Understanding Decentralised Finance — DeFi

‘DeFi’ is the short term for ‘decentralized finance’, a term that covers a range of financial applications using blockchain and cryptocurrency, and which is intended to disrupt the finance market.

DeFi draws on blockchain technology to deliver applications that are not controlled by a central source. Traditional banks are all based on centralized systems, which do not have the agility to provide customers with the speedy transaction service that a DeFi app can, nor do they give customers the direct control over their finances that many would like.

For example, when you pay with a credit card in a shop, or online, your bank sits between you and the retailer: the bank has control over the transaction, and has the power to stop or pause it, as well as record it in its private ledger. With DeFi apps using cryptocurrencies, the bank as middleman is removed from the picture.

And this doesn’t just apply to retail purchases; it also applies to loans and insurance, as well as a host of other ways in which you may spend your money.

How does DeFi work on the blockchain?

Currently, the majority of DeFi applications are built on the Ethereum blockchain, but this may change in the future, as rivals such as Cardano aim to topple its dominance.

The reason DeFi platforms have chosen the Ethereum blockchain is because of its smart contracts. A smart contract automatically executes transactions if certain conditions are met.

These give consumers more control over remittances to family for example, and in a way that traditional banks, or even many other non-bank payment solutions, (e.g. Western Union or PayPal) are unable to offer.

The most popular types of DeFi applications

At the moment, the most popular types of DeFi platforms are:

Decentralized exchanges, also known as DEX

Stablecoins and wrapped Bitcoin

Lending and borrowing crypto

Decentralized exchanges/DEXs

A DEX enables users to exchange fiat currencies for cryptocurrencies. Furthermore, DEX users are able to contact each other directly for trading without having to use an intermediary.

Stablecoins

Stablecoins are cryptocurrencies that are pegged in value to a fiat currency. Tether (USDT) is currently the biggest stablecoin in the market. Crypto investors wishing to avoid the extreme volatility of other cryptocurrencies, whilst also keeping value within the crypto market, buy stablecoins.

Wrapped Bitcoin

Wrapped Bitcoin (WBTC) is the leading ‘wrapped’ cryptocurrency. What is it, and why is it wrapped? Wrapped cryptocurrencies enable crypto assets to be used on blockchains where they are not native. They enable the interoperability that is so important for DeFi platforms. They are ERC-20 tokens in format, and track the value of the asset they represent and can often be redeemed for that asset.

So, for example, it means Bitcoin and other popular cryptocurrencies can be traded, sent or received on smart contract platforms, such as the Ethereum blockchain. As a result, wrapped cryptocurrencies increase the utility and liquidity of smart contract platforms and popular decentralized finance applications.

Lending and Borrowing

Normally, in the lending and borrowing market, a bank, or similar financial service, acts as the intermediary. DeFi apps allow users to lend or borrow crypto using smart contracts, thus cutting out the middleman. DeFi also enables crypto holders to lend their crypto at better interest rates than traditional banks offer, which enables them to make money just by lending it.

Upcoming uses for DeFi platforms

The DeFi sector is always coming up with new ideas, with one of the most popular being Yield Farming. This is a shorthand term for strategies where crypto owners temporarily put their crypto at the disposal of some start-up’s application development, and which earns its owner more cryptocurrency.

How to make money with DeFi platforms

DeFi apps enable people to generate a passive income through lending their crypto, which then gives them an income from the interest charged on the loan. Some use yield farming, and while the returns are often greater, when compared with simple lending, the risks are also higher.