Meet DeFi, the craziest innovation in Finance

DeFi gives market participants ease of exchange void of traditionally monopolizing intermediaries. Decentralized exchanges strip custodians of their power, stablecoins secure unstable climates, DeFi lending purifies peer-to-peer trading.

 

Key Takeaways:

 

  • DeFi differentiates itself in its ability to expand the use of blockchain from simple value transfers to intricate financial use cases.

  • DeFi dilutes away middlemen and intermediaries and is built on Ethereum.

  • 1 billion credit card transactions occur each day—DeFi curtails opportunistic middlemen profits.

  • Famous DeFi products include: decentralized exchanges, stablecoins, lending platforms.

 

DeFi epitomizes values of sovereignty…

DeFi is the diminutive for ‘’Decentralized Finance’’ also formerly known as Open Finance. The term represents an ensemble of financial applications in the world of cryptocurrencies. DeFi is a blockchain geared towards disrupting financial intermediaries by coding disruptive financial products. With blockchain at its heart the transaction networks seen in DeFi offer users more transparency, and more control over their money. This disrupts typical centralized forms of money management who usually tag on fees, and layers of complexities to protect their business.

 

When you pay with a credit card a financial institution interacts between you and the commerce you are buying from. They control the flow of funds from your bank account to the bank account of the business. They can record the transaction in their private ledger, stop, or slow the transaction however they like. The credit card companies like Visa or Mastercard charge the commerce a fee. You just went for a coffee at lunch, and in thirty seconds you have engaged in the complex world of intermediaries, just for a cup of coffee. You and the commerce have paid for the ‘privilege’ of owning a Mastercard, and you have thus granted banks access to your private purchasing behavior. DeFi breaks up your relationship with banks to offer you a perfect 10.

 

In 2020, there were 1.1 billion credit card transactions occurring every day around the world. That is 368.92 billion purchases of goods and services happening in one year. Among themselves, Visa, Mastercard and American Express accounted for 25% of those transactions. That is a lot of money in fees, so good for them. DeFi however is of another opinion, and rightly so! Visa making a business out of your every purchase does not mean they can continue doing so at the expense of your coffee shop’s wallet. In fact, DeFi threatens several more institutions such as real estate, capital markets, and lending. DeFi epitomizes the virtues of blockchain; permission less, immutable, trustless…

 

We wrote an article yesterday on Ethereum, exploring the recent price surge but we failed to mention its importance for DeFi. Let me rectify this and underline that most applications of decentralized finance occur on top of Ethereum! Ethereum (ETH) is unique because unlike the Bitcoin platform, it is easier to build new financial case uses; ETH’s platform for smart contracts offers flexibility through programming languages like Solidity to design and deploy new ideas. What are these new ideas you ask? Decentralized exchanges, stablecoins, lending platforms, wrapped bitcoins, prediction markets, yield farming, liquidity mining, composability, and money legos.

 

Pure peer-to-peer lending…

DeFi Lending

Traditional lending already saw disruption in the likes of online lending companies SoFi, Lending Club, Prosper etc. but these firms still use similar elements traditional banks use in their underwriting, such as a FICO score. DeFi is enabling a new wave of innovation in online lending because collateral has moved from fiat currency, or tangible assets to include tokens like Ether! DeFi loans promote anonymous transactions meaning that your collateral is the only criteria you are required to post up so forget things like social security numbers, or passport numbers or sticky FICO scores.

 

DeFi protocols are much more unique (think Aave, and Maker) because they allow users to become lenders or borrowers in a decentralized economy—smart contracts operating on an open blockchain on ETH allow for more ease in peer-to-peer lending. How so? Lenders supply their tokens into a ‘’money market’’ through smart contracts. Smart contracts look like special purpose vehicles in this case holding money and distributing it—it acts like a digital intermediary but does not charge fees like a custodian. Coins then become available for borrowers but why would people want this in the first place? Borrowers may need funds to cover expenses, they may want to delay capital gains taxes on tokens or use funds to increase leverage on trading positions. And besides, who would not want to trade in the Matrix?

Stablecoins

Stablecoins are types of cryptos whose value is attached to a non-crypto asset like fiat currencies, precious metals, or other cryptos. Stablecoins’ end goal is to stabilize fluctuating crypto prices and make crypto use more inviting to everyday people. The USD’s value does not change as drastically as some crypto prices and this is a problem for people who do not have the tools to correctly hedge volatility. This matters because in periods of political instability in countries folks can transfer their currency over to stable versions and evade internet censorship, bank account or tumultuous political climates.

 

Example of stablecoins

If you remember, Facebook tried launching a crypto called ‘Libra’. It is now rebranded as ‘Diem’ and preparing a 2021 launch. It faced scrutiny and lots of competition because people realized the power it would give an already dominant Facebook. A veteran stablecoin, called Tether (not to be confused with Ether), launched in 2014 as ‘’USDT’’ and now has the largest market capitalization of all stablecoins. USDT’s main goal is to move money between exchanges quickly and exploit arbitrage for example, Chinese importers stationed in Russia use USDT to send dollars into China in order to skip strict Chinese capital controls. Borderline illegal, but feathers will be ruffled we all know that.

Decentralized Exchanges

Also known as a DEX, decentralized exchanges are autonomous decentralized applications that enable crypto market participants to trade without giving up control over their funds to a custodian. A custodian is an entity that secures assets in a transaction and charge fees for the service. DEX eliminates the need for any authority to supervise trades. With smart contracts (a recuring theme in this article), DEX achieves automation in order books which makes for a truly peer-to-peer interaction. DEXs are recognized for enhanced privacy, stronger security, and they offer more user transparency throughout transactions. DEX also have down sides like slow transaction speeds (because of the blockchain), and surprisingly liquidity issues. Some argue that because of those obstacles, more protocols need to be built for more ease of access and comfort of use (Ethereum 2.0?).

 

Uniswap is the largest DEX by trading volume and was started in 2018. It is one of the trailblazer DEXs to pioneer the automate market maker (AMM) systems, a system that enable traders to swap tokens without relying on an order book. The AMM model relies on liquidity pools that pairs a token with ETH ensuring that there will always be adequate liquidity between any two tokens. On this type of exchange, any user can trade without being stopped by some authority and secondly, trades of any token, by suppling a pool with appropriate levels of ETH, can take place.

 

All in all, DeFi stems from the idea of open finance; an unregulated, trustless, permission less network of verified transactions driven by smart contracts built on a native blockchain. DeFi is the most innovative technology we have seen since the iPhone and Facebook.

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