The principal concept of DeFi is centered on decentralization, privacy, and security. These protocols offer financial services without known intermediaries for any given transaction, automated via smart contracts on blockchain technology.
Introduction to DeFi
The term DeFi is a catch-all term for Decentralized finance. It is a financial application built and runs on public blockchains. First on the Ethereum blockchain, it has expanded to other blockchain networks that use smart contracts like BINANCE Smart Chain, Avalanche, Hyperledger Fabric, Corda, Solana, Stellar, and Rootstock to automate transactions.
The principal concept of DeFi is centered on decentralization. These protocols offer services without known financial intermediaries for any given transaction, automated via smart contracts. DeFi protocols also allow cryptocurrency owners to make more money.
These financial applications provide financial products and services to their users instead of relying on banks or other third parties. It offers anonymity, faster and secure transactions with low charges, and allows anyone to modify, link, or build on any existing DeFi application without permission.
Financial services like peer-to-peer borrowing and lending platforms, stablecoins, decentralized exchanges, placing stakes on crypto futures and other derivative platforms, sourcing for bookies, etc., are automated via smart contracts using DeFi applications.
DeFi Products
Basically, anyone with access to the internet can use DeFi products. No experience is required. To access DeFi products, one is required to connect to the application’s website with a DeFi-enabled crypto wallet, such as METAMASK on Ethereum, with most DeFi applications offering anonymity during registrations.
Transactions are initiated using a cryptocurrency that is supported or token-based on blockchain networks. For example, the Ethereum blockchain uses ETH to pay for transactions, SOL for transactions initiated on the Solana network, BNB for Binance Smart Chain networks, etc.
The History of DeFi and its Place Today
The term DeFi was coined by Blake Henderson of 0x, for a movement of open financial applications being built on Ethereum, in an August 2018 Telegram chat between Ethereum developers and entrepreneurs.
The advent of smart contracts on the Ethereum blockchain paved the way for the development of DeFi applications. This trend continued with the emergence of some DeFi protocols like MakerDAO in 2015, decentralized exchanges (DEX) such as EtherDelta along with ICOs in 2017, Compound Finance alongside Uniswap in 2018, Synthetix in 2019; Balancer, Yearn Finance in 2020, etc.
Since the pandemic in 2020, DeFi has witnessed a series of market crashes and increasing growth despite the falling and rising of interests and values, all of these with the launch of new protocols extending to other non-Ethereum blockchains.
Among some of the financial services proffered by DeFi protocols is decentralized exchanges. In order to understand the concept of a decentralized exchange, it is necessary to know what and how a centralized exchange operates.
A centralized exchange facilitates transactions on cryptocurrencies and tokens listed on that exchange for interested parties. Trading on a centralized exchange requires the use of crypto wallets. These wallets (your private keys) are controlled by the exchange, as it acts as a custodian on the user’s behalf but is owned by the registered users.
They act as an intermediary to parties of a transaction, as these transactions do not take place on the blockchain technology but on the exchange application itself.
A decentralized exchange (DEX) uses smart contracts?—?self-executing codes?—?to facilitate trading between parties via crypto wallets. These smart contracts replace the need for centralized control or intermediaries, as it doesn’t control the wallets on these exchanges. Unlike centralized exchanges, DEX doesn’t offer customer services to its users.
Decentralized exchanges offer their users better privacy and security as transactions are initiated on or off the blockchain technology depending on users’ choice mode. It also provides a set of price determinants known as the automated market makers (AMMs) or forego order books. Unlike order books, it replaces counter-parties by introducing algorithms that determine the price of a transaction.
In order to facilitate this trade, AMMs use a type of crypto funding known as liquidity pools. This allows users to be paid by keeping some of their funds locked in smart contracts that can be accessed for transactions.
Liquidity Pools and Yield Farming
As is true for any and all financial systems, liquidity keeps financial activities running smoothly and efficiently. For any transaction to happen in DeFi, there need to be available cryptocurrencies. Cryptocurrencies are the oil that powers any economic activity in DeFi. This supply of crypto assets is carried out through a funding activity known as liquidity pools. What then are liquidity pools? What sustains it?
Liquidity pools are a collection of cryptocurrencies locked in a smart contract, which supply crypto into DeFi markets. These pools act as the backbone that powers DeFi protocols like DEX, where users can perform transactions like lending, borrowing, or token-swapping.
DeFi protocols allow its users to lock crypto assets into these automatic-executing contracts, as a way of crowdfunding called liquidity pools, so others can use them. Users become liquidity providers for the first time, once they have supplied funds to any given transaction.
Another means to add funds to liquidity pools is through yield farming. With yield farming, crypto assets lying fallow in an exchange or a wallet are lent out through DeFi applications for a reward.
Basically, yield farming involves lending cryptocurrency, which is far more predominant on the Ethereum network. Yield farming is normally facilitated using ERC-20 tokens on Ethereum, with the rewards being a form of ERC-20 token. In return for lending out funds to these pools, users are rewarded with fees generated from the associated DeFi platforms.
As a common practice in yield farming, users source for DeFi platforms with higher rewards, with these tokens themselves also deposited in liquidity pools.
Doing this entails greater returns for users, with an accompanying equal risk too. By providing liquidity to a pool on specific DeFi platforms, users can get incentives by accessing and or accumulating tokens not yet available on the open market or with low volume.
Future of DeFi
DeFi platforms are not only a movement for enabling traditional products and marketplaces on blockchain technology but also enabling access to a far wider reach of disadvantaged people looking to make money.
On decentralization, it allows users to control their digital assets across financial platforms and without interference. On privacy and security of transactions, it offers its users a sense of safety and trust, automated via smart contracts on blockchain technology.
With DeFi protocols, cryptocurrency owners are positioned to make more money without trading limitations.
