While investing or trading in cryptocurrencies, you might have come across a category of tokens known as DeFi or Decentralised Finance. With the advancement of blockchain technology and a large variety of cryptos, many consider DeFi to be the future of financing in the world. In this article, we dive into the world of Decentralised Finance (DeFi) and some of its applications.
Before going ahead, we recommend that you go through our detailed article on the basics of Bitcoin and blockchain technology. You can also refer to our piece on the different types of cryptocurrencies.
What is Centralised Finance?
Before diving into DeFi, it is important to understand what a centralised financial system is. As the name suggests, centralised finance (or CeFi) consists of intermediaries such as banks and other financial institutions that act as the central point of access to all forms of financial services. Bill payments, investments, and wealth management are conducted via traditional banking systems. The current system is controlled by a central authority (such as the Reserve Bank of India) at every stage. Banks control/manage our accounts and validate all transactions.
Despite its popularity, centralised finance faces certain drawbacks. Many people across the globe still do not have access to banks or basic financial services. There can be risks of inflation due to mismanagement by central authorities. Storing and transacting money can be costly and inefficient. In the current scenario, centralised financial systems are prone to fraud and corruption.
Thus, the creators of decentralised financing systems and applications aim to address the flaws of the centralised financial system.
What is Decentralised Finance (DeFi)?
Decentralised Finance or DeFi is a broad term that includes peer-to-peer (P2P) financial services or applications built on public blockchains, primarily Ethereum. It removes all intermediaries (or central authorities) that grant permission for conducting financial activities. You will be able to earn interest, borrow, lend, buy insurance, and trade derivatives via decentralised apps (dApps).
DeFi requires infrastructure such as the Ethereum blockchain for programming and running decentralised financial services. One can write automated code (or smart contracts) on the Ethereum network to create or manage financial services. These smart contracts will automatically execute financial transactions if certain conditions are met. Developers have built DeFi-based exchanges, lending services, and even insurance companies that are not controlled by any entity.
The top DeFi projects being developed around the world today aim to bring more flexibility and transparency to financial services and transactions. It also aims to improve transaction speed and costs. Also, anyone can create, modify, mix and match, link, or build on top of existing DeFi products without permission.
Popular Applications of DeFi
- Decentralised Exchanges (DEXs) are online exchanges that help users buy, sell or trade cryptocurrencies. For example, you can exchange the US Dollar for Bitcoin, Ether, or DAI on a DEX. [DAI is a stablecoin whose value is pegged to the US Dollar. It is protected from the wild price swings that are usually associated with cryptocurrencies.] DEXs connect users directly so they can trade cryptocurrencies with one another without having to trust an intermediary with their money.
When you trade on a DEX, there are no exchange operators, ID verification systems, or withdrawal fees. Instead, smart contracts built on the Ethereum platform enforce rules, execute trades, and securely handle funds.
- DeFi-based lending is a rapidly growing segment of decentralised finance. With the help of DeFi lending protocols, you will be able to use your crypto holdings to obtain loans. These loans are easy to obtain and more affordable than those you get from traditional banks. On the other hand, users can also obtain interest for lending out their money. DeFi-based platforms use smart contracts to replace intermediaries such as banks that manage lending activities.
- Stablecoins are another form of DeFi. They are a class of cryptocurrencies backed by reserve assets (cash or commodity). It attempts to offer price stability while ensuring all basic features or benefits of cryptocurrencies. Tether is an example of a stablecoin. Each Tether (USDT) is pegged to (or backed by) 1 US Dollar.
- Yield Farming is considered one of the most promising use cases of DeFi. It is the practice of staking or lending crypto assets in order to generate high returns or rewards in the form of additional cryptocurrency. Using DeFi protocols, a crypto holder can essentially “farm” for more crypto tokens by using his existing holdings.
- Decentralized insurance in DeFi aims to make insurance cheaper and more transparent. Due to automation, coverage is more affordable and pay-outs are faster.
Top DeFi Tokens
|Top DeFi Crypto Tokens||Features|
|Terra (LUNA)||An open-source blockchain platform for creating and trading stablecoins pegged against traditional fiat currencies.|
|Avalanche (AVAX)||A smart contract-capable blockchain platform that focuses on higher transaction speed and low cost.|
|Chainlink (LINK)||Provides tamper-proof real-world data to smart contracts on the blockchain.|
|Wrapped Bitcoin (WBTC)||Enable the use of Bitcoin reserves on the Ethereum blockchain.|
|Uniswap (UNI)||Allows users to buy, sell, and trade cryptos on Ethereum blockchain via smart contract technology.|
|Dai (DAI)||This coin is based on the Ethereum blockchain and pegged to the US dollar in terms of value.|
|PancakeSwap (CAKE)||Enables users to swap between cryptocurrencies.|
DeFi is the next generation of digital financial services that are enabled by blockchain technology. Such a decentralised system would benefit a large portion of the global population that currently suffers from financial discrimination and high charges. Over time, transactions are going to be faster, transparent, and more accessible globally. More users of dApps would lead to mainstream adoption in society.
However, there are various risks associated with DeFi as it is still in an early stage of infrastructure development. The technology associated with DeFi can have bugs, and if not careful, you could lose your hard-earned money. In the past, there have been instances where smart contracts did not define rules correctly, and hackers found ways to exploit existing loopholes to steal money. Even if you decide to test out any of the existing DeFi projects or services, make sure you use small amounts of money you can afford to lose. It is also vital to understand how a DeFi-based product or service works before using them.
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