DeFi, or decentralized finance, is challenging modern banking. It seems that the outdated financial system can not meet the needs of 21st-century users. And it’s exactly the reason why DeFi is becoming more and more popular every day. DeFi makes it possible to earn high interest on assets, borrow, lend, trade, etc. without any middlemen.
All of this is just a small part of what decentralized finance has to offer users. So, if you are looking for a complete guide to decentralized finance and have been looking for the answer to the question “what is DeFi?” you are in the right place! In this article, we will explain all the intricacies of DeFi in simple terms.
Thanks to DeFi, the decentralized crypto ecosystem is able to mimic the features of traditional finance (TradFi) while adding substantial benefits. Besides simply replicating old models, DeFi decentralized applications revolutionize the way financial transactions are conducted. But what is DeFi precisely? The term “DeFi” combines the two words “decentralized” and “finance”. This amazing hybrid model connects the features of decentralized blockchain technology with the products and services we are accustomed to in the traditional financial industry. Moreover, you can integrate completely new assets into DeFi, for example, NFTs (non-fungible tokens). Decentralized exchanges, with the two most prominent platforms, Uniswap and PancakeSwap, are open marketplaces where people can trade both fungible and non-fungible assets in unregulated environments.
Now, let’s take a closer look at what is DeFi and what benefits it brings to our lives. In addition, we will help you understand what decentralized exchanges (DEX), dapps and stablecoins are.
What is DeFi (decentralized finance)?
We have already briefly explained that DeFi is a decentralized finance. This is a general term for a completely new financial infrastructure based on the idea of decentralization. Strictly speaking, DeFi eliminates traditional financial intermediaries. Therefore, this concept, like the underlying blockchain technology, is quite subversive and even revolutionary.
In traditional finance or TradFi, as it is known in the blockchain and Web3 field, there is a need for large or even small institutions’ participation as trusted intermediaries to secure transactions. In DeFi, blockchain technology removes the need for such middlemen. On top of that, blockchains enable parties to conclude transactions anonymously or under a pseudonym.
What is DeFi? Smart Contracts Role
When delving into what DeFi is, it’s natural to wonder – how did it happen that decentralized finance became possible?
DeFi has been made possible through the use of so-called “smart contracts“. Blockchain protocols like Ethereum use smart contracts to establish the rules for transactions to happen. Smart contracts hold assets and implement transactions after set conditions are met. For example, the buyer adds certain amount for a brand new motorcycle, and as soon as the seller completes all the documents and transfers ownership to the new owner, the smart contract will automatically transfer the amount to the seller’s account. If something is wrong with the documents then the reserved money will be returned to the buyer. This technology is implemented in our application for motorcyclists CryptoMoto.
Smart contracts, also called Web3 contracts, are crucial for DeFi. They are the basis of decentralized transactions or transactions without middlemen. In addition, they ensure seamless interoperability of various DeFi platforms. Today, smart contracts are written using Solidity, the Ethereum programming language. However, since the launch of Ethereum, many other blockchains have emerged, each with its own advantages. These blockchains are based on the experience of Ethereum and EVM (Ethereum Virtual Machine). They have modified some aspects that affect the speed of transactions or the structure of contract fees.
NFT, Metaverse and DeFi
Non-fungible tokens, better known as NFTs, can be anything from digital art to tokenized real estate and games. This is ensured by the use of ERC-721 and ERC-1155 token standards that allow virtually anything to be represented as a unique digital asset in the DeFi. Further, they provide fascinating applications in the Web3 metaverse where they can be integrated into GameFi and play-to-earn (P2E) system. These games are not just for fun. They have economic and financial aspects allowing users to earn tokens that can be then traded on DeFi exchanges.
In order to join Web3 and DeFi ecosystem as a user or developer, an individual needs to create a Web3 wallet. The most popular option to date is MetaMask. This is a decentralized wallet that allows to create a Web3 address and authenticate themselves in the system to be able to trade, create dapps and play games. Such wallets do not require user identification (KYC) and personal details to perform transactions. This ensures data privacy and anonymity – the essential qualities of DeFi.
It may seem strange how all of this – games, exchanges, dapps, and everything is accessed just through one wallet. But it is possible because it is one of the principles of Web3 that ensures seamless integration through blockchain interoperability.
Now that we’ve briefly explained smart contracts, dapps, NFTs, and metaverses in the context of DeFi, we can move on with our “What is DeFi?” quest by discovering other types of ecosystem components and players.
DeFi Applications and Components
When talking about the number of possible DeFi applications, we can say that there are as many as there are traditional financial services and institutions. At the moment, DeFi mimics the traditional financial sphere. It innovates and builds over but the possibilities for completely new ideas and applications are limitless.
Now, discovering the topic of “what is DeFi?” let’s take a look at already existing decentralized apps and the essential components of DeFi. Let’s start with decentralized exchanges.
Decentralized exchanges, abbreviated as DEXs, allow anyone to trade crypto assets without traditional user identification (KYC). This means anyone can trade anonymously or under a pseudonym. In addition, trading on the DEX doesn’t require third-party permissions. The most prominent DeFi DEXs are Uniswap and PancakeSwap. Their popularity among users is a clear indication they play an essential role in the crypto ecosystem.
Stablecoins are cryptocurrencies which prices are pegged to a specific value. The majority of them are pegged to the United States dollar (USD) and are backed with dollar reserves. This means a coin will always cost one USD. But there are other stablecoins pegged to and backed by other valuables:
- Stablecoins backed by other crypto coins. They are more decentralized than fiat-pegged stablecoins. To prevent significant price fluctuations they usually have excess collateral.
- Commodity-backed stablecoins. For these stable coins, different valuable commodities are used as collateral. They include real estate, oil, and precious metals.
- Algorithmic stablecoins or stablecoins without collateral. Such stablecoins use a certain algorithm to manage the supply and use a seigniorage approach, i.e. a fee on the right to mint a coin.
DeFi ecosystems require stablecoins because even the major cryptocurrencies and crypto assets, for example, Bitcoin or Ethereum, can be very volatile. This makes them not the best choice for certain purposes. Thus, stablecoins are used as stabilizers or anchors in the DeFi ecosystem. They are also a hedging tool for the mitigation of high cryptocurrency volatility. It’s impossible to answer the question “what is DeFi” without mentioning stablecoins – they play a major role as a stabilizing ingredient of DeFi ecosystems in general and decentralized financial instruments in particular.
Yield farms let you invest or lend out of your cryptocurrency or other assets to receive passive income. They have become pretty popular because they allow to easily generate passive income from existing assets with relatively low risks and small effort.
However, not all-revenue dapps are safe and reliable. You still need to be careful and study your options thoroughly before investing. When learning what is DeFi you need to know that yield farms are part of a passive income system or investment component that further enhances the appeal of DeFi. Thus, they should not be overlooked.
A short explanation of what wrapped coins are: they are coins that are represented by other coins if you want to use them in another blockchain. They have been introduced to facilitate interconnection and promote transaction speed.
Though it may seem a complex concept, it is not. Currently, it’s one of the most effective ideas in DeFi. Wrapped coins allow the original coin to maintain its value in transactions on a different blockchain.
For example, you can use your Bitcoin to make transactions on the Ethereum blockchain using wBTC (wrapped Bitcoin). In this case the value of the wrapped coin is fully backed by the original currency, in our example, by Bitcoin.
Lending and Borrowing DeFi Dapps
There are dapps that allow users to lend or borrow assets. For this they use the same principles that are used in the traditional finance crediting system. The crucial difference is that these transactions in DeFi do not require middlemen. Instead, you would need to create collateral. For example, if you want to borrow stablecoins, you would need to use your crypto assets, for example, Bitcoin or Ethereum, as collateral. You can also earn money by lending crypto assets to other users and receiving interest on the loaned amount.
It may seem strange to talk about gambling apps when discussing the topic “What is DeFi”. But we decided to add them here because precisely in the context of Web3 and DeFi these apps can fully thrive. Their main principles are anonymity, decentralization, and lack of intermediaries or trustees. These dapps also allow full transparency regarding wins and losses while still keeping user privacy safe.
DeFi Guide – Summary
DeFi is a decentralized finance ecosystem that provides limitless opportunities for users and Web3 developers. It enables users to trade, buy, and sell crypto assets and receive passive income from staking their assets easily, anonymously, and without intermediaries. To date, DeFi ecosystem has already attracted millions of users. In November 2021 it already reached an all-time high total value locked of $305 billion.