What is Defi?
A basic foundation of Finance lies in the transfer of value. Imagine you want to send some money to your family or you are taking a loan. All of these require a transfer of value (Fiat currency in this case). It is always not possible to have a hand to hand transfer (even more difficult for large amounts). Hence you need a trusted third party. This is where the banks come in. The Banks act as a central trusted organization that process and expedite your transaction and handle various complexities involved, manually. To automate such a method, you will need to convert the Fiat currency into a digital currency. Enter cryptocurrencies. What if we can build logic on the various procedures which the Banks perform and try to automate them using smart contracts. That’s where Decentralized Finance comes in. It enables the transfer of value digitally in a trustless manner using smart contracts.
Let us now see at a basic level what builds a Defi ecosystem.
Lending and Borrowing
Lending and borrowing were some of the first features which were brought into the ecosystem. MakerDao pioneered it. The concept of lending is simple. If you want to loan a certain amount you have to lock the same amount or higher (in cryptocurrencies) as collateral.
However in crypto, as the price fluctuates, the total value of the collateral will also fluctuate. This means that the Defi system is at a risk to be undercollateralized. Hence, in Defi, the protocols always over-collateralize themselves, so that in case of a downfall in price, there is still a buffer safety zone.
Also in case, the price drop is too much and still goes below a certain value, your collateral will get liquidated to balance it out.
All these calculations happen using smart contracts.
Following up with the above example, a stable coin is very important for borrowing. You do not want to borrow a cryptocurrency that fluctuates in price. You would better borrow a stable coin and then you can use it the way you like. This also simplifies the borrowing process. In the case of MakerDao, they lend you the stablecoin, DAI.
In the case of Decentralized exchanges, a stablecoin is required to hedge against price fluctuations. In this case, though, you also have options for centralized stable coins like USDT, USDC along DAI.
Note that, as the price of a decentralized stablecoin is dependant on supply and demand, there is a minor variation in the price of DAI and it does not always stay at $1 but fluctuate a little.
Governance is a very important aspect to run a Decentralized Protocol. All developments in the protocol are decided based on the results of the voting. Voting can be done by holders of the protocol’s governance tokens. It is to be noted that though voting is decentralized the there are only a few major whales who hold these governance tokens and therefore take the majority of the decisions. In return for the voting, the voters are rewarded with the Protocol’s Governance tokens.
Automated Market Makers (AMMs)
A traditional exchange is based on Order books. You need somebody to sell a cryptocurrency for you to purchase one. AMMs replace that. AMMs allows users to create liquidity pools of 2 (or more, in the case of Balancer) tokens. Purchases and sales of tokens can happen from within this pool.
Note that the pool contributor can sometimes bear a temporary loss called Impermanent Loss. Do study about it before you create a pool.
Bridges make Defi cross-functional across blockchains. Using bridges you can transfer tokens from one blockchain to another. Bridges comprise smart contracts that will lock your native token and will give you a 1:1 pegged token for the other blockchain. You can use this pegged token to use in the other blockchain.
Defi has now evolved into a more sophisticated product. This includes insurance, prediction markets, liquidity mining, derivatives, etc. I will talk about these in the next parts of this series.