Overview
What is a Defi? It stands for "Decentralized Finance," I suppose. In the past, we have always practised centralised finance, in which the movement of money is governed by a single central authority. It is under the sway of the government and banks. They do, even though they don't really claim to. If they so choose, they can print more of it, prevent you from borrowing, and even prevent you from opening a bank account. They have your money, so they could modify it whenever they wanted to and you wouldn't be able to truly object. You could, of course, but how would you demonstrate it? You gave them your money.
Additionally, if you own a business, they may restrict your activities. For instance, they may now warn you not to deposit any money from your small magical tree business—which may be medicinal—into a bank. This prevents you from investing the money or keeping it in a safe place.
The cost of traditional borrowing is another factor. Payday loans can cost up to 500% of your monthly income, whereas credit card interest rates typically range from 25 to 18%. Although these rates are expensive, you must pay them if necessary because that is what you have.
The alternative is decentralised finance, in which there aren't any actual banks, but bits of code that function like them. In addition to being accessible to anyone, they are also censorship resistant and don't require you to trust them because they are basically just code running a program that you can verify by your side and ensure that they are scamming you or not. And they are significantly less expensive than traditional, centralised finance.
Decentralized finance is based on three key pillars:
Cryptography
Blockchain Technology
Smart Contracts
1. Exchanges
We must go to a foreign exchange counter and exchange our money for the currency of the destination nation. We lost 15% of our money right away since the cost was 15% (it changes), which is what currency traders do. Due to tourists' lack of local currency and lack of knowledge, some people are taken advantage of. In Decentralized Finance, however, we have decentralised exchanges where you can swap your coins and tokens for other coins and tokens in place of a foreign currency trader. For those who frequently want to trade their crypto assets, the fees are typically extremely low—less than 0.5 percent.
The majority of well-known decentralised exchanges, or Dexes, operate by having investors pool their funds so that traders can trade that money. The investors receive a fee for each trade. Additionally, everything is coded, making changes impossible. A government cannot intervene and prohibit the purchase of bitcoin. Additionally, the fees are fixed, so they won't increase to absurd rates like 15%.
Decentralized exchanges give users access to a vast array of new tokens and coins. For instance, Coinbase, the first centralised exchange to go public, restricts the number of cryptocurrencies you may buy and sell. They carefully examine each coin before adding it because they are subject to government regulation and are required to adhere to specific rules. There are literally hundreds of tokens available for trading on Uniswap, the most well-known decentralised exchange, and they are all unregulated.That is the decentralised aspect; although there are billions of dollars locked up in these liquidity pools to allow traders to transact, no one has control over them. They are merely according to a written program. In reality, only investors might withdraw funds from the pool, but as loan rates rise, more investors will likely join the fray. Because the code is unchangeable and immutable, we like to argue that it is "the law" in the crypto community. One of the most important exchanges on the Ethereum network is Uniswap, which has enormous sums of money in its pools. Another exchange on the Binance Smart Chain network with a few billion dollars of liquidity is PancakeSwap.
2. Margin + Synthetics
The world of margin trading is entirely new. Let me briefly describe margin trading in the regular setting before explaining it in the decentralised setting. Okay, so you want to purchase Apple stock, which is currently trading at $100. In essence, margin is a debt that will force you to sell your shares if the price drops below your down payment. Therefore, you need a $100 loan to buy the $100 stock, and the bank agrees to provide you with a $100 loan in exchange for a $20 down payment and a tiny annual fee of 5%. So here are two possible outcomes.
A $100 stock increases to a $150 stock. You choose to sell the stock; as a result, you receive $150, repay just $80 of the loan (the bank had previously received your other $20 as a down payment), and keep the remaining balance—a profit of $70. In essence, you spent $20 and made $70. Then you effectively double your investment. This is the power of margin; you use it to multiply your own funds when you anticipate a gain in value.
Here is the second scenario, which is what would happen if the stock dropped below $50. With that said, as soon as the value of what you purchased can not cover the cost of your loan, you must sell. The stock begins at $100 before falling to $90, then to $85 and finally to $80. Suddenly, the bank FORCES you to sell 1 Apple share for $80 in order to recoup the $80 you owe them. The bank now has the $100 that they originally granted you, and the $80 you got from selling the stock, combined with the $20 you paid them as a down payment, equalises the loan. You have now repaid your loan. However, you did not gain anything. Actually, you lost the initial $20. In Centralized Finance, in order to trade on margin, you often need to be able to establish your identity and have a minimum of a few thousand dollars. Furthermore, the costs usually exceed 5%. Margin trading may be much faster, more accessible, and safer in Decentralised Finance.
3. Lending/Borrowing
The lending and borrowing pillars of DeFi are also crucial. In fact, a significant portion of the world's existing financial situation is predicated on lending and borrowing money, so it stands to reason that the blockchain might handle it more effectively.
One of the reasons we can dependably lend to and borrow from banks is that our government has the power to pursue us and put us in jail if we put down a 20% down payment but never repay the entire loan. In summary, not repaying a loan has legal repercussions.
This is a problem with crypto because anonymity is one of its benefits. You may put down 20% and take the remaining balance of the loan with you, never to be seen again. We need to figure out how to handle this. In reality, by using smart contracts, we may really give others access to our money while still maintaining ownership of it.
Let's consider the scenario where Person A wishes to receive interest on his coins and Person B desires to borrow some coins. Person A deposits his funds into a smart contract on a platform for lending and borrowing cryptocurrencies, such as Compound or Aave. A smart contract is nothing more than a piece of executable code. In exchange, he receives interest and copies of his original coin known as CTokens or ATokens. Whenever he wants, he can instruct his ATokens or CTokens to automatically transfer his initial deposit plus interest to the smart contract. This is how the smart contract was developed, eliminating the need for a person to perform the calculation or transaction. Everything is automated and coded. So that takes care of Person A's desire to earn interest through conventional lending.
Person B must overcollateralize his loan during the borrowing portion. Therefore, he must put up $120 as collateral if he wants to borrow $100. Therefore, the smart contract is structured in such a way that it can return person A's coins plus interest if the borrower flees and never repays the loan.
When you already have the money, why would you need a loan?
You must be thinking in US dollars at this point. Consider a scenario in which you possess 10 Ethereum, each worth $1,000, and you don't want to sell any of them. Tether, a stable token linked to the USD, is pledged as collateral when you borrow $800 worth of it. After trading those $800 around, making some money, losing some, and then making more, it's time to pay off your loan. So you pay back the $800 loan with the $850 in tether and get your 10 ethereum back. You already earned $50 from the few transactions you made and the good success you had, but after a few months, the value of ethereum increased dramatically. As a result, 10 ethereum are now worth $150 apiece, bringing your total investment to $1500 plus the $50 you earned from trading. Basically, if you believe in eth, possess it, and don't want to sell it but still need to use its value, you may borrow money against it with the assurance that it will be worth more when you eventually pay it out. However, if you traded, lost, won, and then lost, you still had $750 USD.
You'd have two choices. To pay the additional $50 to repay the entire amount is option A. Option B involves keeping your $750 but forfeiting your 10 eth, which might be very valuable. Another type of cryptocurrency loan is called a "Flash Loan," which is only valid for a brief period of time, like 10 seconds. If you could buy ethereum for $10 on Coinbase and sell it for $11 on Gemini, you could figuratively borrow millions of dollars with a flash loan. In this scenario, your profit was $1. You make a flash loan to borrow $10,000,000, spend $10 on ethereum, sell it for $11, and then pay back the borrowed funds in a single, rapid smart contract that lasts for 10 seconds. You earned $1,000,000 less borrowing costs, which were insignificant because the lender was confident you would repay the loan quickly and over a short period of time. Although this is a more sophisticated method, traditional finance would never allow for this kind of arbitrage.
4. Insurance
Explaining insurance is quite simple. For instance, you might pay $100 per month for auto insurance to safeguard your brand-new Tesla. But one day, while utilising the autopilot function, another vehicle causes the autopilot to malfunction, causing you to crash into a ditch, unhurt but completely destroying the vehicle. Since you purchased insurance, the insurance provider will pay you the value of the Tesla, so you may go buy a replacement. They then forecast how frequently their drivers will smash their vehicles using statistics, and they use this information to forecast how much they will have to pay out each year to set the insurance's monthly cost (which is also called the premium).
The insurance company can be coded, then, using decentralised finance. Let's assume that a farmer wishes to purchase crop insurance so that, in the event that his crops fail, he will still be paid for taking the risk of planting them. If there are any days this summer with temperatures of 95 degrees or higher for 4 straight days, we could programme the Ethereum network to pay Farmer Joe $100,000. He must pay $2,000 to begin this contract. Therefore, Farmer Joe can get crop insurance using what is known as a smart contract, which is just code that checks to verify if the requirements are satisfied before paying him. You might have two inquiries. First, how does the algorithm determine that it is 95 degrees, and second, where does the $100,000 come from?
Oracles, which are reliable sources that serve as a bridge between the current world and the blockchain, are what we need to connect them. We can build a temperature-reading oracle in our city that is certified by a small group of people to prevent fraud. So that it can decide if insurance criteria are met, the smart contract can dependably use it as a data source.
Second, the $100,000 came from other insurance buyers who paid their premiums but did not receive a payout because the conditions were not satisfied. People that supply liquidity to any decentralised finance platform may be rewarded with an interest rate to increase the value of their deposit, much like an insurance company generates money.
5. Yield Farming
Yield farming is the practise of positioning your cryptocurrency in a way that will maximise its ability to generate free cryptocurrency for you.
The phrase "farming" is used to depict the potential exponential growth you can receive by finding the perfect area to invest in because "yield" is a financial term that means what you earn for investing. The majority of American banks can guarantee about $1 per year for every $1,000 invested. Nevertheless, several well-known yield farming are now promoting $3,000 per year for every $1,000 invested.
How does that function? Is yield farming fraudulent?
You might want to pull up your pants and grab a chair before we begin this blog post because it will be about a fun subject.
In my opinion, you should read up on liquidity pools, impermanent loss, and the operation of an automated market maker before reading this blog article. They'll help you grasp things much better. However, adhering to our original slogan, we will attempt to make the subject of yield farming understandable to everyone.
A method of earning rewards with crypto holdings is yield farming, also known as liquidity mining. Simply put, it means that you can receive interest and staking payments for storing crypto assets. The technique of yield farming parallels staking in several ways, but with a few extra layers of complexity.
The majority of the time, yield farming demands that users, also known as liquidity providers (LPs), add money to a protocol's liquidity pool. Liquidity pools are essentially smart contracts that store and protect users' money while also rewarding users for initially supplying liquidity. These benefits could originate from fees produced by the underlying DeFi system or from other sources.
Some liquidity pools pay their prizes in multiple tokens, and these reward tokens may then be transferred to other liquidity pools in order to receive further payments from those pools. The basic premise is that liquidity providers deposit money into a liquidity pool and receive rewards in exchange. As a result, it is very easy to understand how some incredibly sophisticated farming methods might arise from this.
The most popular ERC-20 and BEP-20 tokens for yield farming are used on Ethereum and BSC, respectively. As a result, incentives are typically in one of these two formats. But as yielding protocols advance and begin effectively implementing cross-chain bridges, this may very well change in the near future.
In search of the maximum yields, yield farmers frequently switch between various techniques with their money. Because increased liquidity tends to draw more liquidity, just like on centralised exchanges, DeFi platforms may also offer financial incentives to draw additional money to their platform.
6. Stablecoins
We must first comprehend cryptocurrency that is linked to a physical item as the bridge to decentralised finance. Certain coins are "stable coins," such as DAI, Tether, and USD Coin. This is as a result of their prices being correlated to the USD. Imagine that when you purchase one for $1, a new US coin is created. A US dollar coin gets burned when you withdraw one. Therefore, the coin will always be worth one dollar. This will allow us to trade certain coins instead of having to buy and sell them, giving us a secure means of doing so. Here is a little example of how this is advantageous.
Consider buying one Ethereum for $500. You want to sell it because you think it is too expensive at $1,000 right now. In the absence of stablecoins, you must sell your ethereum via a centralised exchange like Coinbase or Binance, where you will receive USD in exchange. Naturally, they will now take a portion of that transaction; they will request a fee and accept it. The IRS also requires you to pay tax on any profits you make from trading or selling. Avoid attempting to escape the situation since Coinbase or Gemini will leak the fact that you succeeded. You can then withdraw money from them into your bank account if you don't want them to have control over your finances.
When ETH drops to $250 a month later, you decide to purchase more. To do this, you transfer your original $1,000 to Coinbase, wait a few days for the transaction to clear, and then purchase 4 ETH to hold. You decide to sell ETH when it reaches $500 again, so you go to your exchange, pay the fee, and then wait a few days for the money to arrive in your bank account. That is a lot of waiting, taxes, and fees.
Let's imagine that we used a stablecoin like USDC. You paid $500 for one Ethereum, and it now costs $1000. You exchange your single Ethereum for a thousand USDC to avoid all of the hassle. You exchange your 1000 USDC for 4 Ethereum when it falls to 250 a month later.
After it rises to 500, you sell your four ether for 2000 USDC in less than five minutes. You traded on a decentralised exchange, which we will discuss later, so the fees were less than 1 percent, and you could do it virtually immediately. Plus, the USDC was safe and you trusted it since it is code and doesn't change, in contrast to Coinbase, Binance, or Gemini, which are under the jurisdiction of the government and, more significantly, PEOPLE. They've previously experienced hacking.
That is the objective of stablecoins, but we are veering off topic. Without really utilising your state-owned bank, you can participate in the cryptosphere. In nations like the US, we take it for granted, but there are some that have severe restrictions on the amount of money you may transfer or the currency you can purchase from them. In fact, any transaction over $10,000 in the US needs to be examined and approved. While using USDC, you can transfer $10,000,000 from one address to another without raising an eyebrow, and currently for a charge of about $5.