What is DeFi? Everything You Need to Know About Decentralised Finance

Modern-day banking is being disrupted by DeFi, or decentralised finance. DeFi’s popularity is steadily rising as a result of the traditional financial system’s inefficiencies and rapid decline. DeFi also has the advantage of eliminating intermediaries and allowing users to earn high interest on assets, borrow, lend, trade, etc. For Web3 users, the preceding is just a small taste of what decentralised finance will accomplish.

DeFi enhances the sophistication of the decentralised crypto ecosystem to replicate traditional finance (TradFi) activities. Beyond merely reproducing past patterns, DeFi dapps are redefining how financial transactions are conducted. But what precisely is DeFi? The phrase “DeFi” is comprised of the words “decentralised” and “finance.” This innovative hybrid concept combines characteristics of decentralised blockchain technology with conventional financial products and services. In addition, you can incorporate brand-new assets such as non-fungible tokens (NFTs) into DeFi. Decentralized exchanges, including the two most popular platforms, Uniswap and PancakeSwap, include permissionless marketplaces where anyone can trade fungible and non-fungible commodities.

What is Decentralized Finance?

DeFi is an acronym for “decentralised finance.” It is an umbrella phrase for a completely new financial infrastructure predicated on decentralisation. In other terms, DeFi eliminates the conventional financial middleman. Consequently, both the notion and the blockchain technology that supports it are disruptive and revolutionary.

In traditional finance, or TradFi as it is known in blockchain and Web3 , major banks and institutions support transactions as trusted intermediaries. Blockchain technology eliminates the need for such middlemen in DeFi. Moreover, blockchains enable anonymous or pseudonymous online transactions.

The Role of Smart Contracts

The foundations of DeFi are built on smart contracts, commonly known as Web3 contracts. They are the foundation of decentralised transactions, or transactions that do not require the use of an intermediary. They also ensure that different DeFi platforms work together flawlessly. Solidity, Ethereum’s programming language, is being used to create smart contracts (the first Turing-complete blockchain). However, several other blockchains have evolved since Ethereum’s introduction, each with its own set of advantages. These blockchains built on Ethereum’s and EVM’s (Ethereum Virtual Machine) knowledge and tweaked things like transaction speeds and gas fee structures.

Create DeFi Dapps

Smart contracts, also known as Web3 contracts, are essential to DeFi. They are the foundation of decentralised transactions, or transactions that do not involve an intermediary. They also ensure that various DeFi protocols work together seamlessly. Solidity, Ethereum’s programming language, is now used by developers to create smart contracts (the first Turing-complete blockchain). However, many other blockchains have emerged since the launch of Ethereum, each with its own set of strengths. These blockchains have built on Ethereum and EVM (Ethereum Virtual Machine) knowledge and modified certain aspects, such as transaction speeds and gas fee structures.

Create DeFi Dapps

NFTs, the Metaverse, and DeFi

NFTs, or non-fungible tokens, cover a wide range of topics, from digital art to digital real estate and gaming. The ERC-721 and ERC-1155 token standards enable you to represent anything in the DeFi ecosystem as a unique digital asset. They also provide exciting applications in the Web3 metaverse, where they integrate with the GameFi and play-to-earn (P2E) experiences.

DeFi and the metaverse use Web3 wallets like MetaMask. Through these decentralised wallets, anyone can generate a Web3 address and authenticate to any DeFi dapp or blockchain game. Web3 wallets don’t use KYC. They don’t require personal information either. DeFi protects user privacy. Web3’s blockchain interoperability unifies everything. Since we’ve discussed smart contracts, how to develop DeFi dapps, and the function of NFTs and the metaverse in DeFi, let’s look at different DeFi applications and components.

DeFi Applications and Components

As many financial services, companies, and institutions as there are DeFi dapps. DeFi copies, improves, or innovates our current financial services, hence the possibility for more dapps is open-ended. To answer “what is DeFi?” one must also consider its uses and components. The following are samples of DeFi dapps and components.

Decentralized Exchanges

DEX is a peer-to-peer marketplace where crypto dealers trade directly. DEXs foster financial transactions without banks, brokers, payment processors, or other intermediaries. DEXs allow crypto trading without KYC. They allow anonymous trading. DEXs are permissionless. Uniswap or PancakeSwap in DeFi are popular DEXs that support the crypto industry.

Stablecoins

Stablecoins are pegged cryptocurrency. Most are dollar-pegged (USD). A USD-backed stablecoin will always be worth one dollar. Other stablecoins include:

  • Crypto-backed stablecoins are decentralised and over-collateralized to absorb fluctuation.
  • Commodity-backed stablecoins use gold, real estate, oil, and other precious metals as collateral.
  • Algorithmic Stablecoins like this use an algorithm to control supply and seigniorage shares.

DeFi ecosystems benefit from stablecoins. Bitcoin and Ethereum may be volatile and not suited for some uses. Stablecoins stabilise the DeFi ecosystem. They can also soften bitcoin price volatility. Stablecoins help explain DeFi. They stabilise decentralised financial ecosystems and instruments.

Yield Farms

You invest or stake your crypto assets in yield farms in order to earn passive revenue. Yield farms have grown in popularity among Web3 users as a practical approach to earn income on assets with less risk and effort. However, not all yield-type dapps are created equal in terms of trustworthiness, safety, and soundness, so proceed with caution and due diligence before investing. When you look into “what is DeFi?” you’ll notice that yield farms are a part of the passive income or investment component that makes DeFi so appealing.

Wrapped Coins

Wrapped coins, in a nutshell, are coins that are represented by another coin on a different blockchain. This is frequently done to improve interoperability and transaction speed. Although the execution is more complicated than the concept, it is one of the most practical DeFi ideas. Furthermore, wrapped coins maintain the original coin’s value while being traded on a different network. Wrapped BTC, for example, can be traded on Ethereum as wBTC. Furthermore, the depicted currency can fully back the wrapped currency.

Lending and Borrowing DeFi Dapps

Lending and borrowing Dapps follow the same concepts as TradFi credit. The main difference is that they don’t require a middleman. For example, stablecoins can be borrowed using crypto as collateral, such as Bitcoin or Ethereum. Other models entail lending cryptocurrency to other Web3 users in exchange for interest on the loan.

Gambling Applications

If you’ve ever questioned if gambling dapps fall under the category of DeFi applications, the answer is yes. Anonymity, decentralisation, and trustlessness are key features of DeFi gambling dapps. Furthermore, gambling dapps allow for the transparent display of game results while maintaining user privacy.

What is a Decentralized Exchange?

Now that we know the main types of DeFi applications, we can look into

DEXs. DEXs, which stand for “decentralised exchanges,” are a key part of figuring out “what is DeFi?” Also, they are a very important part of the DeFi ecosystem. They let people trade assets without the usual “Know Your Customer” checks.

In recent years, the trading of crypto assets on DeFi DEX platforms has skyrocketed. According to Uniswap’s website at the time of writing, its DEX boasts over $959 billion in trading volume and over 96 million trades in total. Uniswap continues to promote community involvement in addition to its phenomenal growth. Its DEX model features token-based decentralised governance that is novel (using an ERC-20 token). In addition, it offers developers incentives through a grant programme.

The trading of crypto assets on DeFi DEX platforms has skyrocketed. According to Uniswap’s website at the time of writing, its DEX boasts over $959 billion in trading volume and over 96 million trades in total. Uniswap continues to promote community involvement in addition to its phenomenal growth. Its DEX model features token-based decentralised governance that is novel (using an ERC-20 token). In addition, it offers developers incentives through a grant program.

What is DeFi? DEX vs CEX

The difference between a DEX and a centralised exchange (CDEX) is critical to understanding “what is DeFi?” (CEX). DEXs offer an alternative to CEXs, which rely on outdated processes and necessitate a great deal of user input before they can be used. Disintermediation is the goal of DEXs. To make things easier, they use smart contracts.

DEX vs CEX – Order Books

There is no order book trading engine for DEXs. Algorithmic trading engines may be used instead of a traditional order book. In other words, they use automated algorithmic trading facilitated by “automated market makers”, or AMMs. Hence, you need to understand AMMs and liquidity pools.

What is an AMM?

To comprehend “what is DeFi?” and AMMs, we must comprehend the fundamentals of market-making. Market making is the process of supplying markets with liquidity. Market makers quote prices to simultaneously acquire and sell assets. Generally, centralised exchanges utilise an order book and an order matching mechanism to pair buyers and sellers. Order books maintain an electronic record in real-time that lists all purchase and sell orders at any one time. In addition, the engine enables efficient order matching and settlement.

AMM Formulas

Using liquidity pools, an automated market maker (AMM) enables you to trade digital assets automatically. It employs smart contracts to establish token or asset liquidity pools. In addition, it determines the prices of these assets using mathematical algorithms, hence eliminating the need for human market makers.

Whenever customers trade on an AMM-powered DEX, the tokens are instantly sent to the liquidity pool through smart contracts. The smart contracts then exchange the tokens for their trading pair counterparts. The DEX calculates the exchange rate between the two tokens automatically.

The AMM formula on Uniswap is “x*y=k.” “x” and “y” in this formula stand for the number of each traded token in the pool. Also, the exchange makes “k” a constant that has already been set. With this model, each trade will still have slippage. But when liquidity pools are bigger, large orders slip less.

What is a Liquidity Pool?

A liquidity pool is a pool of tokens that are secured under a smart contract. These tokens are market-making instruments on a decentralised exchange. Using liquidity pools, you can switch between tokens while trading on the blockchain directly. Additionally, you can anticipate DEXs to have many liquidity pools. Each pool has two distinct cryptocurrencies that comprise a trading pair. These trading pairs can represent any two crypto assets or tokens that adhere to the same token standard. Typically, the ERC-20 standard is used.

What is DeFi? AMM and Staking

To show how DeFi helps its users, consider the passive income generated by staking. You can become a market maker using an AMM. In addition, you can generate income by staking your crypto assets (tokens or cryptocurrencies) as capital. In DeFi, market makers are referred to as “liquidity providers” or LPs. In addition, as an LP, you provide the equivalent of two tokens to their respective pool. For instance, $100 worth of USDC and $100 worth of ETH can be deposited into the USDC/ETH pool. You will then receive LP tokens indicating your proportional share of the pool. In addition, you can immediately begin collecting fees from the trades in that pool.

Your return reflects your contribution. You receive a proportional portion of the fees earned from trades in the pool. However, you must be aware that each protocol charges a different transaction cost (percentage) Moreover, each protocol’s rewards vary. As DEXs incorporate a governance component, users can also determine their own rewards. To comprehend decentralised governance, please refer to our page on governance tokens.

Simply return your LP tokens to the smart contract to withdraw your earnings and stop supplying liquidity. You’ll get your original staked tokens as well as any earned fees.

Summary

DeFi enables Web3 users and blockchain developers to investigate alternative financial models outside of conventional banking. With these models, one can generate, transact, exchange, and distribute digital assets in novel ways. In addition, DeFi is a vast ecosystem, and its TVL (total value locked) hit a record $305 billion in November 2021