What Is Decentralised Finance? [For Beginner]

The introduction of smart contracts to blockchains have created an explosion of financial protocols and instruments in the crypto space.

Blockchain + smart contracts = Decentralised Finance (DeFi)

Learn more on decentralised finance (DeFi) for beginners.

“Disruption” may be the only word that best describes what DeFi has done to the current financial system. The decentralization and trustless nature of smart contracts and blockchain have given birth to a nascent financial ecosystem that is called Decentralized Finance of DeFi for short.

What Is Blockchain?

Blockchain technology has been around for quite some time and has been creating a buzz on how the future of finance will be like in the future. Bitcoin, the first successful use case of blockchain tech, has paved the way for what is possible.

Never would anyone know that a network of anonymous computers would work together and maintain the integrity of the system in this highly experimental designed economic incentives using cryptocurrency. The success of this achievement creates a glimpse of the future that maybe there is something more than just a cryptocurrency.

Refer to this link for more on blockchain

What Are Smart Contracts?

Vitalik Buterin, the founder of Ethereum blockchain, saw that future and proposed new tools to completely seize the full potential of blockchain tech, smart contracts.

Smart contracts are made up of lines of code using a programming language called Solidity, which will be executed on EVM (Ethereum Virtual Machine). It allows people to create new tokens, store, receive and send funds, automate transactions, customize parameters and logics of tokens and transactions, and act as the mediator/middleman.

Refer to this link for more on smart contracts

It may be a mouthful to understand what smart contracts are but basically smart contracts are rules and agreements that are written in self executing code that runs on the blockchain network. This allows people to create any type of financial instrument or social contracts to run on top of the blockchain layer. Imagine someone wanted to do a simple fund, one can write a smart contracts with logics and agreements that:

  • Every participants need to put money with minimum of 50 MYR
  • The fund can only be cash out with agreement at least ⅔ yes from the participants

Once done, smart contracts can be deployed to the network and it will self execute the code in EVM (imagine Ethereum blockchain is one giant world computer). So once it is deployed, smart contracts runs itself with no middle man, records every event that happens within the smart contracts and stores it into the chain.

No one has control over the fund and it is safe from any bad actors who want to steal it as it is being locked in the contract’s logic that they need to get ⅔ of ‘yes’s from the participants to cash out the fund. This is a powerful tool and with enough creativity, any form of financial instruments or social contracts can be created.

Smart contracts have led to creation of thousands of new tokens and financial instruments which have led to a new movement of open and transparent financial ecosystem called Decentralized Finance (DeFi). In Ethereum blockchain alone, the ecosystem has grown from 1.6 Billion USD in Total Value Locked (TVL) to an astounding 53.38 Billion USD.

Developers now built websites and mobile apps to interact with smart contracts that have been deployed to the blockchain. These apps are called Decentralized Apps. The most popular DApps are Uniswap and PancakeSwap. There are thousands of DApps out there that create an evergreen decentralized finance ecosystem that we know and love today called DeFi.

Characteristics of DeFi

There are many reasons why DeFi can be appealing to investors. Before DeFi, cryptocurrencies were only used as a form of store of value. Now, DeFi helps create new use cases for the current cryptos. Public blockchain such as Binance Smart Chain and Ethereum have a few disruptive characteristics from utilizing blockchain infrastructure and smart contracts:

#1. Decentralization

Nodes in blockchain maintain the and keep the data stored which remove the dependent on central figure that might corrupt the stored data.

#2. Transparency

Data is copied to every node in the blockchain network and open for everyone to see the historical data that has been recorded.

#3. Censorship Resistant

Decentralization of information removes a single point of failure of the network and the integrity of data is maintained throughout the network to any external interference (e.g. governmental crackdowns).The cryptographic hash function makes the data immutable and tampering of past data is not possible.

#4. Trustless

The economic incentives of the system create an environment where it is in everyone’s interest to work and maintain the integrity of the network, which is to be good actors and any malicious attempt will be computationally and economically infeasible.

Contrast to traditional finance where trust on centralized governing bodies is heavily involved which may cause corrupted action from the centralized bodies.

#5. Programmable

Smart contracts let people develop their financial tools with little to no resistance and utilize the power of blockchain tech.

#6. Permissionless

Public blockchains are open to everyone who would like to use and build dapps on top of their blockchain. This trait has helped expand the ecosystem to provide a plethora of investment and use cases of blockchain tech to everyone across the globe.

Popular applications in DeFi

DeFi has provided numerous financial opportunities to everyone who has cryptos in their wallet. These are some of the applications:

Decentralized Exchange (DEX)

  • DEX allows trustless trading without having an intermediary to execute the trading and exchange of cryptocurrencies.
  • Popular DApps for this are:

Stablecoins

  • Cryptocurrency that is pegged to other assets to stabilize the price.
  • Popular Tokens:

Derivatives

  • Contracts that derive its values from the market performance. Usually in traditional finance, the contracts are executed by a third party called “broker” but with blockchain, the third parties can be solely smart contracts.
  • Popular dapps:

Lending platforms

  • Lending are done on smart contracts that replaces the banks or any middle man.
  • Popular Dapps

Insurance

  • Using smart contracts to hold funds for insurance, the practices will be the same with insurance in the traditional sense. Major insurance Dapps are mostly catered to secure the risks of smart contrast from other Dapps and projects.
  • Popular dapp

Bridges/Multichain Transfer

  • Transfer tokens from one blockchain to another different blockchain such as sending USDT in Ethereum to Binance Smart Chain in decentralized manner.
  • Popular Dapp

NFT collections

  • NFT are unique form of token that catered to special ownership like artwork and game items that exist to trade in blockchain.
  • Popular Dapp

New Concepts Introduced By DeFi

Decentralized Autonomous Organizations (DAO)

  • An internet native entity which is regulated and enforced by the rules set in smart contracts on the public blockchain with goal to have a sustainable organization and incentivise people to achieve a common mission.
  • Example of DAO

Initial Coin Offering (ICO)/Initial DEX Offering (IDO)

  • Initial Coin Offering are practices of raising funds to create new crypto projects. This practice is similar to Initial Public Offering.
  • Initial DEX Offering (IDO) is the same as ICO except the offering is being done on DEX’s that offered their platform to launch the projects to the public.
  • Example:

Yield farming/Liquidity Mining

  • It is a practice of earning cryptocurrencies passively by providing liquidity in decentralized exchanges (DEX’s) as liquidity pairs (LPs).
  • DEX requires huge pools of cryptocurrencies that allows the exchange of cryptocurrencies in their platforms.
  • These pools are locked in smart contracts which the DEX’s have little control to no control and distribute rewards to in terms of transaction fees from the pools or in a form of governance tokens.
  • Examples:
    • LPs in PancakeSwap
    • LPs in Uniswap

Airdrops

  • A practice where crypto projects will distribute their own issued tokens to specific wallet addresses for free as reward for supporting their projects. These tokens are usually tradable in the secondary market and usually the tokens are a form of governance tokens.
  • Examples:

Composability/Money lego

  • Smart contracts allow developers to build financial instruments and apps to fit or into other projects.
  • The best example one can create and application on top of existing DEX (such as PancakeSwap) that allows the exchange of tokens, and the same application can build on top of lending protocols such as MakerDAO to allow users to deposit their tokens and get DAI tokens and exchange the DAI to other tokens that will increase in price.

Key Takeaways

  • Smart contracts on top of blockchain helped the creation of thousands of new tokens and financial instruments which have led to a new movement of open and transparent financial ecosystem called Decentralized Finance(DeFi)
  • Developers now built websites and mobile apps to interact with smart contracts that have been deployed to the blockchain. These apps are called Decentralized Apps or DApps for short
  • Decentralized Finance (DeFi) has disruptive properties which are decentralized, transparent, Censorship Resistant, Trustless, Programmable, and Permissionless
  • Decentralized Finance has Decentralized Exchange (DEX), Stablecoins, Derivatives, Lending platforms, Insurance, Bridges/Multichain Transfer, NFT collections, and Decentralized Autonomous Organizations (DAO)

Conclusion

The potential of DeFi remains elusive to many and it is understandable. The space moves so fast and jumps to many edges of social and economic reform in utilizing blockchain tech.

Again, the industry is in its infant stage and the risk involved here can be astronomical but it could lead to massive gains. Iterations after iterations have been from projects in the space to onboard new users since its increased popularity from 2020 to now. There are many cases of smart contracts bugs and rug pulls that cost millions of dollars in losses from retail investors. The industry is unregulated as it is out of the government’s control to dictate the market.

Nevertheless, it does not undermine the future of the industry. More and more projects are coming up to fill the inefficiency both in the industry and traditional financial market. Institutional investors are taking notice of the space and starting pouring in large amounts of investment and help establish the legitimacy of the industry.

This financial technology is new and experimental, nobody truly knows the limit of the this tech, one could imagine the world may very well be transform finance, governance, and even identity.

 

What do you think of the future of decentralised finance? If you like this article, share it with your friends and families.

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