DeFi Guide: What is Decentralized Finance & How Does it Work

Decentralized finance (DeFi) is a big deal in 2022 and the rise of cryptocurrencies. In this DeFi guide, you will learn all there is to know about this financial system.

What is DeFi?

Specifically, DeFi is a subcategory within the wider crypto space. DeFi offers many of the services of the mainstream financial world but is controlled by the masses rather than by a central authority.

It may have been lending that got the whole thing off the ground, but DeFi applications today have a wide range of applications, including saving, investing, trading, market-making, and more. The ultimate goal of decentralized finance is to challenge traditional financial services providers and eventually replace them. In many cases, DeFi uses open-source code, allowing anyone to build on preexisting applications in a permissionless, reusable way.

Finance is the easiest term to understand, but what is “decentralization?” Decentralization is defined as a system in which no single body is in charge of something. Banks and other financial institutions have the power to control your money to a certain extent. These companies can freeze your assets, and you remain at their mercy as far as their hours of operation and cash reserves are concerned.

There is a decentralized aspect to DeFi that involves the dispersal of power and the dispersal of risk. For example, if a company stores all of its customer information in one place, a hacker may only need to access that particular site to access an incredible amount of information. However, storing that data across several locations or removing that single point of failure might improve security on the other hand.

DeFi Components

Combined with some of the more definitive characteristics of DeFi, such as being non-custodial, open, transparent, and decentralized, here is a summary of some of the more technical layers that make up the standard stack of DeFi, as described by Fabian Schär of the Federal Reserve Bank of St. Louis:

Settlement Layer: Referred to as the most crucial component of DeFi, the settlement layer serves as the foundation for all three subsequent components by integrating a public blockchain and a native currency. Similar to what is happening with Ether (ETH) with Ethereum, the currency or token is often a complementary component of most decentralized applications (dApps), which helps users earn passive income or interest through activities like staking (explained in more detail below). Furthermore, it can also be used for governance (voting rights) and exchanged on other centralized or decentralized marketplaces.

Protocol Layer: Protocols govern how certain actions, such as sending, receiving, and formatting data, are performed via a computer network. A wide variety of DeFi protocols are used to contain the rules or guidelines that users have to follow (as per industry standards) and provide a level of cohesion that allows different entities or developers to collaborate, scale, and improve services for the end-users. Therefore, the protocol layer must be stable and scalable in a DeFi ecosystem to achieve a sufficient and scaleable level of liquidity.

Application Layer: Considering the application layer to be another integral component of DeFi where user-facing applications are stored, the application layer provides essential services through dApps (decentralized applications) that directly reflect the structures of the underlying protocols. As part of the application layer, we find many of the most well-known web3 applications, including loan services (Aave) and decentralized exchanges (DEXes, such as Uniswap and PancakeSwap).

Aggregation Layer: Finally, aggregators serve as the final layer in the financial ecosystem, combining a variety of apps and resources from each of the preceding layers to enhance the utility for end-users and streamline the transaction process between different financial instruments.

The Advantages of Decentralized Finance: Why DeFi Matters?

The following are several key points that will further illustrate why DeFi, when compared with traditional systems, makes a lot of sense:

Traditional Finance:

• Many people do not have access to bank accounts or are deemed eligible to use financial products or services in their respective nations.
• In the absence of these services, job opportunities may not be available to those who do not have access to them.
• A bank or an intermediary like PayPal can prevent users from receiving or sending funds.
• Almost all financial institutions use and exploit the data of their clients.
• There are times when governments can close or impose heavy restrictions on markets at their whim.
• The trading hours are often limited and out of sync with the time zones around the world.
• Because of manual human input, some international transfers can take a few days to complete.
• Because the intermediary institutions need their commissions and fees to provide the financial services, most financial services require a premium.

Decentralized Finance:

• It allows for total independence and autonomy – users are free to decide what and how they want to spend their money.
• There is an almost instantaneous transfer of funds – at most, within a matter of minutes, depending on the nature of the network.
• It is possible to transact anonymously or pseudonymously.
• Everyone is welcome to use the network and infrastructure.
• The markets do not close.
• It developed a system of transparency that allows anyone with enough technical knowledge to audit or inspect a product’s data and how the system functions.
• Even though the landscape of decentralized finance is growing on an exponential basis.

Difference Between DeFi and Traditional Finance

We are going to use the example of a commercial bank in order to make this comparison. You may utilize a financial institution for a variety of reasons in the traditional world, such as storing your money, borrowing capital, earning interest, making payments, etc. Throughout history, banks have been around for a very long time, and their performance has been proven over and over again. In addition, commercial banks are able to provide insurance services in addition to having security measures in place to prevent theft and deter it.

On the other hand, such institutions hold and control a great deal of your assets. As a result, there are restrictions on the hours during which certain actions can be taken, and transactions can be cumbersome and require a lot of time on the back end for settlement. Moreover, commercial banks require specific customer details and identification documents in order to participate.

There is a segment of the economy called DeFi, which has financial products and services readily available to anyone with an internet connection, without banks or any other third parties. Because the decentralized financial market does not sleep, and as a result, transactions happen in near real-time, 24/7, while no intermediary has any power to stop them Cryptocurrency can be stored and accessed in many ways, such as on your computer, in hardware wallets, or using other methods.

Cryptocurrencies such as Bitcoin and most other cryptocurrencies hold these characteristics because of the technology that backs these assets. The DeFi platform is dependent on blockchain technology, which makes transactions between DeFi and its users faster, cheaper, and in some cases more secure than if the transactions were handled by humans. There are a number of issues that exist in the traditional financial markets that are being addressed by decentralized finance through the use of cryptographic technologies.

On the whole, DeFi gives participants a variety of opportunities, such as borrowing and lending markets, holding long and short positions on cryptocurrencies, and earning returns from yield farming. For those 2 billion people without access to traditional financial services in the world, in particular, who do not have access to traditional financial services for one reason or another, decentralized finance could be a game-changer.

The DeFi solutions are built on various blockchains and consist of peer-to-peer ecosystems, where participants interact in a peer-to-peer sort of way, facilitated by distributed ledger technology and smart contracts, which keep the system in check. Therefore, the results of such a study are not determined by geographic borders, and participation does not require the presentation of identification documents.

The framework for this financial system is programmed to function based on predetermined rules. For example, as opposed to going through a third party such as a bank, you would instead send amounts of cryptocurrency to a secure digital location – such as a smart contract – as collateral for your loan and receive another kind of asset in return for it. If you don’t return the loan amount to the lender, then your collateral assets will be locked up until you do.

It is important to recognize that, even though you may or may not interact in a P2P manner when using DeFi solutions, the spirit of the process is P2P. Third parties are replaced with technology not governed by a central authority.

What Are DeFi Limitations

First, DeFi 2.0 hopes to solve the problems before diving deeper into its use cases. Many of the issues here are very similar to many of the problems with blockchain technology and cryptocurrencies in general:

Scalability: In blockchains with high traffic and gas fees, DeFi protocols often provide slow and expensive services. For instance, simple tasks can take too long and become expensive.

Oracles and third-party information: There is a need for higher quality oracles (third-party sources of data) to provide financial products that rely on external details.

Centralization: The goal of DeFi should be to increase the amount of decentralization. Unfortunately, there are still projects that do not adhere to the principles of DAOs.

Security: In most cases, users are unaware of the risks present in DeFi, or they cannot manage them. As a result, thousands of dollars are staked on smart contracts that they do not fully understand are safe. Furthermore, despite the fact that there are existing security audits, they tend to become less valuable as updates take place.

Liquidity: Liquidity is spread across several different blockchains and platforms, resulting in market fragmentation. Providing liquidity is also a way to lock up funds and the total value of the funds. Since tokens staked in liquidity pools cannot be used anywhere else, capital inefficiency results from tokens staked in liquidity pools.H2:

What is DeFi 2.0?

The DeFi 2.0 movement attempts to fix some of the problems seen in the original DeFi wave and upgrade it. In regards to DeFi, it was revolutionary in providing decentralized financial services to anyone with a crypto wallet, but it still has some flaws. This process is already seen in cryptocurrency, with second-generation blockchains like Ethereum (ETH) improving on Bitcoin. In addition, DeFi 2.0 will also need to respond to new compliance regulations that governments intend to introduce in the future, such as KYC and AML regulations.

Let’s take a look at an example. The use of liquidity pools (LPs) has been a huge success in the DeFi equation since it allows liquidity providers to earn fees from staking pairs of tokens. On the other hand, if the price ratio of the tokens changes, liquidity providers may lose money (impermanent loss). Therefore, a small fee could be charged in exchange for insurance against DeFi 2.0. This solution offers a greater incentive to invest in LPs and is beneficial to users, stakeholder organizations, and the DeFi space as a whole.

There are already several projects presenting new DeFi services across multiple networks, including Ethereum, Binance Smart Chain, Solana, and other blockchains with the capability to execute smart contracts. Let’s have a look at some of the more common ones here:

Unlocking the value of staked funds

If you have ever staked a token pair in a liquidity pool, then you have received LP tokens in return. Using DeFi 1.0, you are able to stake the LP tokens in a yield farm so that you can compound your profits. In the past, this was the end of the chain in terms of extracting value from DeFi 2.0. As a result, large sums of money are locked up in vaults, providing liquidity. However, there is potential to improve capital efficiency further.

DeFi 2.0 is using these yield farm LP tokens for collateral purposes, taking this one step further. That could be for a crypto loan from a lending protocol or the minting of tokens in a process similar to MakerDAO (DAI). The exact mechanism of receiving the APY will vary from project to project; however, the idea is that your LP tokens will be unlocked for new opportunities while still generating APY.

Smart contract insurance

It isn’t easy to conduct enhanced due diligence on smart contracts unless you are an experienced developer. With only partial knowledge of the project, you can only evaluate it in part. DeFi projects are subject to a large amount of risk due to this. The DeFi 2.0 platform offers the possibility of getting DeFi insurance on specific smart contracts.

Imagine that you are using a yield optimizer and that you have staked LP tokens in the smart contract of the yield optimizer. If the smart contract is compromised, all deposits will be lost. However, in exchange for a fee, you can get a guarantee on your deposit with a yield farm through an insurance project. Keep in mind that this will only be applicable to a specific smart contract. In most cases, if the liquidity pool contract is compromised, you will not receive a payout. However, it is also possible to receive a payout if the yield farm contract is compromised and is covered by the insurance policy.

Impermanent loss insurance

If you invest in a liquidity pool and then start mining liquidity, any change in the price ratio of the two tokens you have locked may result in financial losses for you. A process like this is known as impermanent loss, but new methods are being explored to mitigate this with the new DeFi 2.0 protocols.

Consider, for example, adding one token to a single-sided LP, where you do not have to add a pair. After that, the protocol adds their native token as the other side of the pair. That means that you will receive fees paid from swaps in the respective pair, and the protocol will also receive fees.

By using their fees, the protocol is building up an insurance fund that can be used to protect your deposit against the effects of impermanent loss over time. Moreover, if there are not enough fees to pay off the losses, the protocol can mint new tokens to cover the losses. Finally, in the event that there is an excess of tokens, they can be stored for later use or burnt to reduce the supply of tokens.

Self-repaying loans

Taking out a loan is typically associated with liquidation risk and interest payments. Fortunately, this is no longer necessary when it comes to DeFi 2.0. Suppose, for example, that you take out a loan from a crypto lender worth $100. Your lender lends you $100 in crypto but requires you to put up $50 as collateral. As soon as you provide your deposit to the lender, the lender uses this to earn interest in order to pay back the loan. Your deposit is returned to you after the lender earns $100 with your crypto and extra as a premium on top of that. Hence, there is no risk of your deposit being liquidated. However, in the event that the collateral token has depreciated in value, the loan will take longer to be repaid.

What Are DeFi Wallets and Smart Contracts?

UNISWAP:

Hayden Adams, a mechanical engineer from the New York area, founded Uniswap on November 2, 2018. It is a decentralized finance protocol, and exchange (DEX) launched on November 2, 2018. Using a smart contract, the protocol facilitates automated transactions between cryptocurrency tokens on the Ethereum blockchain using the Ethereum protocol. As of this writing, Uniswap facilitates daily crypto trading of approximately $2 billion or more. According to CoinMarketCap, the project’s governance tokens, UNI, have a market value of about $13 billion.

CURVE:

There are many similarities between Curve and Uniswap, with the key difference being the type of assets that can be traded. Uniswap allows users to trade any ERC-20 token with enough market liquidity. In contrast, Curve is a platform that focuses specifically on trading Ethereum compatible stablecoins.

One of the core advantages of Curve is that it has a very low slippage rate and low fees, which has helped it earn critical acclaim as a popular automated market maker platform (AMM). In addition, as part of Curve, users can participate in a pool of stablecoins that can earn income from transaction fees, thereby providing liquidity to the Curve pool. Moreover, Curve contributes to creating a stronger sense of cohesion in the wider DeFi ecosystem by contributing pool tokens to the Compound protocol and Yearn.

AAVE:

Founded in 2017 by law student Stani Kulechov (originally known as ETHLend), Aave acts as a lending platform that lets users lend and borrow crypto tokens; according to Defi Pulse, users have injected more than $14 billion in collateral for loans on the network.

MAKERDAO:

MakerDAO is an open-source lending and borrowing platform created in 2014 and later launched in 2017. The platform utilizes Dai, a stablecoin linked to the US dollar. MakerDao has since become one of the largest decentralized applications running on the Ethereum blockchain and the first decentralized application to gain widespread adoption. In total, over 400 apps and services have been integrated with the Stablecoins Dai, including wallets, DeFi platforms, games, and more. DeFi Pulse is currently regarded as one of the most extensive DeFi protocols with $9.5 billion of system collateral.