DeFi – Transforming the Financial Transactions

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Around 2008 when International Financial Markets went turmoiled and were under crisis there was a spark of a new revolution called bitcoin, a Blockchain-enabled cryptocurrency that was distributed and transparent and the way it is been received is no secret with the value of one bitcoin peaked around 67,500 USD and experts say it just a start.

So every 10 years, there is a big change in the way we do transactions and DeFi or distributed finance is one such big revolution which is just started.

According to the latest statement in the episode of the “All-In Podcast” released Wednesday.

As per the prediction by Billionaire investor Chamath Palihapitiya, Visa and Mastercard, two prominent payment processors, will soon be replaced by the upcoming blockchain and DeFi alternatives by 2022.

So before we move further let’s understand what is DeFi or decentralized finance

Decentralized finance (DeFi) is the most recent financial technology which is built on protected decentralized ledgers.

The objective of the DeFi system is to minimize the authority of banks and financial institutions on money, financial products, and services.

In simple words, DeFi rules out the control of banks and DFIs have on financial products and services. In the DeFi system, there is no need for any third party to control the activities of the users. Hence, it brings in the role of the technology to manage their transactions and deals of the users.

Let’s understand the features of DeFI

Third-Party Elimination

DeFi eliminates the need for a third party thus no need to go through a bank, financial institution, or an intermediary like traditional finance.

It completely cuts out 3rd parties so that users can maintain control of their money and in case of any disputes arise they will be resolved in a pre-specified manner with help of smart contracts which are in simple terms a computer logic code on a blockchain network that trigger its execution on specific conditions and without instead of human intervention.

Automation and Cost Saving

Thus smart contracts automate the process with speed and accuracy and save a lot of legal costs.

Autonomy

Smart contracts have the terms and once the stakeholders agree to them they are not subject to external authority. Since contracts are digitally acknowledged, it prevents any further manipulation by either of the two parties involved. This makes these contracts keep it safe, secure and foolproof.

Digital Wallet enables security of the money without the need of any bank and transfer of assets is fast within a few seconds.

Hence, we can see that DeFi is emerging as the most feasible application based on blockchain technology that uses smart contracts!!

Getting deeper, we need to understand the existing financial system and how decentralized finance differs from centralized finance.

Image: Traditional vs Decentralised Finance (DeFi)
Source: https://medium.com/stably-blog/decentralized-finance-vs-traditional-finance-what-you-need-to-know-3b57aed7a0c2

Centralized Finance vs DeFi

Centralized financial system: Here, a financial institution such as Bank is holding and controlling the money with a motive to make money.

The DeFi system primarily comprises many parties together facilitating transactions among one another. However, they will levy a certain fee for their service.

For eg., a simple credit card transaction charges around 2% fees for every payment which is nothing but service fees.

Besides, stock exchanges levy the brokerage for their service. This can be anywhere from 25% to 1%.

Hence, in a centralized system financial transactions cost overhead charges and time.

As compared to the Centralized Finance mentioned above, DeFi system removes the mediators by increasing the role of stakeholders, I .e. the consumers, merchants, and business entities in controlling the financial transactions through blockchain technology.

This technology primarily uses peer-to-peer financial networks with security protocols and can access from anywhere with an internet connection. Hence, one can trade, take or give loans with the help of software that keeps a record of all the transactions distributed across the financial database. Moreover, it verifies them for validity. These distributed databases collect and aggregate the records from all users and which is verified by a consensus mechanism and these databases are accessible from various locations.

The DeFi system empowers the stakeholders to utilize financial services anywhere. It provides them with more control over their money in their digital wallets.   personalized trading services.

How Does DeFi Work?

As earlier stated, DeFi is the most practical example of blockchain technology which make it distributed and secured.

The applications that facilitate transactions through blockchain are known as “dApps”.

In a blockchain, the dealings are first traced and recorded in the form of blocks. These are then certified by others users through a consensus bases process. Thereafter, the block is encoded or encrypted. Now, the new block has the details of the block preceding it. Further, all these blocks are linked to each other by mapping the data of each successive block. Hence, we get a “blockchain” in the end. The safety procedures are there at every stage to ensure a secure transaction.

DeFi has peer-to-peer financial transactions i.e. core premises behind DeFi and when both parties agree there is no need for any intermediary and one has more options from anywhere in the world.

For Eg. one has to take a loan through traditional centralized finance and now for this, he has to go to a bank or another lender or financial institute and apply for a loan.

Once the loan is approved after a few days there would be interest and service fees for using banking or lender services

However, in DeFi System using peer to peer lending with more options from anywhere in the world and with decentralized finance application ( dAPP ) one need to enter the loan requirement and with algorithm would run matching with peers that match your needs and with smart contract one need to agree to the lender’s terms.

Since these trades are encrypted in a blockchain, they are substantiated through consensus. Only then the loan is sanctioned.

The transaction can be programmed via dApp. This app also functions on the blockchain principle.

A few examples of DeFi exchanges are Pancakeswap and Uniswap. Thus, making it huge in 2021 alone.

A seasoned crypto investor and co-founder of the DeFi platform Vesper Matthew Roszak has told that the growth of the decentralized finance industry has swelled to $80 billion in 2021. He further predicts that this industry is set to reach 10X in the coming few years.

In his words:

“Right now the market cap of DeFi is around $80 billion. My view is that after a year it will add a zero.”

Hence, there is no doubt that in the next few years, current players like Visa and Mastercard are going to face difficulty in similar growth trends like in previous years.

Here Are the Most Popular Types of dApps

  • Decentralized exchanges (DEXs): 

DEXs enables the exchange of one currency to another e.g.  Ether (ETH) to Tether (USDT); or BTC to USD. They can work as popular exchange links, through which the users can directly trade in cryptocurrencies with no role of an intermediary.

  • Lending platforms: 

These platforms employ smart contracts eliminating the need for intermediatory such as banks or financial institutions which manage the lending.

  • Stablecoins: These are a type of cryptocurrencies that are connected to a non-crypto regular currency such as USD, EUR, GBP, etc. This keeps its value stable.
  • “Wrapped” bitcoins (WBTC): This is a process in which a bitcoin is transferred to the Ethereum network such that it can be directly used in Ethereum’s DeFi system. In this way, the users can earn interest on their bitcoin that they lend out.
  • Prediction Markets: These markets are the future places of gambling. Here, the users can bet on the outcome of future events, such as elections, sports events, price change of various assets, and the like. The objective will be to facilitate same functionality as in the traditional gambling, but without the role of bookies who are intermediaries.

DeFi Glossary

With the growing popularity of DeFi, it is important to learn the new technical jargon related to the crypto vocabulary:

Liquidity Pools

These refer to the pools of tokens that are sealed in a smart contract. The investors can earn returns on their tokens alongside helping in effective trading.

You can get the Liquidity Provider Tokens (LP tokens). These show how much percentage share you have in a liquidity pool. Whenever you put some units into the pool, these LP tokens will be automatically produced for you. Whenever you withdraw funds, they will disappear. In this way, the total capacity of LP tokens that you have remains equals to your percentage share in the pool. But here is one catch, and that is a sudden loss. Although the equilibrium of funds, you will not receive your share of the transaction fee.

In January 2021, funds to the tune of $250 million were there in the USDC-ETH pool.

Farming

certain DeFi apps like PancakeSwap also have “farms”. Here traders can couple their crypto and store them in “farms” as pairs. From these, they will receive a regular return in the form of a “harvest”. This process takes the LP tokens, thereby placing them in a “farm.” This is called Staking on a “farm”. Users generally get rewards in the form of another token, which is yet to gain popularity in exchange for your “farm” where you’ve parked your LP tokens. These are of 2 types:

Yield farming: These are meant for seasoned investors who are ready to take a big risk. Here, they can examine many DeFi tokens in order to earn a higher return.

Liquidity Farming: Liquidity farming or liquidity mining is a process wherein a DeFi platform brings in new users to its network by giving them free tokens. Over the past few years, this has also evolved as the most popular yield farming method.

Composability

Composability is a feature of DeFi apps, which means that they are open source and anyone may look at their code. Users can even “assemble” and create new applications with this code.

What are DeFi Exchanges?

DeFi exchange is a special kind of application, where you lend or borrow money from other users, and trade in cryptocurrencies. Besides, you can insure yourself against risks. In addition, you can get returns in savings accounts. Many DeFi apps offer high-interest rates to investors. However, they often come with high risks.

How to Use a DeFi Exchange?

On a DeFi exchange, the users can connect through a Web3-enabled browser or software e.g. MetaMask, Binance Chain Wallet, Coinbase Wallet, etc. Thereafter, you can start exchanging crypto coins immediately with your wallet.

What are the benefits of using DeFi exchanges?

  1. Easy to use: In DeFi system users can directly lend or borrow funds from each other. Besides, they can trade in crypto market and utilize their liquidity pools.
  2. No need of KYC: You don’t need to go through any KYC for using a DeFi for crypto exchange. This is because there is a Web3-enabled browser extension such as MetaMask and Coinbase Wallet for the incorporation of your wallet.
  3. Secure crypto trading: Transactions are done only via non-custodial wallets that are crypto encoded, which ensures safe transactions.
  4. High speed and low cost. With no role of bank transfers, there are no pay bank fees any more. Now you don’t need to wait at all for executing your transactions. Hence, you get high speed at low cost.

What are the downsides of using DeFi exchanges?

  1. Coding faults: The blockchain transactions are mostly irreversible. This means if you do a wrong DeFi transaction or send an erroneous smart-contract code you can’t undo it. For instance, Yam Finance, a business that began in 2020, had crashed due to a technical fault a few days after its launch. At that time it had already raised the deposits to $750 million.
  2. Easy duplication of code: Since DeFi smart contract is an open-source program, it can be easily pirated. This may result in great difficulty in funds transfer from one platform to another, and may even result loss of funds.
  3. Anonymous control: No doubt, the idea is to distribute the financial system, the major risk is that the entity who is running the DeFi system is not acknowledged. A worst case scenario can be that he may run way with all the funds.
  4. No customer support: Although lack of an intermediary is a benefit in this system, it also means that there is no customer-support desk. Users with low expertise might face difficulty in interacting with DeFi platforms. The naive and newbie investors may even lose their funds. This is the reason why many investors still hesitate to participate in this platform.

These are some key demerits that must be addressed so that DeFi system can become an all-time hit. 

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