strategies of other users using a simple drag and drop system. Users can use this method to build their strategies based on the ideas of other successful vendors. Users can also visualize complex DeFi agreements using drag and drop blocks that can be placed on top of each other.
Decentralized Marketplaces
Instead of operating within the intermediate exchange, investors in the lower market can communicate directly. Empowered markets are real markets that use empowered funds, such as cryptocurrency. The medium-sized market communicates and displays prices / requests in real time using a variety of digital devices. Buyers, sellers, and retailers do not need to be in the same place to make transactions in this way.
Real estate is a typical example of a low-end market, where buyers engage directly with sellers.
The virtual markets and the blockchain system, both of which use bitcoin, are a very recent example.
Defi Prediction Markets
Predicting markets are stock markets that are designed to trade event results. Market prices can reflect what the public believes is a possible event. Forecast market is a market where people can buy and sell predictions. It can be any type of prediction, such as financial predictions, event forecasts, or price predictions for any cryptocurrency / token / coin.
With the growing popularity of blockchain-based applications and cryptocurrencies, low-cost forecasting markets have advanced. Because the crypto industry is so young and there are so many restrictions and laws to obey, it’s tough for crypto investors to keep track of everything. These prediction markets play an important role and are extremely beneficial to crypto investors and traders in this respect, as they provide market predictions and alternative solutions based on current statistics.
PlotX and Augur, built on Ethereum, the most widely used blockchain, are two existing markets based on DeFi.
Layor One
A blockchain is referred to as a Layer-1 network in the decentralised ecosystem. Layer-1 blockchains include Bitcoin, Litecoin, and Ethereum, for example. In order to achieve scalability, layer-1 scaling solutions supplement the blockchain protocol’s foundation layer. A variety of techniques that directly increase the scalability of blockchain networks are now under research and use.
Layer-1 solutions alter the protocol’s rules in order to enhance transaction capacity and speed while simultaneously accommodating additional users and data. To enhance total network throughput, layer-1 scaling options might include increasing the amount of data included in each block or speeding the pace at which blocks are validated.
Defi Use Cases
Here are some most essential use cases of Defi.
Insurance
One of the most important financial businesses, insurance, has already proven to be one of the most important DeFi use cases. The existing insurance system is clogged by mountains of paperwork, antiquated auditing systems, and cumbersome insurance claim procedures.
Analytics and Risk Management Tools
Users were able to discover and evaluate an unprecedented quantity of data because of transparency and decentralization. Users may make well-informed company decisions, uncover new financial possibilities, and improve risk management strategies with access to this data.
Tokenization
One of the most important aspects of the DeFi ecosystem is asset tokenization. On a blockchain network, tokenization is the process of creating, issuing, and managing digital assets. Because any asset can be tokenized and kept on a blockchain, it effectively creates a new economic system.
Trading platforms and tools
Trading is one of the most basic financial instruments that has been in use since the dawn of civilization. The advent of the DeFi ecosystem, on the other hand, has opened the door to a slew of new trade opportunities. Crypto trading, margin trading, derivative trading, NFT trading, and other emerging forms of trading are all examples of this newer type of trade.
Payments and stablecoins
Non-bank or non-banking services from the beginning was a great incentive for DeFi. DeFi’s internal features make it ideal to deal with problems with today’s global payment systems. Compared to older systems, DeFi offers some faster, safer and more transparent methods. The DeFi-based blockchain in payment systems may be attractive to non-bankers because it reduces the need for intermediaries, making payments easier and more transparent.
Stablecoins are a better option than cryptocurrencies. Solidcoin is a cryptocurrency supported asset. Fiat funds, gold, oil, commodities, and other cryptocurrencies are among the assets placed in the lake. Stablecoins can therefore help reduce the total instability of the bitcoin ecosystem and make them a viable payment option globally.
Margin and leverage
The old trading system includes trading margin as a standard component. It means the act of borrowing money from consumers to invest and make temporary profits.
Traders do not have to rely on retailers to borrow money when using DeFi. Instead, smart contracts can be used to create lending systems, which are not held. Such loan agreements have already been submitted by DeFi startups such as Compound and dYdX. Private financial markets are a term used by some to describe this activity.
The migration of DeFi to regular banking institutions has created a void in the lending market. As a result, the borrowing and lending process is one of the most essential applications of DeFi.
Defi-Native Activities
DeFi components are similar to those in the current financial environment in that they require stable finance and a range of different utility cases. Stable coins and services such as crypto exchanges and loan services are examples of DeFi items. Smart contracts provide a framework for DeFi applications to work because they integrate the conditions and actions required for these services to work. All of this is done by code rather than by a bank or other organization by hand.
The software stack contains all the components of a distributed financial system. The components of each layer are designed to play a specific role in the development of the DeFi system. Stability is a distinguishing feature of the stack because the components from each section can be combined to create a DeFi app.
Defi Risks
There are a lot of risks for Defi but we are going to discuss three major and bigger risks.
Governance Failure
There is disagreement about whether whales can wield enough power to vote in their own best interests and harm the community, while others believe that whales would not self-sabotage a system if their money was invested in it. There are also continuing discussions regarding CeFi’s huge pockets exerting influence on DeFi governance in order to preserve the mega-exchanges’ interests.
Oracle Failure
In DeFi 2020, Oracle failure has been a key avenue of attack. When unscrupulous actors utilise a flash loan to purchase or sell an item, the asset price is manipulated long enough for them to arbitrage the difference and profit millions of dollars by exploiting a protocol.
Admin Key Risk Always keep an eye out for centralised admin capabilities that allow a developer or team to freeze or transfer money that have been placed into the DeFi app.Normally, the most reputable DeFi teams, such as Compound, will implement a time lock to prevent code changes without the approval of multiple parties or a DAO that governs upgrades and proposals, as well as a second time delay to alert the community if a potentially unfavourable or controversial change to the protocol is on the way.