Intro to DeFi

Intro to DeFi: 

If you’ve never heard of DeFi, or you’re curious about what it is, you’ll want to keep reading. This article is part one of our Deep Dive into Decentralized Finance (DeFi). With our DiviBridge set for release in quarter one of this year, we’ll be creating easy-to-digest content for our community to begin their DeFi journey, no matter their experience level. 

Cryptocurrency stands to create an entirely new economy. One that is based on no trust and no central authorities. Right now, many cryptocurrencies offer secure protocols, low fees, and fast transactions, but lack some of the financial systems people are used to with traditional fiat currencies. After all, how do you offer loans in a decentralized ecosystem? Who assumes the risk? Who puts up the capital?

The answer is everyone. DeFi creates an ecosystem whereby everyday people become lenders, borrowers, and even market makers. With DeFi, cryptocurrencies can now do everything that traditional finance can, at a fraction of the cost, and without central control.  

What makes DeFi different? 

To understand what makes DeFi unique, we need to first understand how the current system works. 

How banks and exchanges do it: In this case, the institution holds all of the capital and the risk. The bank lends borrowers capital, or facilitates the trade, and takes a percentage cut. 

DeFi achieves this in a decentralized way. No longer are market makers or centralized exchanges required. This is made possible by:

1. Smart contracts

Smart contracts are contracts that execute automatically when parameters are met. These parameters are built into the blockchain, so they cannot be altered. In the case of blockchain, these are given immutable qualities as they can only occur on the chain, making them incredibly secure. 

2. Decentralized applications (dApps)

Because of the functionality of smart contracts, developers can now develop decentralized applications or dApps. A dApp is simply an application that runs on a decentralized network. The biggest dApp and smart contract network is Ethereum (there are many others), which allows developers from all over the world to come together and create.  

3. Liquidity pools

The fundamental entity that underpins all of DeFi’s offerings is the liquidity pool. Simply put, a liquidity pool is a bunch of funds pooled together, usually on both sides of a trading pair (let’s use ETH/USDC as an example). Users add equal amounts on both the Ethereum and USDC sides of the pair, thus providing liquidity to both sides. These funds are locked in a smart contract to ensure their security. Users who add these funds are then rewarded with trading fees that are generated on that pair, proportional to their share of the overall liquidity.  Liquidity pools are the reason decentralized exchanges (DEXs) can exist.

DeFi in reality is a simple concept. A secure, decentralized, peer-to-peer exchange of value. The many pieces of DeFi take some time to understand, however, the overarching principle remains clear. Connect people without intermediaries. 

DEXs have made market-making accessible. Anyone can earn funds for supporting liquidity on a variety of tokens. This brings cryptocurrency closer to the peer-to-peer ecosystem that Satoshi imagined in the Bitcoin whitepaper.

To achieve decentralized finance, there exists an ecosystem of different platforms, blockchains, and protocols, linked together by smart contracts. Solutions range from open-source to proprietary, all with the goal of creating a trustless and direct connection between buyers and sellers, lenders and borrowers.

Recommended reading:
👉 DeFi Is On The Move To The Institutional Market- Forbes

👉 DeFi 2.0 Primer- The Defiant

👉 DIVI Everywhere

👉 What is a DAO?

Join us in the next installment as we tackle Web3! As with all of our advice, please do your own research and determine your own tolerance to risk. This is not financial advice!