Understanding DeFi

Kelly Kigan
January 26, 2022

The current dominant financial ecosystem is classified as centralized finance, where the government and banks control the financial systems. The government and the banks are the central authorities that control the flow of money. These authorities do not admit that they control the flow of money, but in essence, they do. For instance, the government can print more money when they want, and banks on the other hand decide who borrows their money. These central authorities decide who can bank with them, meaning they limit certain investors. It gets worse with centralized finance because the overarching goal of the gatekeeper is to make money. The centralized financial system is therefore marred with third parties who facilitate money transactions between two parties while charging each for using their services. This points to the expensive nature of centralized finance, which is also reflected in their loans. Centralized finance loans are extremely expensive but most people have no choice but to deal with the government and banks. There is an alternative however, it is called, Decentralized Finance (DeFi).

What is DeFi?

Decentralized Finance or DeFi, involves the removal of intermediaries and third parties who grant permission to do financial transactions. This means that there is no government or banks in DeFi to grant permission to a transaction. Instead, there are pieces of code that run and act as a bank. These pieces of code do not operate on a trust basis as is on the centralized finance system. The pieces of code are open to anyone and their work only involves running a program. They cannot scam the parties involved, and those in doubt could sit and study the codes to ensure they are safe.

The elimination of intermediaries who grant permission for financial transactions means that DeFi is much cheaper than centralized finance. Since no third parties are involved, transactions are peer-to-peer, which significantly reduces any fees involved¹. DeFi is also censorship resistance². This means that no party in the system can alter or reverse transactions. DeFi operates on the blockchain, and when a transaction is added to the blockchain, it is spread across thousands of nodes and added to a distributed ledger. This process makes a transaction immutable.

Building Blocks of DeFi

Decentralized finance is built on three critical technologies. These include blockchain technology, cryptography, and smart contracts.

Blockchain

Blockchain is a system of recording information in a way that makes it difficult to hack the system, impossible to cheat, or even alter the information. In DeFi, it is a digital ledger of transactions that is duplicated and propagated across an entire network of computer systems in the blockchain network³. This is a starting point that defines the safety of DeFi, compared to centralized financial systems.

Cryptography

Cryptography involves the development of protocols and methods meant to prevent third parties from gaining access to information from private messages in a communication process⁴. It is no secret that the government and banks are privy to information between two transacting parties. In DeFi, cryptography protects the knowledge of data between two transacting parties, maintaining their anonymity and critical data.

Smart Contracts

Smart contracts are similar to traditional contracts, only that they are digital. A smart contract in the blockchain is a piece of code that accomplishes something if something else happens. In technology, it is simply referred to as “If This Then That” (IFTTT)⁵. These programs stored in the blockchain, therefore, run when certain predetermined conditions are met.

These three building blocks of DeFi are the underpinning elements of the financial system, free from government and bank interference. In as much as there is no regulatory body, there is assured safety, anonymity, and assurance in transactions.

Pillars of Decentralized Finance

DeFi has pillars, almost similar to pillars of traditional finance, which are set to disrupt the entire traditional finance system.

Stablecoins

Stablecoins make up one of the most important pillars of DeFi. They serve as the bridge between traditional finance systems and the DeFi ecosystem. Stablecoins are cryptocurrencies matched to real-world assets. The most common stable coins include Tether and USD Coin. They are called stable coins because their value is directly tied to the United States dollar⁶. The essence of stable coins is to help in trading volatile coins and make the most of the profits, without involving a centralized exchange platform such as Binance. There is guaranteed security when trading with Stablecoins such as USDC and the fees are extremely low compared to using centralized exchange platforms.

Decentralized Exchanges

In the traditional finance system, foreign exchange traders charge huge fees in foreign currency exchanges. One ends up losing between 10–15% of their money because of foreign exchange rates. It is different in DeFi, where foreign exchange traders are replaced with a decentralized exchange. The decentralized exchange allows the exchange of coins and tokens for other coins and tokens. The exchange is further facilitated with negligible transaction fees. The negligible transaction fees favor people who regularly trade their crypto assets. Decentralized exchanges, also known as Dexes, expose one to a whole new world of a variety of coins and tokens⁷. Uniswap for instance, a popular decentralized exchange platform, has thousands of tokens one can trade. Uniswap is not regulated by anyone, but by the code, which is immutable.

Lending and Borrowing

A significant part of the current traditional financial system is based on lending and borrowing money. This means the blockchain could perform this task better, given that it is a decentralized system, and there is no central authority to bar certain people from accessing loans. Central authorities like banks and government require a higher percentage of collateral for a loan taken, and even guarantors, who will pay the loan if one defaults. The financial institution will further conduct a credit risk assessment to determine if you should get the loan. These barriers are eliminated in DeFi. You can borrow against the collateral you provide the lending protocols as the protocols manage liquidations on a loan-to-value (LTV) ratio basis⁸.

Insurance

In the traditional finance systems, payment of insurance premiums guarantees compensation when tragedy strikes. For instance, car owners pay premiums annually to insure their cars. When the cars get accidents or are stolen, or any unfortunate incident happens to the car, the insurance company will compensate the owner with money equivalent to the value of the car. The insurance companies use data and statistics to determine the possibility of accidents happening in a year. The results of these statistics will be used to generate the premiums that should be paid by car owners. In DeFi, code is the insurance company, while smart contracts facilitate a cost-effective business environment through storage and management of policies allowed in the blockchains⁸. DeFi insurance protocols, therefore, allow you to hedge against the risk of a venture where you have money locked⁸.

Governance

The governance of crypto projects is widely decentralized. Currently, Decentralized Autonomous Organizations (DAOs) are trending. These are smart contracts used in the governance of companies. Decisions of companies in the blockchain sphere are no longer a reserve of the management board. Everyone who owns a stake in the company contributes their opinions on the DAO platforms. Picture a scenario where a company has made enough profits to expand into another venture. In normal traditional companies, the management board will make the decision. In a DAO, everyone invested contributes to company decisions⁹. Since everything is coded into the smart contract, funds for the new venture will not be released until a vote is passed.

The current traditional financial system may still be strong and in place. However, if history is anything to go by, it is important to watch out for DeFi. DeFi is fast disrupting the traditional financial system, controlled by banks and the government. People are massively adopting DeFi because of the advantages of its financial ecosystem. There is guaranteed anonymity, the safety of assets through decentralization, and freedom from interference by third parties.

References

[1]. Decentralized Finance (DeFi) Definition. (Investopedia, December 30 2021).

[2]. Censorship-resistance. (Binance Academy, 2021).

[3]. DeFi: A comprehensive guide to decentralized finance. (Cointelegraph, 2021).

[4]. Cryptography. (TechTarget, 2021).

[5]. What is IFTTT? How to use If This, Then That services. (Computerworld, September 2021).

[6]. Stablecoins are taking over the crypto world and they’re a hot topic for Congress — here’s what they are and the fastest-rising ones to keep an eye on. (Fortune.com, December 2021).

[7]. What are decentralized exchanges, and how do DEXs work? (Cointelegraph, 2021).

[8]. 6 Key Pillars of DeFi. (Rizvi Haider, LinkedIn, July 2021).

[9]. What are DAOs? Here’s what to know about the ‘next big trend’ in crypto. (CNBC, October 2021).

*Editor’s note

Sankore 2.0 is an Africa-focused community integrating the NEAR blockchain with projects and solutions conceived and built by local developers in Kenya. As noted in the content of this blog, Sankore 2.0 seeks to promote the development of Web3 products in Nairobi — for Kenya and for Africa as a whole

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