What is Decentralized Finance(DeFi)?

Finance is the way we use our money. What can we do with our money? We can spend, borrow, lend, invest, and also insure some valuable things with our money.

We use banks to save our money, we deposit our money in the bank and trust the bank to keep the money safe. We earn a small amount of interest on our deposits while banks loan to some others for higher interest rates. Many people in the world don't have access to the banking system yet.

Banks issue loans that are more than the deposits they have. It is known as Fractional Reserve Lending. If the corporations couldn't pay the big loans they borrow, then the bank halts the cash withdrawals.

We can lend money to someone we know and earn a certain rate of interest. There is always a default risk. We borrow money from the banks as personal loans, mortgage loans and pay interest on them. We also borrow collateral loans such as Gold loans, where we deposit some Gold and borrow money. When the price of Gold decreases, our collateral will be liquidated.

Stocks, Commodities, Derivatives, Bonds, Currencies are traded on stock exchanges and stockbrokers facilitate the transactions. Very few percent of an entire country are educated about these.

All of these are a part of traditional finance(TradFi). All of these activities take place on centralized platforms owned by public or private entities. While we take care of our privacy on a social media platform, we seem to care less when banks and other financial institutions require all our information to make a single deposit or to transfer a small amount of money.

Bitcoin was the first step to DeFi

Bitcoin was the first step to decentralized finance. Bitcoin is a peer-to-peer decentralized digital money. What does that mean? Bitcoin is digital money. We can transfer bitcoins on the internet to any person, anywhere in the world, without any bank or financial institution as an intermediary.

While banks store our data in centralized servers, Bitcoin transactions are stored by every node in the bitcoin blockchain. Nodes are the computers that verify and process transactions on the blockchain. There are about 14000 bitcoin nodes worldwide that make the bitcoin network decentralized. Even if a few nodes go offline, other nodes continue to process your transaction. All of this happens without you revealing your identity.

One just needs to have a Bitcoin wallet to send or receive some bitcoins. Bitcoins can be bought on centralized exchanges like Binance, Coinbase, etc. Bitcoin mining is the way to create new bitcoins, where you can get bitcoins directly to your wallet. But bitcoin mining is an energy extensive process and costs you a lot of energy.

What is Decentralized Finance(DeFi)?

Decentralized Finance is the technology that offers finance instruments without intermediaries like banks, financial institutions, brokerages, etc. Instead, decentralized finance uses smart contracts and blockchain and anyone with an active internet connection can access DeFi products.

We have DeFi applications where we can swap one cryptocurrency for other, borrow cryptocurrencies, lend some to earn interest, invest in tokenized stocks and also trade perpetual futures contracts.

Users also deposit their stable coins to earn interest on them. Stable coins are the cryptocurrencies that are pegged to fiat currencies like the USD. USDT, USDC, DAI are some examples of stable coins. The value of these stable coins will always be equal to 1 USD. People can use these stable coins to earn interest where the interest rates offered by banks are too low.

DeFi platforms offer collateralized loans, where you have to deposit some cryptocurrency to borrow stable coins or deposit some stable coins to borrow other cryptocurrencies. If the price of the cryptocurrency you deposited, falls below a certain ratio, then your collateral will get liquidated.

Every DeFi protocol has a governance token that is used to incentivize the users and also used in the decision-making of the platform. Token holders will have voting power. They can decide on the proposals made on updates of the protocol.

Ethereum is a platform on which decentralized applications(dapps) can be developed using smart contracts. These smart contracts make sure a trade, borrow or lend happens as it is programmed.

An example of what a smart contract does is, we can write a smart contract to buy $100 worth of ETH every month. Now we just need to add some dollars to our wallet and done, the smart contracts buy $100 worth of ETH every month, without our intervention. Nobody could take down this smart contract, not even you.

Currently, most of the decentralized finance applications are on Ethereum. You just need an Ethereum wallet to interact with the decentralized applications, which you can simply download from Playstore or Appstore. Metamask is the most popular Ethereum wallet.

What is TVL?

TVL means Total Value Locked. TVL is the total value of cryptocurrencies that are deposited in the protocol. We use this term to represent how trusted the protocol is and how the protocol can be valued against its peers. TVL also increases or decreases with the price of cryptocurrencies.

Decentralized Finance(DeFi) Examples

MakerDAO

MakerDAO was the first DeFi project. It was created in 2015. Using MakerDAO, you can borrow DAI(a stable coin pegged to USD), by locking your Ether(ETH) in the MakerDAO's vault.

Let's say you have some ETH and you need some money to trade but you don't want to sell your ETH. Now, you can lock your ETH in MakerDAO and borrow DAI to trade or do whatever you like.

For example, you want to lock 1 ETH in MakerDAO. The current price of ETH is $2819. You won't be able to borrow DAI worth $2819. There is something known as the Minimum collateral ratio, which is currently equal to 145%. So you can borrow $2819/1.45 = $1944 worth of DAI with a collateral/lock-in of 1 ETH.

As ETH price is volatile, over-collateralization is required to borrow DAI. If the ETH price decreases below the minimum collateral ratio, your ETH will be liquidated, which means you cannot get your ETH back and you don't need to pay the borrowed DAI.

MakerDAO has a TVL of $15.24 billion and it is the third highest TVL among all the DeFi platforms that exist.

Uniswap

Uniswap is an AMM(Automated Market Maker) protocol, or it is simply a decentralized exchange(DEX). It is the number one DEX on Ethereum. Centralized exchanges are used most commonly to buy or sell cryptocurrency where takes custody of our funds. Using Uniswap, we just need to have ETH and we can swap it straight from our own wallet to any other cryptocurrency.

There are 600 cryptocurrencies to swap on Uniswap and anyone can add a new cryptocurrency. Uniswap has an average trade volume of more than $1 billion every day. It is still very less compared to the average trade volume of $20 billion on Binance, which is the number one CEX. Uniswap has a TVL of $7.39 billion.

AAVE

AAVE is a decentralized lending and borrowing protocol on Ethereum. We can deposit our assets and earn interest on stable coins like USDT, USDC, DAI, and also on cryptocurrencies like ETH, BAT, CRV, etc. We can get collateralized loans on various cryptocurrencies. There are no intermediaries here and no one can stop the transaction to happen. Interest rates in AAVE are adjusted on the basis of the amount of cryptocurrency lent and borrowed.

AAVE also provides flash loans, which are loans without any collateral. These loans are used for arbitrages and have to paid back along with the interest in a single transaction.

About $12 billion worth of cryptocurrencies is locked in AAVE protocol. USDC is the most borrowed cryptocurrency with about $3.2 billion worth of USDC being borrowed.

DYDX

DYDX is a decentralized derivatives trading platform. Cryptocurrency perpetual futures can be traded on DYDX. On DYDX, we can use leverage on our position. DYDX offers leverage up to 25x, which means you get to buy $2500 worth of cryptocurrency with just $100. With 25x leverage, your $100 becomes zero with a 4% drop in price.

28 cryptocurrency perpetuals are available to trade on DYDX. The protocol has a daily average trade volume of $2 billion. It also has a TVL of $954 million.

There are just a few of many DeFi protocols out there but the functionality is more the same. Some protocols issue additional rewards to attract TVL. There are DeFi protocols on other blockchains like Avalanche, Fantom, and Terra but Ethereum protocols have the highest TVL.

DeFi is still in its early stages and there are some risks involved in using them. The current DeFi protocols are constrained to cryptocurrencies but the real-world use cases need to evolve. Decentralized finance is absolutely necessary to eliminate the middlemen and make finance accessible to every part of the world.