Cryptocurrencies are today a trillion-dollar industry disrupting the entire fintech sector.
With the advancement of cryptography, cryptocurrency has become a remarkable innovation.
However, the very first cryptocurrency bitcoin has been in existence for the past 12 years, but mainstream financial institutions are still hesitant to adopt it as legal currency. The reason for this is the high volatility of cryptocurrencies, especially Bitcoin, in terms of price stability.
In the crypto, arena users experience rapid changes and its ecosystem. Currently, decentralized finance is getting popular among users. If you have no idea what DeFi is, then let's look into it and learn all the basics.
Let's start with learning the definition of DeFi:
What is DeFi?
DeFi stands for decentralized finance that comprises all kinds of fintech services and products. However, only users who use blockchain for transactions can enjoy DeFi services. Moreover, DeFi is a popular term in the Ethereum space.
DeFi allows users to access its services 24 seven every day as any central authority does not regulate it. Hence there is no unnecessary delay in making transactions.
DeFi eliminates the usual financial services human errors in traditional payment systems. Also, due to automation, transaction processing happens at a comparatively faster rate. Users consider transactions through DeFi as secure as complex code handles them. Moreover, this code is accessible to the entire network member who can easily detect any mistake or fraud behaviour.
With the growth in the DeFi ecosystem, users can easily borrow, lend and earn considerable interests and so forth. This quality of cryptocurrency trading over DeFi offers users to gain financial freedom. Moreover, crypto helps users to survive during high inflation. Some people claim that cryptocurrency has helped them in paying huge loans while allowing them to be anonymous.
This is because DeFi executes a smart contract mechanism to detect the credibility of any transaction. Hence, the identity of the sender or receiver is not necessary for cryptocurrency trading. Instead, data provided by both parties must match the criteria of the smart contract to process the transaction.
What can you do with decentralized finance/DeFi?
Quick global transactions
Defy executes on blockchain technology which performs global transactions within minutes. For sending crypto, you just have to write the ENS name and valid address of the receiver, and your payment will be sent shortly.
Accessibility to global funds
Using centralized finance gives you accessibility to global fundings stored in the network. This way, you don't have to depend on a specific financial institution for loan approvals. When you get a loan from a DeFi network, you also get the benefit of reasonable interest rates.
Tax benefits
Asset sales are liable to taxation even in crypto. However, without selling your assets, you can borrow loans through decentralized finance. You can pledge your crypto assets as collateral to get a stable coin loan.
This way, you can receive the desired loan amount as well as keep your crypto assets with you. Among other cryptocurrencies, stable coins are the most reliable ones. This is so because stable coins maintain high stability in comparison to other coins.
What is DEX?
DEX stands for decentralized exchange. DEX is an essential protocol of DeFi. It has the highest number of capital storage in its network in comparison to any other DeFi protocol.
It works as a P2P marketplace allowing users to trade directly. The decentralized exchange facilitates financial transactions without needing approval from any central authority. DEX completely removes the need for any intermediaries to access financial services.
Some of the well-known decentralized exchanges are SushiSwap and Uniswap. Both of these platforms work over Ethereum blockchain. Users can get access to a wide range of financial services through their digital wallets directly.
How do decentralized exchanges work?
Decentralized exchanges only allow trading between cryptocurrencies. Hence users cannot exchange cryptocurrencies with Fiat currencies.
With decentralized exchange, you can margin your trades or set limit orders. Additionally, all the transactions over a DEX are handled by an order book. The order book defines the value of cryptocurrencies as per their existing buying and selling orders. This method resembles the pricing system of stock exchange markets.
Decentralized exchanges use a predefined set of smart contracts to operate exchanges. In DEX, you will find liquidity pools where crypto holders can store their fundings and receive remarkable interest as rewards in returns.
Such liquidity pools help traders in the network to carry out exchanges.
Furthermore, blockchain stores every DEX transaction over its network. Decentralized exchange is an open-source platform that allows anybody to access its code.
This makes it easier for external developers to discover DEX codes and build a competitive platform. It can be risky for original developers of the particular decentralized exchange. However, the platform that continuously improves its functionality is always going to be on top.
What can you do with DEX?
Protect your asset from hackings
DEX users don't need to trade or share their assets with any external party.
Hence, users are free from the risk of downfall or system hack of any third-party organization. Thus, DEX users receive robust security from cheats.
Secures you from any kind of market manipulation
Because of its P2P exchange mechanism, DEX protects your cryptocurrencies from market manipulation. Hence, users are well-taken care of from facing any fraud and speculative trading.
Protects the identity of users
With DEX, users do not need to go through KYC proceedings. Hence, users get maximum privacy in the network. The only identity they share is their public address.
Understanding different types of decentralized exchanges:
Due to the present scalability limitations of blockchain, full decentralization of the network is not possible. In fact, the majority of DEX is only half decentralized. This DEX uses off-chain order books and exclusive servers to put away information.
Additionally, any kind of third-party program or data for exchange regarding users' assets is also stored in off-chain order books.
Hence we can say that DEX has some percentage of dependability on a centralized system. Therefore some operations of semi-DEXs may work under the supervision of the government.
However, DEX users will always have full and exclusive control over their fundings with their private keys.
Even though decentralized exchanges are developing and presently operate with numerous other decentralized applications, they commonly execute only over a sole blockchain.
Let us understand the primary components of a decentralized exchange:
On-Chain Order Books
A few DEXs use only on-chain order books to alter or reject orders. Theoretically, on-chain offers maximum transparency and decentralization within the network. This is so because on-chain brings complete trustlessness in the operations by eradicating the existence of external controllers. However, if we look at it from a practical perspective, this functionality is not that achievable.
When all the orders are placed on the blockchain, DEX will need a lot of time to process the transaction. It will need to verify the transaction with each and every node present in the network before it adds the data in the network. Hence, this process becomes incredibly daunting. Also, users need to pay some amount of money to complete the transaction.
Off-Chain Order Books
We can consider off-chain order books as a centralized system; however, practically, they are half decentralized. But, in comparison to on-chain, these are more into centralization.
In off-chain order books, the system does not put away orders on the blockchain network. Instead, some central authority stores all the orders. Also, it can control the order book.
Hence, users do not consider off-chain as credible as third-party entities can easily alter and misuse orders. However, DEXs non-custodial mechanism will still be securing users' fundings.
Furthermore, to maintain the decentralization aspect of off-chain order books, parties oversee off-chain order books by including smart contracts. This way, parties get access to bigger liquidity pools and let traders exchange orders. Once two parties commence to trade with one another, the exchange is done over on-chain.
This mechanism is more beneficial for users as they don't have to depend on an on-chain order book for the entire process. Off-chain order books are comparatively much quicker and cause less traffic.
Automated Market Makers (AMM)
AMM readjusts DEX order books with a pricing mechanism. This mechanism makes use of algorithms to set real-time rates for currency pairing. With an Automated market maker, users can formulate a market over the blockchain. On AMM-empowered DEXs, liquidity pools replace the ordinary order book. The liquidity pools contain funding for both the currencies pairing ( Ex. Litcoin and USD) for the trade. Here, users provide fundings on liquidity pools to earn rewards in return. Their rewards come from the trading cost that traders pay for exchanging over the pool. The reward amount depends on the percentage of the contribution they offer to the pool.
AMMs is a user-friendly mechanism and collaborates with well-known crypto wallets.
What is coming next for Decentralized finance?
Cryptocurrency is the newest form of digital money. The adoption of cryptocurrency in the financial industry across the globe is on the surge. Hence we can say that in the coming years' financial services might work with the crypto ecosystem alongside Fiat. Until now, DeFi has provided us with lending, borrowing, exchanging, and storing cryptocurrencies. So what can we expect to improve in DeFi ecosystem next!
The initial protocols of DeFi depend on the collateral system for security. The collateral system implies that users need to maintain specific crypto amounts in order to pledge them as collateral to borrow more coins.
However, for unsecured loaning and borrowing, a cryptocurrency needs to integrate identity systems. It is actually very beneficial for users as they can work on their credit and boost their eligibility as trustworthy borrowers. The biggest challenge to integrating the identity system entirely in decentralized finance is that it needs to be both secure and universal.
Additionally, progress and advancement are taking space in the insurance space. The majority of decentralized finance loans today are overly collateralized. Hence it reduces the risk of not having adequate funding during inflation.
But at the same time, the vulnerability of smart contracts in the decentralized finance ecosystem is a matter of concern.
In this scenario, if a cyber attacker discovers and misuses any loophole in the open-source code, then users will lose a huge amount of money. This drawback can seriously affect the reliability of a decentralized financial system. However, some of the developer groups are formulating decentralized insurance that can protect users from smart contract hacks.
One more change that we are experiencing in the DeFi interface is a better user experience. The initial interface is more suitable for blockchain experts and people who are good with technologies. The initial framework of DeFi has excellent potential for progress; however, it is not accessible to a more extensive user base.
The current goal of developers is to offer a simplified design and easy-to-use framework. This way, DeFi would be open to a larger population that can enjoy its financial services.
One more progress to note for the DeFi system is the decentralization of decision making and authority to users. At the same time, developers are working to offer maximum security in different DEXs.
Developers have control to shut any of the DeFi projects if they feel there is some issue. It is in practice to streamline quick and easy upgrades within the system. Also, to conduct emergency shutdown when developers discover a bug within the network. However, with the advancement of codes, users are anticipating that developers will not need to do an emergency shutdown in the future.
Moreover, the decentralized finance community is trying to find ways to include asset holders in the decision-making process. For this, they are making use of blockchain-enabled DAOs.
Conclusion
The DeFi ecosystem is deliberately matching up with the conventional financial network. Even though there are multiple barriers that will come in the way while adopting this latest innovation, decentralized finance is progressing towards success. Many experts believe that DeFi is the key to bringing safe, quick, and reliable financial services to the regular population. At the same time, some speculators think that DeFi would fade with time. However, it is hard to tell the actual future of this new financial disruptive system. But, looking at the progress, we can assume a positive outcome.
