What is DeFi? The Ultimate DeFi 101 Overview
7 min read

What is DeFi? The Ultimate DeFi 101 Overview

What is DeFi? The Ultimate DeFi 101 Overview

Summary:

  • DeFi is short for decentralized finance, an umbrella term for a range of monetary applications in cryptocurrency or blockchain tailored towards disrupting financial intermediaries.
  • DeFi aims to expand the use of blockchain from basic value transfer to more complicated economic use cases.
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Why is DeFi Important?

Outlined below are several key points supporting the necessity of DeFi relative to problems in conventional systems:

Traditional Finance:

  • Not every person is given access to a savings account or considered qualified to utilize monetary products or services in their respective countries.
  • Lacking accessibility to these solutions can restrict job possibilities.
  • Financial institutions or intermediaries like PayPal can prevent other users from receiving or sending customer funds.
  • Some central authorities can take advantage or make use of their client's information.
  • Federal governments can shut down or enforce heavy restrictions on markets.
  • Traditional trading hours are often restricted.
  • Many international transfers can take many days to process.
  • Many monetary solutions include transaction fees

Decentralized Finance:

  • Enables full autonomy and freedom - customers have control over where and how one's money is spent.
  • Fund transfers happen almost instantly, depending on the network.
  • Purchases can be pseudonymous or confidential.
  • The network is open to any person.
  • Markets never close.
  • Developed on a system of open principles.

The History of Decentralized Finance

The term was born in an August 2018 Telegram conversation between Ethereum developers and entrepreneurs, comprising Inje Yeo of Set Procedure, Blake Henderson of 0x, and Brendan Forster of Dharma.

Although decentralized financing is still in its developing phases, the total value locked (TVL) in DeFi agreements is greater than $200 billion since November 2021 and, according to information from DeFi Llama, Ethereum commands are greater than 60% of the TVL. Although this data might appear considerable, it is still in its early stages as many decentralized finance tokens lack sufficient adoption, liquidity, and volume to sell in the web3 market.

How it started with Ethereum

Although Bitcoin leads the foundations for an open and a meritocratic economic system, the constraints of its programming language, Script, prevented a series of options that a lot of centralized financial services can offer to their customers.

These restrictions gave an incentive for Ethereum, which was launched in 2015. With a Turing-complete language, Solidity, and an adaptable ERC-20 contract criterion that allows for compatible tokens and applications, Ethereum offered developers the liberty and adaptability to improve its procedure. In doing so, it worked as one of the first truly programmable variations of money. Two layers characterize Ethereum: layer 1 and layer 2.

At the threat of oversimplifying, Layer 1 is commonly taken into consideration as the base layer (or the primary network) on which distributed and decentralized platforms like Ethereum and Bitcoin function.

Although the Ethereum Mainnet (layer 1) has aided solid protection and decentralization, other elements like scalability have been delayed relative to alternative blockchains. A confluence of elements like periods of high network activity contributed to data blockage, making purchase costs increasingly expensive and reducing the performance of some dApps on Ethereum. The above factors (and much more) generated Layer 2.

Layer 2 is an additional network that works on top of the mainnet. As a basic term, layer 2 assists applications by taking care of load off the mainnet, while still keeping the benefits like the decentralized model of Mainnet.

Ethereum is commonly considered an organic and harmonious structure in DeFi for several reasons:

  • Open Network: no single entity or individual possesses Ethereum or its tapestry of smart contracts. This gives everybody an equal opportunity to make use of financial services. No single person or entity can change the guidelines.
  • A singular language: As many applications are built on the Ethereum network, they share interoperability with the ERC20 token or similar token contracts. Thus, creating a seamless atmosphere to allow items to work together. For instance, customers can buy tokens on one system and exchange the interest-bearing token in a different application. This is comparable to redeeming loyalty points.
  • Common ledger: The tokens and cryptocurrency are constructed right into Ethereum. Therefore, a common ledger is monitoring the financial transactions and possession.
  • Self-governing: Ethereum is open-source and based on a decentralized autonomous system, it enables users to have total financial liberty.

From MakerDAO to Uniswap

MakerDAO, building on the work of Satoshi and Ethereum's cumulative heritage of self-governing and programmable money, created a dent in the DeFi market.

Conceptualized in 2014 and later introduced in 2017, MakerDAO is considered among the oldest protocol on Ethereum. It operates as a procedure that allows individuals to release a decentralized Stablecoin-- DAI-- fixed at 1-to-1 to the worth of USD by utilizing electronic assets as security.

By providing its customers the capacity to get the Dai Stablecoins versus Ethereum's cryptocurrency (Ether), MakerDAO produced an approach for any person to get lending without relying on systematized entities. It also made a dollar-pegged digital property.

With its lending procedure and Dai Stablecoin, MakerDAO helped create the very first building block for a new, open, permissionless economic system. From there, various other economic methods were released, creating a progressively dynamic and interconnected environment. Substance Finance launched in September 2018, developed a market for customers getting collateralized lending and loan providers to generate interest rates paid by those consumers. Next, Uniswap launched in November 2018, allowing customers to switch any token on Ethereum.

Below is a quick infographic depicting the history of some important DeFi projects.

How does DeFi work?

The DeFi system is still in the early days and there is no definitive template. However, in this section, we will unpack the various technical layers of the DeFi stack:

  • Negotiation Layer: Considered a vital DeFi component, the negotiation layer acts as a foundation by integrating a public blockchain with a native currency. Comparable to the dynamics of Ether (ETH) with Ethereum, the token or coin is typically a complementary feature of most decentralized applications (dApps). The tokens aid customers make easy income via tasks like staking. It can also be used for governance or traded in other streamlined or decentralized marketplaces.
  • Protocol Layer: DeFi protocols help define the rules or guidelines that customers need to comply with (as per industry criteria). The protocol also offers a level of cohesion allowing allows different entities or programmers to work together and enhance solutions for the customers.
  • Application Layer: The application layer is frequently home to the most widely known web3 apps, including financial services and decentralized exchanges (like Saddle 😎). A vital component of DeFi ecosystem, application layers, helps in giving a user-facing programs using dApps (decentralized apps) which reflect the structure of the underlying protocols.
  • Gathering Layer: As the last layer, collectors integrate a diverse combination of apps and sources from the prior layers. The collectors assist in adding additional resources for end-users and enhance interfacing between different financial tools.

DeFi Applications

Most decentralized finance applications are built on top of Ethereum. There are newer blockchain networks coming up, where similar DeFi ecosystem is being built. The smart contracts are at the core of DeFi. Some of the popular applications of DeFi include, but not limited to:

  • Decentralized exchanges (DEXs)
  • Stablecoins
  • Futures & Options
  • Liquidity pools & Yield Farming etc

How do I make money with DeFi?

Yield farming and staking are some of the popular “passive income” generation methods. By loaning out their money as liquidity, by leveraging on arbitrage, and generating returns from their financing, users have many avenues to make money.

Is Investing in DeFi risk-free?

Even though many believe DeFi is the future of finance, it’s risky. There could be significant volatility in the crypto market in addition to technical risks.  It's also tough sometimes for newcomers to separate the good projects from the bad.

As DeFi has enhanced its activity and popularity during the bull run of 2020, some DeFi applications crashed, sending out the marketplace capitalization to near $0 in few hours. Several investors have shed a lot of money. It’s advised to do your due diligence before investing.

When will DeFi go mainstream?

While more and more individuals are being drawn to these DeFi applications, it's tough to claim where it will go. This financial innovation is new, experimental, and isn't without technological and financial risk, especially when it comes to protection or scalability. Developers hope to eventually fix these issues. Ethereum 2.0 might take on scalability worries with a principle known as sharding, a way of splitting the underlying data source right into smaller pieces that are extra workable for private customers to run.

The technology is modern, the communities around the technology are young. We will certainly continue to see a series of applications and new user cases emerge in the coming years.


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