A Beginners guide to Decentralized finance (DeFi)
October 21, 2022
After Bitcoin was launched in 2009, the decentralized finance (DeFi) sector was one of the most significant advancements that were created as an alternative to traditional financial services. To be a bit more specific, DeFi allows users to access the same financial instruments as they would with traditional financial institutions.
In this article, we will explain what DeFi is, how it works, and the different applications that make up the ecosystem.
DeFi, in simple terms, means a decentralized finance system that allows people to send money through peer-to-peer, effectively cutting out the need for third-party systems like banks. It offers many of the services that are often provided by banks and brokerages in the conventional financial world, but it does so in a way that is controlled by the general public rather than a single organization or corporation.
How Does DeFi Work?
To properly understand how DeFi works, we would first of all have a look at the difference between Decentralized Finance and centralized Finance.
The DeFis financial system architecture operates in accordance with predefined rules called smart contracts. These smart contracts first automate, then monitor the agreement terms between each party of a transaction thereby keeping trades fairer, more transparent and secure.
Lets look at an example of how this works if you were to request for a DeFi loan. You would transfer amounts of a certain cryptocurrency to a secure digital address as collateral for your loan instead of via an intermediary like a bank, and you will get a different asset in return. After that, your collateral assets would be kept locked up until you send back the loan’s principal.
Also known as DEXs allow users to hold assets away from centralized platforms while still allowing you conduct blockchain enabled transactions from your wallet.
Aggregators and wallets
A trading pool aggregator is a user interface that gives DEX users access to several trading pools from a single dashboard. The storage and exchange of digital assets is done using wallets. They are capable of storing a wide range of assets and can be found in a variety of formats, including hardware, software, and exchange wallets.
These allow users to transact with one another in a trustless way- that is without the need for an intermediary such as the banks.
Oracles/ Prediction Markets
Decentralized oracle networks (DONs) allow for the implementation of hybrid smart contracts, which mix on-chain code and off-chain infrastructure to support complex decentralized apps (DApps) that react to real-world events and interoperate with traditional systems.
A Layer 1 blockchain network is in charge of on-chain transactions and serves as the foundation for additional apps, protocols, and networks to be built on top of. Ethereum is the main layer-1 solution in decentralized finance but there are other options, including Polkadot (DOT), Solana (SOL), BNB, and Cosmos (ATOM)
Some DeFi Use cases
- Lending and borrowing are some of the major use cases of DeFi. Users can borrow funds while using cryptocurrency as collateral through lending protocols.
- Stablecoins are a core component of DeFi that allow Fiat currencies like the U.S dollar and other assets to be represented on the blockchain as digital tokens.
- Margin and leverage components allow users borrow cryptocurrencies on margin using other cryptocurrencies as collateral. Leverage can also be built into smart contracts to perhaps increase the returns for users.
- It permits DeFi-native activities like yield farming, where users lend out their cryptocurrency to other users in order to earn interest that is paid in cryptocurrency, and liquidity pools, which offer trading liquidity for buyers and sellers.
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