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Understanding DeFi | How is it Different From the Centralized Finance That We Use Today?

December 14, 2021

Understanding DeFi | How is it Different From the Centralized Finance That We Use Today?

Even before decentralized finance (DeFi) became mainstream, crypto enthusiasts incessantly maintained that it would replace the traditional centralized financial system. While this is probably lightyears away, to their credit, DeFi is gaining traction even within the traditional banking sector – which has been anti-crypto from the start. Although DeFi mimics the functions played by centralized finance, it is designed to fix the faults that plague it.

What Exactly is DeFi?

DeFi, as we've pointed out, stands for Decentralized Finance. It is an entire financial sector ecosystem based on blockchain and operates primarily on smart contracts. The participants of DeFi can utilize numerous decentralized applications (DApps) designed for the financial sector. Hence, we can say that Smart contracts and dApps are the backbone of DeFi.

Smart Contracts

Smart contracts are self-executing digital contracts with a specific function. Here, the terms of the agreement between buyer and seller are written directly in lines of code. Smart contracts are decentralized applications that work together with a blockchain or distributed ledger technology. The code of smart contracts and the agreements contained therein are over a distributed, decentralized blockchain network. 

Smart contracts enable the execution of trusted transactions and agreements between different, pseudo-anonymous parties. There is no need for central authorities of a legal system or an external enforcement mechanism. They make all transactions traceable, transparent, and irreversible. There is no central office, but the network and its participants verify the transactions based on the smart contract.

Decentralized Applications (dApps)

dApps are all applications built on distributed ledger technology. In the broadest sense, every cryptocurrency is a dApp. Unlike conventional apps, such as the instant messenger WhatsApp, dApps are not operated, maintained, or further developed by a single provider. If WhatsApp were a DApp, it wouldn't be run by Facebook alone. Facebook can alter WhatsApp's software anytime it wants, anyway it wants. But for a dApp, this wouldn't be possible. 

The term dApp covers a wide range of applications. Nevertheless, an application must meet certain criteria to earn the designation.

  • The application is open source, the development community-driven.

  • All dApps must store data, reports, and source code on a decentralized blockchain.

  • All data must be cryptographically encrypted in a blockchain.

  • dApps must use a mechanism to generate cryptographically encrypted tokens so that miners can receive a reward. These tokens are generated according to a cryptographic scheme based on a clearly defined consensus procedure.

dApp is comparatively easy to create and can be programmed as desired. The developers can fall back on different functions and thus publish an individual result. Once implemented on the blockchain, a DApp is independent and decentralized. These dApps run on smart contracts.

How is DeFi different from CeFi?

Established financial institutions have also recognized the potential of blockchain technology and are offering their own products. Here's why.

DeFi Lending 

Open loans are a term from the banking sector. Open credit protocols refer specifically to the area of decentralized financial transactions. The complete credit protocol is an electronic credit template that serves as an evaluation basis for the decision-makers.

Secured lending now encompasses an entire ecosystem in which numerous advantages over traditional credit structures speak for themselves. The high functionality of smart contracts is only one point. They achieve the minimization of trust between business partners and, in most cases, are based on Ethereum.

Decentralized credit protocols are based entirely on the public structure of blockchains and convince by:

  • Instant transaction processing

  • More efficient processes

  • Standardization of processes

  • Fully automated

  • Broad access to new target groups

  • Without credit check

Lending digital assets are currently the most widely used DeFi application.

Earn passive income with DeFi

Most investors especially see the potential to earn passive income by borrowing and lending cryptocurrencies. There are different possibilities, which also entail different risks.

This is also a form of investment, which is why certain basic rules must be observed. For example, fundamental analysis of cryptocurrencies can help you find a solid project. Technical analysis and sentiment analysis can be used to determine whether it is a suitable time for an investment. 

Through DeFi, investors have the opportunity to participate in the platform and generate profits through:

Staking

Staking cryptocurrencies has established itself as a popular form of generating passive income. However, not all tokens offer this form; in addition, there is still the risk of price losses. Holders of certain tokens can deposit the respective currency, which is then deposited in a smart contract. Often this process is used to secure a specific blockchain. In return, the lenders receive a fixed interest rate of the respective cryptocurrency.

Yield Farming

The simplest but also least profitable option for yield farming is to lend cryptocurrencies on DeFi platforms. The interest earned for this is paid by those who borrow cryptocurrencies (for example, to bet on falling prices 'shorten'). Different platforms have different interest rates that are also variable. Getting the best out of these interest rates is called yield farming.

Decentralized exchanges have developed, which are based entirely on smart contracts. The trade takes place automatically, and there is no company behind the project. In addition, different tokens can be exchanged directly with each other, which makes trading faster and less complicated. Previously, a change into the key currencies Bitcoin or Ethereum often had to take place.

Since trading is based on token swaps, there is also no order book. Rather, each currency has a specific deposit, which serves as liquidity. This deposit often comes from investors or from the project itself to enable trading with the token. For providing liquidity on a DEX, the lenders then receive remuneration. 

On centralized exchanges such as Uniswap, users can act as market makers and provide liquidity to a pool so that the exchange of cryptocurrencies takes place without large price fluctuations (slippage). For this service, "Yield Farmers" are rewarded with different fees, depending on the trading pair.

Liquidity Mining

Liquidity mining refers to the process of providing coins in a DeFi pool, which is rewarded by the issuance of new tokens. Liquidity can be, for example:

  • Stable Coins or tokens lent on lending platforms.

  • Provision of tokens for exchange on decentralized exchanges (liquidity pool)

Liquidity mining incentivizes the use of mostly new platforms with a new token to attract new users. 

Bottom Line

Notably, DeFi has made huge strides these past few years; DeFi can handle every aspect of the centralized financial system, and the biggest win for DeFi is that it's cost-effective. CeFi processes are usually very cost-intensive and time-consuming, not to mention the bureaucracy. DeFi employs dApps and smart contracts, eliminating the bottlenecks of CeFi. It has excelled at being the bank for the unbanked since no stringent KYC policies are required – which tend to lock out several would-be borrowers. Most notably, DeFi offers several lucrative passive income-earning opportunities, including staking, yield farming, and liquidity mining.  

Many have argued that the only clear path forward for DeFi and CeFi is to commingle, bringing the gaps between the two worlds. What's your opinion? Do you think DeFi will replace the traditional financial system?

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