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DeFi 101: Decentralized Finance (DeFi) in Crypto

Blockchain technology has come a long way in a short time. And in this short time, we’ve seen quite a lot of potential use cases for the technology. While some, like the Metaverse, are still more speculative and futuristic, others, like the one we’re talking about today, have started challenging the status quo.

In the rest of this article, we’ll be doing justice to what Decentralized Finance is. We’ll discuss its applications, benefits, and drawbacks. By the time you’re done, you would have a clear picture of what DeFis are now and what they may be in the future.

So, What is Decentralized Finance (DeFi)?

What is Decentralized Finance

Decentralized Finance, or DeFi, in crypto, is a model of financial transactions for digital assets that are done directly between peers, as opposed to through intermediaries or centralized institutions. This value transfer technology is carried out through blockchains, thus eliminating all forms of intermediaries.

Centralized Finance vs Decentralized Finance

In case you weren’t already clear, our current financial system is a centralized financial system. And at the very top of this food chain are central banks issuing all the fiat currencies. Examples are the United States Federal Reserve, the Bank of Canada, and the Swiss National Bank.

Also, somewhere on the food chain are banks, credit institutions, and so on. Pretty much every company that handles your money on your behalf, short or long term.

What all of these institutions have in common is that they can make policies and decisions that can affect the value of your money. And that’s the first issue with centralized finance: too much control in the hands of intermediaries.

Suppose you want to send money to your friend. You would have to do it through your bank. Your bank here is the intermediary between you and your friend. And if your friend uses a bank that’s different from yours, there are now two intermediaries between you and your friend. If that transaction was within two countries with different currencies, then the number of intermediaries increase. And the more intermediaries are in between you and your friend, the more complex the process gets. That is the second issue with centralization: complex financial transactions.

Also, centralized financial systems cost a lot to run. A typical traditional institution would have to pay for office space, employees, utilities (electricity and water), and so on. They have to make up for these expenses by charging you high fees. While this is understandable, it’s still extra money coming out of your pocket. Make that the third issue with centralized finance: High charges.

If you wanted to get a loan from the bank, you would be subjected to an unforgiving scrutiny from the banks. Your credit history and your current financial situation are brought under the spotlight. But guess what? The money they want to loan you wasn’t even theirs in the first place. It is the funds of other customers like you who have deposited their funds with your banks.

As a result of all of these, wherever centralization is involved, the following are ever-present: Lack of transparency, and privacy.

How Does DeFi Work?

How Does DeFi Work

DeFi is all about this: Everything you can possibly do with traditional financial institutions, including loans, savings, banking, and so much more, should be possible through decentralized blockchain technology.

But for all of this to be possible, something has to “oversee” these financial transactions. There has to be a platform that allows people to initiate transactions and oversee those transactions to ensure that both participating parties fulfill their end of the agreement.

This platform is made available through DeFi Smart Contracts.

Smart Contracts are contracts written in code and running on a blockchain. They automatically execute themselves when the conditions in the contract have been met. These conditions and their resulting actions must have been written into the code.

You could see smart contracts as referees in a game. They aren’t playing the games, but they’re there to ensure fair conditions between participating players. 

So, suppose John wanted to borrow funds from Carla. They could do this on a smart contract that matches lenders with borrowers, oversees funds transfer from one party to another, and awards Carla interest the longer John holds the loan. When it’s time to repay, it gets the fund from John and returns it to Carla. And just like that, John has his loan and Carla has earned her interest. No credit checks, no intermediaries, and no one else knows about it.

Also, smart contracts are also made public for everyone to see, so it’ll be quite hard to hide some dirty tricks in plain sight. 

Ethereum, Solana, Bitcoin and Cardano are some of the most common blockchains on which Decentralized Apps (DApps) are built. Ethereum, though, is the most commonly used. 

Use Cases of DeFi Protocols

Use Cases of DeFi Protocols

Decentralized Applications (DApps) have many use cases.

  1. Lending Platforms

This is perhaps one of the most popular DeFi applications. DeFi lending is a way to loan out your cryptocurrency assets and earn interest on it. 

DeFi lending is often collateral based. The borrower often has to stake some form of cryptocurrency or any other valuable item that can be tracked by a smart contract (like an NFT). Interest rates are also enforced by this same smart contract. And these interest rates are often responsive to demand and supply. So, when there are more lending transactions revolving around a particular cryptocurrency, the interest rate on it may be higher, and vice versa.

Examples of DeFi platforms for lending include Compound Finance and MakerDAO.

  1. DeFi Trading

This is another common one among DeFi applications. Decentralized Exchanges (DEXs) provide a potential use case that competes with traditional finance and even centralized exchanges. A decentralized exchange allows you to directly exchange digital assets with another user without even having to disclose your identity.

Defi cryptocurrency trading has gained momentum among crypto enthusiasts, with this space already becoming the home of various DeFi projects.

  1. DeFi Stablecoins

Stablecoins are the DeFi solution to having stability in the very volatile crypto market. These coins have their values pegged to the value of an external instrument, such as a fiat currency, gold, or anything of value. Tether (USDT), one of the most popular stablecoins, for instance, has its value pegged at $1. So, while other cryptocurrencies are rising and falling, the value of Tether remains more or less $1. 

The idea behind stablecoins is that they help to make transactions easier in the crypto ecosystem. You can send $50 worth of USDT to your friend and still expect the value to remain the same years from now. 

Despite their peg to stable assets, stablecoins carry inherent risks such as the potential for the issuer to not have sufficient reserves to back the coin, or regulatory actions that could impact their operation and value.

  1. Prediction markets

This is another fast-growing DeFi application. There are markets where you can predict the outcome of events. If you’re sure the sun is going to shine tomorrow, you can visit a prediction market and place a wager on your prediction. Wait for someone who thinks otherwise to counter your prediction, and you have a bet. Usually, DeFi-based prediction markets are best for wagers whose results are binary (Yes or No, True or False).

DeFi Prediction markets differ from their traditional counterparts in that DeFis usually don’t have a peg on how much can be wagered. Also, DeFis don’t take the charges that centralized financial institutions take. 

Advantages of Decentralized Finance

What benefits does DeFi bring?

  1. Accessibility

This is perhaps one of the biggest advantages of DeFi. Anyone from anywhere, as long as they have an internet connection, can get access financial services directly. You can trade cryptocurrencies with someone halfway across the world or secure loan from another DeFi user thousands of miles away from you.

Most centralized systems can’t offer this, as there are often a lot of protocols, laws, and regulations that shroud financial services the farther away from the origin.

  1. Absolutely Peer to Peer

In DeFi, all transactions are peer-to-peer. In other words, transactions are directly between the parties that are involved. Where intermediaries used to be in the traditional finance system, computer programs (in the form of smart contracts) now take their place. And this brings us to the next advantage.

  1. Completely Trustless

Centralized financial institutions are heavily dependent on trust. You leave your money in banks because you trust that your money is safe with them. When you take loans from institutions, they’ll delve into your financial records. And you trust that they will not divulge your private information.

Unfortunately, trust is fragile. But with most DeFi applications, this trust is mostly eradicated from the equation because you are directly dealing with the party that matters the most.

  1. Privacy

Privacy is a huge problem with intermediary-governed centralized financial institutions. They claim to never divulge your private data, but don’t be too sure of that. Some institutions sell your data. They include the clause that allows them to do this in the long and boring terms and conditions contacts they make you agree to. They know no one reads them.

With most DeFis, though, you don’t need to give as much information as you would give with traditional financial institutions. For instance, you don’t need your credit history to get DeFi loans. You only need collateral. And you could even use staked cryptocurrency for collateral.

  1. Transparency

Once your money is in the hands of the intermediary, there’s no way to see what’s going on with it or what is being done with your money. The bank, for instance, gives out loans with the monies deposited with them. They also do other forms of investments with people’s monies. Some of these deals are safe. Others, not so much so. 

On the flip side, at every point in time during a DeFi transaction, you know what is happening to your money. If you’re doing a P2P trade, for instance, your funds are either in your address or in your receiver’s address. And when the transaction has been added to the blockchain and is awaiting approval, you will see it on your trading platform.

Downsides of DeFi

Decentralized Finance is not without its downsides, some of which include:

  1. DeFis are still very risky

While we strongly believe that DeFi (and the entire crypto ecosystem) is the future, it is still relatively new. It’s not going to knock down in a day, the centralized system that has taken hundreds and even thousands of years to build. 

In fact, the DeFi space is still so new that there are so many risks attached to it. There are scams all over the place, with regulations only struggling to keep up. And often, if your funds get lost to scams or even your errors, it’s gone forever. 

  1. Low liquidity or High Volatility or Both

Despite the buzz around crypto, participants in the many DeFi use cases are still very few. And as such, money is not being moved as “liquidly” as it would in traditional financial institutions. So, you may find that it takes some time to get your loan, or your crypto exchange takes forever to go through. 

That’s on one hand. Depending on what you’re doing on the DeFi ecosystem, your event could also be shrouded with an insane amount of volatility. If, for instance, you were trying to trade a popular cryptocurrency, t…

  1. Costly Transaction Fees

Most of the Decentralized Ecosystem rests on the Ethereum blockchain. It is the network on which most smart contracts are built. And if there’s one thing Ethereum is notorious for, it’s its high transaction fees. The more pressure there is on the network, the higher the fees. The more complicated the transaction you want to perform, the higher the fee. 

While Ethereum and some other blockchains currently face high transaction fees due to network pressure and transaction complexity, advancements in technology like Layer 2 solutions and upcoming upgrades such as Ethereum 2.0 aim to significantly reduce these costs and increase scalability.

Decentralized Finance (DeFi) FAQ

Here are some commonly asked questions about this decentralized financial technology.

  1. Is Bitcoin decentralized finance?

No, Bitcoin is not decentralized finance. Bitcoin is a blockchain and a cryptocurrency part of DeFi, but none of those two in isolation can be decentralized finance. Even Ethereum, the blockchain on which most of the DeFi ecosystem rests, can’t claim to be Decentralized Finance all by itself.

Decentralized finance is that umbrella term that covers everything that has to do with direct peer-to-peer transactions, where traditional intermediaries are replaced by smart contracts. Bitcoin and other cryptocurrencies can be a part of DeFi, however. 

  1. How DeFi works?

In the place of traditional intermediaries, DeFI uses smart contracts, which are auto-executing contracts that are programmed on the blockchain to perform specific tasks after specific conditions are met. And because these transactions are happening on blockchain-based decentralized applications, they inherit the security that comes with blockchains. 

  1. What is the difference between DeFi and crypto?

A cryptocurrency is a token or a coin that is used for value transfer. DeFi, on the other hand, is the technology that allows for direct peer-to-peer financial transactions without the need for intermediaries.

The Role of Vezgo in Decentralized Finance

DeFi applications are gradually becoming the norm as more and more users are switching from centralized finance to a decentralized alternative.

There’s only one problem, though. Tracking digital assets becomes trickier the more the number of applications a user uses. And for projects and companies that want to build solutions that’ll use this aggregated data, it’s usually a nightmare.

This is the problem that Vezgo solves.

Vezgo offers a single API that aggregates data from over 300 blockchains, wallets, exchanges (CEX and DEX), and NFTs. Examples of decentralized applications that can be built with this Vezgo API include:

  • Financial Dashboards
  • Digital Banking applications
  • Wealth management software
  • Lending and Auth software
  • Crypto Insurance
  • Taxes and Accounting software, and so many more.

Already, dozens of DeFi and traditional companies rely on Vezgo, and the number keeps going up. That’s how important Vezgo is to the Decentralized Finance ecosystem.

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