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 What is DeFi? 

 DeFi is short for “decentralized finance,” a term used to describe financial applications in cryptocurrency or blockchain built for the disruption of financial intermediaries. It is important to note that they are financial services solutions. They are created on blockchain networks like the Ethereum and Bitcoin blockchain. 

The essence of this category of crypto is to recreate traditional financial instruments in a decentralized environment, outside of the control of governments and private entities or individuals. 

According to Alex Pack (Managing Partner at Dragonfly Capital) – “The goal of DeFi is to reconstruct the banking system for the whole world in this open, permissionless way,” 

DeFi is disparate because it redefines the use case of blockchain from painless value transfer to more convoluted financial use cases. Maker is credited as the first DeFi coin, after which we’ve had many others such as Chainlink, Uniswap, Dai, amongst others. 

To understand DeFi, we must discuss Smart Contracts and the Ethereum blockchain 

Smart contracts help you exchange value of any form in a conflict-free way without the use of a 3rd party. Most “DeFi” applications are built on top of Ethereum, the world’s second-largest cryptocurrency, and the complexity of financial applications that can be created on the ERC-20 blockchain is highlighted by Ethereum creator Vitalik Buterin back in 2013 in the original Ethereum white paper. 

Ethereum is flexible for the creation of smart contracts – which automatically executes transactions if certain conditions are met. Ethereum programming languages liike Solidity, are specially designed for creating and utilizing such smart contracts: rules governing under what conditions money can change hands. 

Importantly, smart contracts not only dictate the rules and penalties around an agreement in the same way that a traditional contract does, it also automatically enforces the rules of the contract, such that the required conditions are either met, or there’s no exchange of value. 

For instance, Flash Loans (an uncollaterized loan option) uses smart contracts to enforce a rule that the money won’t be loaned out unless the borrower pays all outstanding debt back; or that money can only be transferred at a certain temperature level based on figures from Weather.com. Pretty cool right?…haha..I know. 

With smart contracts at the core, dozens of DeFi applications are operating on Ethereum, some of which are explored in this writing. Although Ethereum has scalability challenges, it is expected that Ethereum 2.0, an upgrade to Ethereum’s current network provides lasting solution to the scalabity issues on its network. 

Bitcoin as a DeFi 

Bitcoin and Ethereum are the original DeFi applications. Both are controlled by large networks of computers, not centralized authorities. Ethereum stands apart from Bitcoin because of its ease of use in building other forms of decentralized applications beyond simple transactions. While Bitcoin is rather simpler in its use for payments and other straightforward transactions and a good number of investors use bitcoin as a store-of-value that protects against inflation (just like gold), Ethereum has been instrumental in helping startups crowdfund their business. 

This is not to say that Bitcoin cannot be flexed for complex transactions. For example, companies such as DG Labs – a remittance settlement company, and Suredbits, are working on a Bitcoin DeFi technology called Discreet Log Contracts (DLC) where through preset conditions, wealth can be distributed between two parties without revealing the conditions on the blockchain. 

Why Is DeFi Growing? 

Decentralized finance is becoming popular for several key reasons, which are the same reasons for the growing interest of the public in Bitcoin itself. Banks are not needed and neither is any other 3rd party, you don’t have to trust the other party, there is a 24/7 access, and settlements are comparatively rapid. 

One might then wonder why DeFi are ever needed when Bitcoin already exists. Direct purchases isn’t the only type of financial solution needed. There are other finance needs such as loans, insurance, crowdfunding, derivatives, betting and more, all of which are to be chiefly tackled by various DeFi coins as a result of the limitations birthed by the relative simplicity of the Bitcoin blockchain. As an addition, DeFi is permissionless, censorship resistant, immutable, programmable and offering minimal counterparty risk. 

The total valuation of DeFi coins as of February 2021 is around $35billion which signals the market’s expectation of the future performances of these projects. So, if you are looking to make some cool cash from DeFi, below, we discuss some of the most common use cases for DeFi coins. 

Lending and borrowing 

Lending services appear to be the most adopted DeFi projects with coins like Dharma Lever, Compound and Celsius Network rising as pace setters for decentralized lending services. The term “Yield farming” has suddenly become a crypto lingua which means not only receiving interests in return for lending, but also receiving digital tokens as compensation. Although DeFi lending coins are not there yet, it is expected that the future of DeFi would be such that would have a big impacts on lives of people. The creators’ and users’ dream is that one would be able to buy a house or property on a DeFi platform under a mortgage agreement where repayment is made over a period of years. The deeds of the property would be put up in tokenized form on a blockchain ledger as collateral and, where there is default repayment, the deeds would mechanically shift to the lender. This process will require no lawyers or banks and could positively affect the price of properties since service charges would be excluded. 

Derivatives, Margin Trading, & Prediction Markets 

dYdX and Nuo as of the time of this article can allow users to leverage up to 4x and 3x respectively, thus encouraging shorts, hedging and margin trades. Financial solutions are also springing up for Prediction markets, with Augur (decentralized betting platform with no limits attached) being the most relevant example. One key factor held constant among all these financial solutions, is that they require no third party, bank or clearing house, and usually are entirely permissionless. DeFi for Prediction markets can be used for betting on the outcome of future events like elections, and are able to do this without intermediaries. 

Decentralized exchanges (DEXs) 

Online exchanges such as (Uniswap, Sushiswap, Venus, Ox protocol) provide platforms for users to swap currencies for other currencies; for example, U.S. dollars for bitcoin, ether for DAI. DEXs are the next big step in the cycle of exchanges, which link users directly so they can trade cryptocurrencies with one another without having to trust any intermediary with their money. 

Stable coins 

Although some have argued that stable coins do not typify DeFi because they do not offer any special financial solution other than being the equivalent of a 

particular fiat, it is actually one of the simplest forms of DeFi, as they can be used as a safe haven backed by a more stable currency than that of the user’s environment. Initiating lending contracts and other financial products in a volatile asset such as bitcoin, is impractical, therefore most DeFi contracts integrate stablecoins (such as DAI) at the depth of their functionality. Other more known stablecoins trading today include USDT, USDC, TrueUSD, and Paxos. 

Banking the Unbanked and Saving 

DeFi potentially offers much higher returns to savers than high-street institutions: Compound, for example, which is popular for saving, lending and “Yield farming”, has been offering an annual interest rate of 6.75% for those who save with the Tether stablecoin. Not only do you get interest, you also receive Comp tokens, which is an added attraction. With two-thirds of people without bank accounts in possession of a smartphone, DeFi has the potential and capacity to bank them, such that the local traditional banking institutions are wholly replaced by DeFi projects. 

Potential systematic risks of decentralized finance 

We have discussed extensively about DeFi in all its glory, but this is not all that there is to DeFi. The technology and the social development is not perfect yet and some of the reservations we have are briefly discussed here. 

As of now, it is difficult for newcomers – noobs to separate the good projects from the not-so-good ones. And, there has been quite a number of terrible DeFi projects. 

Even as the popularity of DeFi burgeoned in 2020, a number of DeFi applications, such as meme coin YAM, has crash-landed and become valueless, with its market cap going from $60 million to $0 in 35 minutes. Other DeFi projects, such as Hotdog and Pizza, have suffered the same fate, and many investors lost a lot of money. 

DeFi bugs are regrettably still a main-stay in the space. Smart contracts are very powerful tools, but they can’t be changed after the rules are set into the protocol. Therefore if there was a bug while setting the rules of a smart contract, it becomes a permanent part of the project since rules are irreversible. 

Other risks of DeFi applications could also include hacking. Pack says that “The smart contracts could be hacked. There could be a backdoor that allows someone to steal all of your keys. But you’re trusting in open-source code—over time, many eyes are looking at it.” 

Thus, we urge all who are hoping to make some money by investing in DeFi projects to tread cautiously and DYOR. 

All You Need to Know About DeFi
Article Name
All You Need to Know About DeFi
An Introductory article on decentralized finance and blockchain smart contract.
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Uptrend Africa
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