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April 9, 2020

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Decentralized Finance (DeFi)

This article is meant to serve as a guide into the world of Decentralized Finance (or DeFi) since it is gaining momentum at a rapid pace. DeFi refers to building traditional financial tools on a blockchain. They are mostly created with the help of open-source protocols so that users can enjoy transparency that is missing in centralized banking structures. Users can take advantage of regular financial services without participation of any intermediary. DeFi offers a range of different products for the convenience of users.

Table of Contents

Disadvantages of Centralized Finance: Why DeFi Came About

The world of cryptocurrency has welcomed the emergence of Decentralized Finance (DeFi), and the hype is unlikely to die down any time soon. If you want to know more about DeFi and understand how it can benefit you, this article will help you.Traditionally, the finance market has always been a centralized unit. The central monetary authorities are responsible for issuing regular currency that is then distributed across the economy. The currency is used to conduct trade in every industry. This means that the central body is in charge of managing and regulating creation and supply of the currencies. Moreover, we tend to place our faith in different financial organizations such as banks and allow them to control our assets in the hope of receiving better returns.

However, there is a significant risk with this system. Since power and control are centralized, it means that the danger of failure is also concentrated in one place. Central organizations are not flawless. In fact, they consist of human beings who are likely to make mistakes and errors in judgment from time to time. We store our money in banks and various financial institutions for safekeeping. This allows us to control our savings and gain profit depending on the type of deposit we opt for. The institutions use our money to invest in share markets and hand out loans to other people at high-interest rates. We, the depositors, do not get adequate returns. The real value of the return falls further because of the high global inflation rate in the world.

You will not be totally safe even if you choose to invest by yourself. If you consult financial advisors, you will have to rely on their schemes and mutual funds to score a good return. You have to remember that recommendations given by professionals do not always play out to the best. While you may get better returns, you will not be cutting down on the risk factor. The wealth disparity existing all across the globe is also an important concern because we are not all equal. We will not handle our finance in the same way as our next-door neighbor might, just because our circumstances will always be different.

With a centralized body in place to make all important decisions, we might have to deal with a lack of transparency. The global economy is progressing every day, and we need to advance alongside. Decentralization could prove to be the savior.

Does Cryptocurrency Rely on a Decentralized Mechanism?

Many would consider cryptocurrency and decentralization to go hand in hand, and that is true to some degree. Cryptocurrencies are massive open-source networks that are designed to give a user complete control of their financial activity without involving any centralized institution.

Decentralization is meant to ensure that there is no single weak point and prevents a complete breakdown of the system. Crypto coins give their users access to secure peer-to-peer trading and not depend on any intermediaries. As a result, users can utilize their assets in any way they see fit. However, it is important to notice that cryptocurrencies by themselves cannot decentralize the entire financial system. Instead, they have managed to decentralize how money is issued and stored.

The two main obstacles that prevent blockchains from completely decentralizing the financial system are:

  • Most cryptocurrencies have to be accessed with the help of centralized access points like exchanges, even though they are meant to be decentralized.
  • Many centralized companies, that are in charge of crypto projects, lack accountability, being not too transparent to their customers.

Decentralized Finance is a key component that is required in order to make cryptocurrencies universally accessible without any risk.

What is DeFi?

The Decentralized Finance (DeFi) movement includes digital assets, smart contracts, dApps, and protocols that are built with reference to a blockchain. The Ethereum platform is an ideal option if you want to run a DeFi application, but that does mean you cannot apply to other platforms. You can imagine DeFi in the form of a financial ecosystem that is open to everyone. You will be able to create your own efficient financial tools and services as you like. They are decentralized and do not have one point of failure.

You might be wondering what smart contracts are. They are programs that will run automatically on your blockchain if certain conditions are met. Smart contracts allow developers to access more sophisticated functions rather than just sending or receiving cryptocurrency. Also called decentralized apps, they are created with the help of decentralized technology and not controlled by a centralized all-powerful entity. If you are not familiar with DeFi, you might feel that the process sounds futuristic, but the truth is that the system has been in development for a while. You have access to many DApps, even today, and create stablecoins.

There are plenty of advantages of using DeFi, and we will cover them all one by one. The primary function of DeFi is to grant you undisputed control over your own assets. You might be swayed by the claims of many new-age banks who assure that they hand over more control to users, but those promises hardly become reality. If you truly want to manage your funds personally, then you’d better opt for a decentralized system. The blockchain technology used by DeFi makes it possible with as little hassle as possible. Financial app developers are beginning to adopt open-source protocols to facilitate trading via decentralized exchanges.

Since all the protocols to be used are open-source, you will be able to create your own financial products over them easily. The spirit of collaboration will give developers the chance to come up with new products that are even more protected and innovative. It does not matter who you are and where you stay; you will be able to store, invest, or trade your assets via blockchain securely. Not only will the process be more transparent, but the returns will also be much higher.

Why Decentralized Finance?

The current global financial situation is less than satisfactory, which is why so many people are reacting positively to this switch. DeFi products differ from traditional financial products in the following ways.

  • These businesses do not have a collective center. They are not operated by an overarching business or institution, being not dependent on any human employees. The transaction rules are included in the code so there can be no violation. As long as a smart contract has been imposed on the blockchain, the DeFi DApps will have no problems running by themselves. They do not even require human intervention, though developers prefer to upgrade them over time.
  • You can access the code anytime you want. It is available on the blockchain to maintain transparency. Feel free to audit if there is something you do not understand. This system fosters a relationship of trust because users know that they are engaged. They will be able to access the contract’s functionality and even find bugs that may cause malfunctioning. The transactions made via the DeFi apps are usually public, and anyone can view them. User privacy is not compromised by the system because all the transactions are made via pseudonyms, which means that nobody is obliged to reveal their real-life identity.
  • DApps do not impose any geographical restrictions. They are global financial products and offer the same functions to everyone in the world. You will be able to use the same services and networks as all other users, irrespective of your location (as long as you have a stable internet connection). However, it is important to note that they are subject to local regulations.
  • You might hear that DApps are “permissionless” to create. This means that you can create your very own DeFi app without having to wait for anyone's approval. Moreover, they are “permissionless” to participate, which means that you can use them without having to undergo any formal procedure. There would be no intermediaries to deal with, and you will not have to handle elaborate accounts. You can interact with your smart contracts directly using your crypto wallets. Such accessibility in the global platform can go a long way in reducing inequality caused by the centralized financial system.
  • The user experience in DApps is usually pleasant and very flexible. You will be able to customize the app based on your preferences. Not only can you make changes to existing apps, but you can also simply create your own app. Smart contracts resemble an open API that allows everyone to become creators.
  • All the records of the blockchain are stored in a scattered manner across many devices so that there is no centralized server controlling the system.
  • Creating new DeFi applications is not that difficult because it can be built just by creating combinations of different DeFi products such as stablecoins, prediction markets, and decentralized exchanges. You can craft totally new DeFi products.

It is clear why DeFi is one of the hottest sectors in the world of cryptocurrency at the moment. Let us move on to the different products it offers.

Products Offered by DeFi

The common products that are associated with DeFi are usually born out of a union of blockchains, open protocols, and digital assets—with conventional financial structures.

Open Lending Protocols

This digital money lending platform operates completely on a blockchain. Open lending protocols have emerged as one of the most popular open finance sectors recently because of the frequent usage of peer-to-peer protocols and liquidity pool designs.

Users will be able to deposit their money without involving intermediaries if they want to earn some interest. Just like a bank offers interest on a deposit when someone else borrows the digital assets, open lending protocols also do the same without involving any middlemen. Smart contracts will determine the terms of the loan and be in charge of connecting lenders with borrowers. The smart contracts also flawlessly manage interest distribution. Since the blockchain is a transparent system, the lender will be more likely to get higher returns. Moreover, transaction risks are clearer, which helps make more informed and efficient decisions.

You will find that the Open Lending Protocol is usually built on a public blockchain (such as Ethereum). More people around the globe will adopt it soon because of the growing importance of lending digital assets. They have several advantages over the traditional lending and borrowing structure:

  • It allows for effortless integration with lending and borrowing of digital assets. You will not have to put in any extra effort to ensure smooth functioning.
  • It offers collateralization of the digital assets so that you are secure when there is defaulting on the loan.
  • With Open Protocol Lending, you will be able to settle transactions instantly. Moreover, the lending methods are secure and trustworthy so that you face no hassles.
  • Open Protocol Lending allows for standardization along with interoperability. Automation can help cut down on the costs you will have to bear.
  • The process does not involve any credit checks. This means that people who are unable to use traditional financial services will be able to use Open Protocol Lending services.

There are some open protocols like Dharma and MakerDAO that offer secured lending services. All public blockchains rely on basic cryptographic verification processes to ensure that the platform is safe for everyone. MakerDAO has emerged as the most favored decentralized lending protocol in recent times. You will find that Open Lending Protocols form the most popular sector in the open finance movement because of their ability to cater to people from all backgrounds with varying needs. Since they are restricted to Ethereum for now, there could be development in the future as the service tries to expand.

Stablecoins

Stablecoins are tokens issued by the blockchain, and they are meant to have a particular assigned value. Stablecoins are usually pegged to fiat currencies so they can hold on to the value. They consider collateral so as to allow for some price variation.

Since the value does not show drastic fluctuation, stablecoins can be viewed by the general population as a form of digital currency. Stablecoins make it easy to tokenize real-world assets. As a result, they can be stored on the blockchain where they have better security. You will find three types of stablecoins in the crypto world:

1. Fiat-Collateralized

Fiat-Collateralized stablecoins are very popular as they represent values in different currencies. The US dollar and euro are commonly used to assign a value to them, and they can be redeemed at a 1:1 ratio regarding the pegged currency. Such stablecoins are usually compliant with regulations and audited. As a result, they can be adopted by the general masses to meet their regular needs. In order to support the existing circulation of a token, a fiat currency reserve is always stored in a bank. Stablecoins like USDC and Gemini Dollars fall within this category.

However, you should be aware that this system centralizes transactions to an extent. This can give rise to counterparty risk. Such stablecoins will need to place their trust in a centralized entity because of which they render themselves vulnerable. Any kind of destabilization, loss of peg, or other geopolitical factors may cause complications. Moreover, the lender will have to rely on the central party. Developers counteract this issue by making the stablecoins auditable. This helps maintain transparency and keeps a user in charge. The firms that issue the stablecoins usually source the revenue from the interest gained because of deposited funds.

2. Crypto-collateralized

If you want strictly decentralized stablecoins, then these are ones that will suit you. Their collateral consists of crypto assets, and there is no involvement of central authorities. These stablecoins are dependent on trustless issuance. They usually keep the 1:1 peg against crypto assets with the help of methods such as incentives and over-collateralization. These stablecoins are fully transparent because of the trustless issuance. You will find that the reserve is auditable as well. Maker’s Dai is a popular crypto-collateralized stablecoin.

The collateral against the stablecoins is stored in the form of a smart contract that can be accessed only after the stablecoin debt has been cleared. In case the excess collateral does not meet a certain fixed level, the system can dissolve the smart contract, and sell the stablecoin.

However, this model is not flawless either, and you should be careful when carrying out your transactions. The underlying of the collateral is volatile, and that can pose certain threats. For example, if the collateral value drops, the system understands that it is under-collateralized. This may lead to the execution of fallback procedures such as stablecoin liquidation. Maker’s Dai only consists of borrowers, and the protocol stands in for the lender.

3. Non-Collateralized

These stablecoins are not centralized in any way. Moreover, they are not over-collateralized because of crypto assets. The procedure relies on the following algorithm. The system increases the supply of tokens when the demand rises and the price of every token falls in order to keep a stable peg. The process works vice versa as well. However, you should not consider this a risk-free stablecoin. Maintaining stability can be a difficult task while contracting the supply of money constantly. Moreover, it implies that participants have to believe that the demand may increase in the long run. If there is a permanent dip in demand, this stablecoin will be unable to maintain the peg.

Remittance Market Solution

One of the most important sectors in which DeFi could make a significant impact is the remittance market. This market focuses on the practice of transferring millions of dollars across physical borders by people working away from their homeland. It is only natural that workers in a foreign state feel the urge to send their earnings home. However, they have to face numerous problems when sending the money across long distances. They have to pay extra fees just to send money as a result of which they end up sending less than they intended. The fees are so high that someone may find sending even the smallest amount unaffordable. Decentralized Finance or DeFi can be helpful in such circumstances as it can cut down the cost of sending money by at least 50%. When using DeFi, overseas workers will not have to worry about sending money across the borders to their family members. All DeFi services are accessible to users irrespective of their location.

Exchanges and Open Marketplaces

DeFi facilitates peer-to-peer transactions with digital assets on the blockchain. The transaction is limited to the two parties involved, and there is no third-party interference. This means that no third party can make any important decision regarding the transaction. With this approach, one can avoid sign-ups, identity verification, and the burden of withdrawal fees. The popularity of decentralized exchange markets has soared in recent years. You will find both P2P marketplaces and decentralized exchanges ready to offer you service. However, the development of these exchanges has been relatively slow, and hence they have not been adopted widely as of yet. Currently, they are at the early stage of adoption, being unable to deal with substantial volume. They are limited in number, and their user interfaces are still not intuitive.

DEXs, like centralized exchanges, employ innovative techniques such as atomic swap in order to swap crypto tokens. They use other non-custodial methods when they have to exchange one asset for another with the lowest possible risk and shortest settlement time. However, you should be careful when you are considering DEXs’ services. Do not take everything at face value. Some DEXs claim that they are non-custodial and decentralized, but the reality might be starkly different. If you want to avoid getting duped, do your own research before making any decision. Some popular DEXs are IDEX, Binance DEX, EtherDelta, and Radar Relay.

You will also find open marketplaces that deal with the exchange of non-fungible tokens (NFTs) or crypto-collectibles. If you are planning to buy or sell such crypto-assets, you can check out platforms like OpenSea and Rarebits. You can discover the potential of these tokens and use them as you see fit. If you want to go the extra mile, you can check out marketplaces such as District0X—this platform will allow you to come up with your own marketplace. You will be able to vote on your unique governance procedures.

P2P marketplaces that are based on Ethereum are likely to stand the test of time. They should be able to cover markets for tokenized real-world assets and digital assets soon enough.

If you are planning to use such services, it is always best to do some homework before you actually take any steps so that you do not suffer any losses in the long run. The technology is still in the works, so you will not get the best out of these systems just yet.

Issuance and Invest Management Platforms

Under this sector, you will be able to explore a wide range of platforms. One of the most important functions of issuance platforms is focusing on the security token market. You need to explore these platforms in order to uncover these platforms. They include exchanges such as tZERO from Overstock that are meant to function as issuance mediums as well.The two most popular security token issuance platforms are Polymath and Harbor. They are designed to provide issuers with all the required tools, resources, and the framework—if they want to introduce their own tokenized securities that can exist on the blockchain. The platforms are equipped with standardized token contracts securities like ST-20 and the R-Token. As a result, they are able to automate compliance requirements. They also have the power to customize trade parameters so as to meet all the regulatory requirements. Moreover, the platforms have in-built integrated service providers to make your job easier. You will be able to get in touch with broker-dealers, custodians, and other legal entities faster.

You will stumble across many smart contract-based asset management platforms, such as Melonport—that focuses on giving you better access to necessary services. Melonport consolidates various services like exchanges, price feeds, compliance, and risk management. Those services provide you with a front-end digital asset management structure that can be created on IPFS.

Issuance platforms and investment management services are advancing slowly because the customer base is not large enough yet. However, once more people start using these institutions on a daily basis after entering open financial markets, they will see more engagement.

Decentralized Prediction Markets

Open finance can pave the way for decentralized prediction markets. One of the most attractive sectors of DeFi, these prediction markets can be challenging to operate, but nobody can deny that they have immense potential that is yet to be uncovered. When Augur launched, it got warm reception from users who appreciated its usefulness as a censorship-resistant prediction market for Ethereum. This encouraged other well-loved platforms, such as Gnosis, to do the same.

Prediction markets have already been existing for some time now. In this context, they have always been a useful financial tool for people who like to speculate about world events and take their chances accordingly. The advantage of decentralized prediction markets is that they allow users the same liberty but with cryptocurrencies. Moreover, they do not allow for censorship in the markets, which is a huge advantage for some. Augur, for example, can be used for all purposes. Whether you are interested in something political or just upcoming weather predictions, the platform will serve you. You can even deal with real-world events without having to be careful. There are some drawbacks to having no censorship market, but most users are willing to put up with them.

While Augur did receive quite a bit of fanfare, it failed to garner a significant volume because of the high entry point in a decentralized prediction market. However, it is expected that such platforms will be in the limelight in the near future.

DeFi’s Global Impact

The influence of Decentralized Finance is unlikely to be localized, considering that the platform is a universal asset.

1. Common financial services are available everywhere

As long as you have a reliable Internet connection, you will be able to take advantage of decentralized financial services. DeFi does not consider your demographics, location, or financial status as factors determining whether you can use its financial tools. The current financial structure places too much emphasis on credentials, entry-level funds, and physical location. The global reach of DeFi can make this a game-changer in more ways than one.

2. Affordable payments across distant borders

As mentioned before, DeFi can play a major role in making remittance services affordable for everybody. It eliminates the intermediaries who charge extra fees and thus leave people who want to send money abroad in dire straits. There is no reason why sending money from one continent to another should be so exorbitantly expensive. Decentralized finance could reduce remittance fees to under 3% (from the current 7%).

3. Better security

It might seem that the transparency in DeFi, that allows users to view all transactions, can be a breach of security. But, the truth is that blockchain platforms do not require anyone to reveal their actual identity. Users will have complete control over their wealth and not have to rely on a central party to make important financial decisions. On the other hand, conventional financial institutions collect personal information from users and it can be a huge problem if there is a data leak at some point.

4. Censorship-resistant marketplace

Since blockchains do not answer to any central authority, they cannot be shut off or pulled down by corporations, governmental organizations, or banks. When you are operating in a decentralized financial system, all transactions have to be immutable. Users can resort to decentralized financial systems if they have to protect their wealth. People living in countries with poor governance and financial turmoil can secure themselves.

5. Ease of use

DeFi is simple to use and makes complex financial services accessible to everyone. The plug-and-play interoperable apps in the DeFi system can be used intuitively by users. They do not involve complex paperwork and legal issues that come with a centralized financial institution.

DeFi’s Risks

Since DeFi offers high returns, it follows that there will be some degree of risk involved. If you are dealing with cryptocurrency for the first time, you should be especially careful. There is a learning curve to using DeFi successfully. You should be able to handle your cryptocurrencies properly and not give away any personal information. Educate yourself on the basics before you even start using the finance tools. It is always the user's responsibility to secure their account properly and efficiently.

With a cryptocurrency, you cannot eliminate the risk of hacking. There are hackers out there who are ready to exploit even the smallest vulnerability in the code. However, security of decentralized apps and smart contracts has been strengthened in the light of recent hacking incidents. A few DeFi tools have even been put through security audits. If you add in your own authentication measures, you will reduce the chance of mishaps.

As a user, it is your duty to update yourself with any changes that are made to the terms of services in different products like exchanges, wallets, and crypto projects. At times, DeFi products may also be given new dimensions so that you can use them in conjunction with DAOs that control the protocol or platform.

Historical data and statistical benchmarks are usually used to evaluate the performance of traditional currency and assess the risk of investment opportunities. However, DeFi does not have an elaborate history based on which one could make risk predictions. As the platform develops further and forms clearer trends, it will be easier to draw inferences.

DeFi solutions can prove to be beneficial for millions of people if only more awareness is encouraged. The adoption of DeFi has gained some momentum in the crypto universe, but there is still a long way to go. It will still be a while before DeFi becomes mainstream enough for people to trust it. One also has to consider the limitations of public blockchains because they might not be able to handle very heavy loads at once. A system has to be improved to sort out such a disadvantage. Moreover, recent times have seen cryptocurrencies becoming more volatile.

Is DeFi Really Decentralized?

If we are talking about decentralized finance, we must consider how decentralized the system can be realistic. Decentralization occurs on multiple levels. Not every DeFi service will have the same degree of decentralization because every component needs to be treated differently.

  • Degree 0 Defi or CeFi: CeFi products are usually custodial, and they initiate margin calls, utilize centralized price feeds, and determine interest rates centrally. Ex: BlockFi
  • Degree 1 DeFi: Not custodial, such products do use centralized price feeds. They also provide liquidity, fix interest rates, and administer updates centrally. Ex: Dharma.
  • Degree 2 DeFi: Non-custodial in nature, these products have an extra decentralized component but are otherwise centrally operated. Ex: Nuo.
  • Degree 3 DeFi: Non-custodial products offering provision of margin call liquidity along with permissionless initiation of margin calls. Everything else is centrally administered. Ex: MakerDAO
  • Degree 4 DeFi: Have all the features of Degree 3 DeFi products. The only difference is that their price feeds are also decentralized. Ex: dYdX
  • Degree 5 DeFi: Have decentralized components of Degree 4 DeFi products and also offer decentralized interest rate determination alongside. Centralized control over platform developments and upgrades. Ex: bZx.
  • Degree 6 DeFi: Every component should be decentralized. However, it is not possible to execute because no DeFi product can be completely decentralized.

All stablecoins are not decentralized either. In order for DeFi to be completely decentralized, the law will have to make way and adapt.

Conclusion

It will be unwise to compare the existing DeFi market to conventional financial solutions, but there is enough room to appreciate that DeFi has witnessed tremendous growth since last year. The emergence of more advanced projects and efficient financial dApps will boost market functionality. We might have to wait a while for a decentralized financial scenario that maintains perfect harmony between the traditional finance market and blockchain to materialize in real life. However, diving into DeFi will give you a view of what the future holds for digital finance. You can start taking steps as early as now.

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