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What is DeFi in Crypto?

Last updated 29th Nov 2022
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Decentralized Finance (DeFi) crypto is a spectacular fintech revolution in which traditional financial services like borrowing, lending, trading, and insurance are modulated into a peer-to-peer ecosystem by leveraging the technical capabilities of blockchain technology.

In this comprehensive guide, you’ll learn about the foundation technologies that contribute to the development of the DeFi infrastructure, why you may want to use a DeFi exchange like Pancake Swap, the pros and cons of DeFi crypto, and much more.

DeFi is Built on 3 Core Technologies

DeFi is built on top of three core technologies that serve as the foundation of this innovation- cryptography, blockchain, and smart contracts.

Cryptography

Advancements in digital technology have opened various windows for the end-users to trade money, goods, and services. However, data traded or exchanged online is vulnerable to threats as bad actors are always on the hunt to explore loopholes and steal the data for personal financial gain.

Cryptography is the answer to building a robust wall of defence around the data, a security envelope that uses advanced computation combined with mathematical theory to encrypt/decrypt data using encryption keys and algorithms.

Encryption keys play the most important role in cryptography, responsible for rendering a message or transaction unreadable for the unauthorized party. The keys make the information discrete. Let’s understand how the Bitcoin network uses public-private key encryption to ensure the security of your crypto funds.

The Bitcoin network issues the users a private key using which the network cryptographically generates the public key through an encryption method called- “hashing”.

The public key can be shared with others for receiving the funds but not the private keys as it unlocks access to your funds. Bitcoin network uses two other encryption methods as well including Symmetric Encryption Cryptography and Asymmetric Encryption Cryptography.

Since the private and public keys are interlinked with each other, the network is aware of the crypto funds that belong to you as long as you have access to your private key. The users only need to protect their private keys because it is the only gateway that can open access to the funds.

Blockchain

The blockchain is a distributed ledger or database that shares information and computing power among the nodes. Information is stored digitally, and their biggest application is running cryptocurrency technologies. Blockchains maintain a secure record of transactions, which promotes trust in the system without requiring a single party to oversee the network.

One of the biggest differences between typical databases and blockchains is data structuring. Blockchains group the data into blocks and they have a data storage capacity. Once it’s met, the block is closed and linked to the previously filled block. This process is repeated to form a chain of blocks and each block is given a timestamp to signify when it was created.

A variety of information can be stored on blockchains, but in the context of DeFi crypto, they are utilized as a ledger of transactions. Therefore, blockchains promote decentralization since no single user has control of the network. Instead, transactions are verified by random nodes on the network, and data changes are irreversible. Overall, blockchains make it extremely difficult for anyone to “game” the system.

Smart Contracts

Smart contracts are an agreement between two parties that is written into the lines of code, and it’s a self-executing in nature. The contracts exist on a distributed and decentralized ledger as part of a blockchain network. Additionally, the code ensures that transactions are traceable and irreversible.

Therefore, DeFi users can interact without the need for oversight by a third party to ensure that the transactions are fair and honoured by both sides. Users can inspect the code of smart contracts to learn how they work and determine if the technology can be trusted.

Some of the top use cases for smart contacts in DeFi include:

  • Digital identity: smart contracts can be used to verify the digital identity of a user. Therefore, a user’s digital assets can be protected from others.

  • Insurance: smart contracts are being used to settle insurance disputes between users in a way that’s fair and effective. The insurance policy is created in the smart contract and the program can enforce the rules of the insurance agreement.

  • Asset management: the process of managing assets is quick and effective with smart contracts without the need for 3rd parties. Also, there is full transparency and no grounds to complain since the lines of code of the smart contract dictate how the assets will be managed.

  • Mortgage: automation is induced in the mortgage system with smart contracts, which make it easier for buyers and sellers to interact. The process of giving and receiving mortgages is faster, and there is less hassle for both parties.

  • Supply chain management: smart contracts can be used to accurately monitor the movement of goods within a supply chain. The enhanced tracing and verification reduction means pinpointing the location of something in a supply chain is more efficient.

5 Pillars of DeFi Crypto

In this section, we will cover the main pillars of DeFi crypto so you can better understand the uses of the technology and what’s involved in a DeFi financial network.

Stablecoin

Stablecoins, as the name suggests, have a stable price over time, and it's pegged to a fiat currency - for example, USDC is pegged to USD where 1 USDC = 1 USD. The idea is to offer the benefits of cryptocurrencies while avoiding high volatility. You can think of them as a tokenized version of fiat currencies.

In theory, a 1-to-1 ratio of the stablecoin and corresponding fiat currency should exist. In practice, there might be slight deviations that quickly get corrected. Collateral stablecoins maintain a pool of assets used as collateral to support the coin’s value. Therefore, when coin holders want to cash out, an equal amount of assets are utilized.

Stablecoins allow DeFi users to generate yield on crypto assets while alleviating the potential adverse effects of market volatility. Instead of cashing out fiat currencies in a bank, a process that is time-consuming and costly, users can exchange cryptocurrency for stablecoins.

Lending and Borrowing

DeFi lending in a decentralized finance network is similar to traditional bank lending. The biggest difference is that P2P decentralized applications known as DApps are used to facilitate lending and borrowing, which means cryptocurrency holders can earn an income.

It’s a trustless approach since the crypto lender can lock their assets on DeFi lending platforms like Aave and MakerDAO. Furthermore, lenders can receive interest, which allows them to earn even more money.

Typically, lenders add money to a lending pool on these platforms, which allows for the fast distribution of funds to borrowers using smart contracts. Borrowers need to research each platform to figure out the rules and interest they might have to pay for the service.

The advantage of using DeFi for borrowing and lending is the speed of the entire process. Whereas at banks, you might need to wait days or weeks for a response, and the fees would usually be higher. Also, you’ll need to pass a credit check to ensure you are eligible for a loan.

Decentralized Exchanges

Decentralized exchanges (DEX) are peer-to-peer marketplaces that allow users to interact without the involvement of third parties. Therefore, funds are not handed over to an intermediary, as you would with centralized exchanges like Coinbase and Binance.

Transactions on decentralized exchanges are handled through smart contracts, which are self-executing agreements written in code as explained above. Users can interact with DEX using Defi wallets like MetaMask. No registration or KYC verification is required, so DEXs support anonymity.

The growth of DEXs was fueled by aggregators optimizing slippage, swap fees, and token prices. Some of the top DEXs include:

  • PancakeSwap: this DEX was launched in 2022 and is currently one of the more popular options running on the Binance Smart Chain and makes use of permissionless liquidity pools. CAKE is the native coin and cryptocurrency shot up in price quickly because of its excellent utility. You can invest in CAKE with centralized exchanges like Binance, Kraken, and KuCoin.

  • Uniswap: this DEX has the native coin UNI and was launched in 2020, so Uniswap is a relatively new platform. Exchange cryptocurrency is the main use case of Uniswap and the exchange has a market cap of around $4.9 billion at the time of writing. It’s built on the Ethereum blockchain, and you can buy UNI on many centralized exchanges.

  • Curve: this DEX also runs on the Ethereum network, and the main use case is swapping between stablecoins. You simply need an Ethereum wallet to connect to Curve to begin trading stablecoins. Curve is an automated market maker protocol and a pricing algorithm is used instead of an order book. The automated nature of the system keeps the fees low and transfer times fast.

Insurance

There are two types of DeFi insurance to consider:

  1. Standard: this insurance type aims to replace insurance general insurance deals that you would have already come across. This includes car insurance, health insurance, home insurance, and much more.

  2. DeFi activity: this insurance type aims to ensure users take part in DeFi transactions and want to offset the risk of hacks, scams, smart contract exploits, and other shortcomings of DeFi protocols.

DeFi insurance schemes allow users to create pools of risk where users pay premiums for protection against financially punishing events. Through smart contracts, users would receive insurance money if the criteria for payment are met.

Also, no centralized entity decides if an individual will receive payment based on the case. Instead, the smart contract code springs into action and releases payments when conditions are met.

Margin Trading

Margin trading on DEXs is similar to how it works on other platforms, funds are borrowed from the exchange so that you can access leverage and open larger positions than you would otherwise. You’ll need to hold a percentage of the borrowed amount on the platform as collateral, and the position will only remain closed if the price of the invested assets doesn't drop below the amount of collateral stored.

However, to receive loans for margin trading traditionally, you’ll need to use a brokerage firm that might charge high fees and require large minimums. Whereas margin trading with DeFi platforms allows for faster processing speed and lower fees.

Defi Crypto Pros and Cons

Now let’s turn our attention toward the pros and cons of DeFi Crypto, so you can get a balanced overview of the revolutionary financial technology. This will help you figure out if it’s something that you can make use of when trading cryptocurrencies.

Pros

Accessibility

Anyone with an internet connection can join DeFi platforms. There is no need for credit checks, extensive documentation, and eligibility from specific countries. In fact, you’ll have complete anonymity when using DeFi platforms since you can interact with them by simply linking a DeFi wallet like MetaMask.

Therefore, people in regions with bad finance infrastructure can access DeFi financial applications. This promotes financial freedom across the world and reduces financial inequality.

Security

The security in DeFi is arguably safer than data stored in a bank, where a bad actor employee could potentially access your personal account and use the money how they please. In comparison, data on DeFi systems is stored on hundreds or thousands of nodes, so a hacking attempt is extremely difficult. Consensus protocols prevent individual users of the DeFi network from harming other users, which promotes security and trust in decentralized financial systems.

Profitability

The high-interest rates and inflation of centralized finance reduce the profit potential for traders. In comparison, the fees on DeFi platforms are far lower, and the yearly yields can reach upwards of 20%, but that’s not a guarantee.

Autonomy

The limitations of centralized systems are not present in DeFi finance. For example, regulatory changes, fee format alterations, bank opening hours, and slow transfer times are a thing of the past in the world of DeFi platforms. Instead, transactions are executed autonomously 24/7 when they are requested. Also, no extra fee is charged for the service, meaning users don’t have to choose between paying less or enjoying faster transfer speeds - they get the best of both worlds.

Cons

Poor User Experience

Most DeFi platforms don’t provide a seamless experience for users that are easy to get started. People don’t understand these systems, and there is a steep learning curve to ensure you get the most out of DeFi finance. The unregulated nature of the technology means users have to be careful and research the tools they are using to avoid getting burned.

Limited Integration

Centralized finance is run by powerful institutions that are very slow to integrate with new systems. Also, the loss of control from DeFi technologies is not appealing to many lawmakers. Therefore, DeFi has limited integration and application in day-to-day life.

For example, a limited number of employees pay out in cryptocurrencies, and you are unlikely to pay for groceries in cryptocurrencies at your local store. Therefore, DeFi enthusiasts have to be patient until there is widespread adoption.

Lack of Regulation

The unregulated nature of decentralized technologies is both a blessing and a curse. The regulation aims to protect users from bad actors or platforms that can simply take users’ money and run. Government-backed organizations like the Securities and Exchange Commission and the Federal Trade Commission protect consumers and enforce antitrust laws.

Some regulation is required in DeFi to ensure that users are protected. Otherwise, it will continue to be the Wild West of finance and prevent it from going mainstream.

Volatility

Cryptocurrencies are generally more volatile than fiat currencies. Therefore, holding most of your savings in a crypto asset is not the best choice. The high volatility means that you should invest long-term if you can afford to lose the money you’re holding in cryptocurrencies.

Final Thoughts

In summary, DeFi Crypto is an exciting technology with a lot of upsides. It solves various problems of centralized finance, including lowering fees, increasing accessibility, improving data security, and ensuring better profitability for traders. However, the drawbacks of the technology include high volatility levels, low adoption, and a poor user experience compared to centralized technologies.

However, the DeFi Crypto technologies are evolving rapidly, and you can invest in projects by buying coins that support them. Some of the best centralized exchanges for buying these coins include Binance, Coinbase, and eToro.

Is it safe to invest in DeFi exchanges?
What are the top DeFi exchanges?
What is the difference between Defi and CeFi?
Is DeFi just about cryptocurrencies?
What is required to buy cryptocurrencies on DeFi exchanges?

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Martynas Pupkevicius

Martynas Pupkevicius

Martynas is a seasoned freelance writer that has written on a broad range of topics over his 10 year career. He enjoys diving into the research and sharing what he's learned with readers.