What is Decentralized Finance (Defi)?
We are all familiar with the traditional finance market, which is centralized. Central authorities issue the regular currency. This drives our economy and is used for every trade by the government, banks, and citizens. Thus, the power to regulate the flow of currency in an economy lies in their hands. Now since all the funds and the control are centralized, the risk also lies at the center.
Now, what does risk mean here? The risk of human error, on account of false judgement. For example, Central bodies may decide to print more currencies in case of the financial crisis, without considering that it may backfire in terms of inflation. For instance, the Venezuelan government printed a huge amount of money amidst oil price drop, resulting in inflation exceeding 10,00,000%, as per IMF.
These days, depositing money in banks is becoming more and more unfavourable. Banks invest our money in the share market and give loans at high-interest rates, thus pocketing the spread, And with the high global inflation rate, the return of the interest also becomes unattractively less. Even when it comes to the alternative of investing, we hire a financial advisor in exchange for a certain percent of your return. This also does not equip us with the security of our funds as it again is prone to human error of false judgement, which may be committed by the advisor.
All these issues arise because of the centralization of funds in our economy. Thus, the solution is to decentralize.
Before going on further, one thing that needs to be clarified is thinking of cryptocurrency as the door to decentralization. Cryptocurrency offers peer-to-peer trading without the need for intermediaries like banks and gives users complete control over the assets. However, cryptocurrency can mostly be accessed via centralized access points like exchanges. Besides, majority of the crypto projects are managed by centralized companies which lack accountability or transparency.
Introduction to Decentralized Finance
Decentralized Finance (Defi) Includes digital assets, protocols, smart contracts and Dapp, built on a blockchain.
Smart Contract: Imagine you need to sell a house. It’s instead a complicated process which entails a lot of paperwork and communication. In case you hire an estate agent, you may lose about 7% of the sale price as his/her commission. This brings about a substantial financial loss to the seller. That is where smart contracts are coming in really handy and are expected to revolutionize the entire industry. They work on an ‘if-then’ principle, which means that the ownership of the house will be passed on to the buyer, only when an agreed amount of money is sent to the system.
Decentralized Finance is to create a financial system that is open to everyone and minimizes the need to trust and rely on central authorities. Technologies like the internet, cryptography, and blockchain give us the tools to collectively build and control a financial system, without the need for central authorities.
Difference between traditional and decentralized Finance:
1) In decentralized Finance, a public blockchain acts as a trusted source. In contrast, public financial institutions act as a trusted source in case of centralized Finance.
2) It continues to gain traction because of its open-source nature and transparency. Software programmers can build applications on top of blockchain and revolutionize different industries while making it decentralized.
3) Cumbersome barriers to entry have made it improbable for the traditional finance industry to embrace innovation, as necessary licenses and authorization from regulators has limited various ideas, in contrast to decentralization.
Products of Defi:
Open Lending Protocols:
Just like a bank, users deposit their cryptocurrency, and when someone else borrows the cryptocurrency, they earn interest. However, instead of intermediaries like banks, smart contracts make up the loan terms and conditions, connect lenders and borrowers and distribute interest. For example, P2P lending was reintroduced with a project called ETHLend. On this lending platform, you can put up any ERC-20 tokens, and borrow ETH. The loans are based on smart contracts on the Ethereum network, i.e. borrowers and lenders work directly on the terms.
BlockFi has proved to be another forefront of the Bitcoin lending industry, as it provides its customers not only high returns but advanced security measures as well. It is one of the only lending platforms which provide compounding interest on account balances, paid to clients in cryptocurrency. Individual borrowers are often tricky to manage and assess, especially in case of digital asset lending.
Thus, BlockFi utilizes institutions and not individuals, as counterparts in crypto loan transactions, like investment funds, over-the-counter market makers and businesses which utilize cryptocurrency in their operations. Such institutions are trustworthy and more likely to pay back their debts, providing a more secure stream of interest for lenders.
Stablecoin: Stablecoins are a type of cryptocurrency that has the value pegged to another asset. Value pegged means the value of cryptocurrency is kept such that it maintains a fixed exchange rate to another asset, which may be the following:
a) Fiat Collateralised: For every single stablecoin issued, the issuer has to keep $1 with a central custodian like a bank. This means that you should be able to exchange between the two effortlessly without significant expense. When someone wants to redeem cash with their coins, the issuer will take out the amount of fiat from their reserve and destroy equivalent stablecoins.
b) Crypto Collateralised: In this case price volatility is still possible; however, it is tackled by over-collateralization, meaning $2 worth of crypto is deposited with the custodian, for every $1 of stablecoin. Thus, a stable coin can absorb any fluctuations in cryptocurrency.
c) Non-Collateralised: They do away with the idea of having reserves altogether. They use smart contracts (If-Then-That) to monitor the demand and supply of stablecoins. The smart contract is such that when the prices go too low, the issuer will buy back circulating stablecoins to increase the demand and hence price, and will issue more in case price becomes too high, to increase the supply and thus lower the price. They also have a pegged asset like the US dollar, which is not collateralized.
MakerDao is a company with Dai stablecoin. Dai is valued at 1 USD and is crypto collateralized. Users lock up their Ether (cryptocurrency) in CDP (Collateralized Debt Position). Then CDP generates Dai for users. If later on, users want to withdraw their Ether, they will have to pay back an equivalent amount in Dai.
As explained before, in the case of crypto collateralized stablecoins, over-collateralization occurs, to avoid fluctuations. For example, the collateralization ratio in case of Dai is 150%, that is for every $1 worth Dai, $1.5 worth Ether is kept as collateral in CDP by the user.
1) Etherisc: It is a decentralized application that improves the travel industry by allowing companies to sell insurance and people to buy. Etherisc uses software (data application) or hardware (Internet of Things) as an oracle, which verifies real-world occurrences and submits this information to smart contracts, triggering predefined actions.
For example, in etheric’s flight delay product, the customer pays a small premium into the smart contract. The smart contract, through Etherisc’s oracle, gets informed about the flight being delayed and informs the seller to pay the buyer the amount promised under the insurance policy.
2) Golem: The Golem DApp takes decentralization to the next level. It allows users to rent out their extra computing power in return for its token – GNT. People who require extra power can hire this from another user on a peer-to-peer and decentralized basis.
3) Ethlance: It aims to decentralize the freelance marketplace. Usually, the intermediaries between skill provider and skill required to charge a hefty amount of fees, with some platforms charging as much as 20% of the project value. Ethlance builds a smart contract between the two parties, where people are paid on time when the project stands completed.
4) Power Ledger: Electricity is a resource that is required by everyone. Unfortunately, it is becoming more of a profit-making business these days. Power Ledger is a blockchain organization that is developing a Dapp to resolve this issue. It shall allow people to sell the extra electricity through a peer-to-peer marketplace, at a fair and transparent price. This removes middlemen who usually take a large cut of the profit.
However, all is not rosy as it seems. There are a few potential attacks that can be performed against blockchain networks. Such an attack may happen if one entity manages to control more than 50% of the network hashing power, which would eventually allow them to disrupt the network by intentionally excluding or modifying the ordering of transactions.
Proof of Work is usually very inefficient, since mining is highly competitive and there is only one winner every 10 minutes, the work of every other miner is wasted. The resources used by the bitcoin network has increased significantly in the last few years, consuming more energy than countries like Denmark, Ireland, and Nigeria.
But nevertheless, we cannot put aside the kind of revolution which decentralized Finance has brought about in the world, as it quickly does away with today’s financial bureaucracy, which is a considerable burden of centralized banking. Decentralized finance is going to eat the market share of traditional finance in coming years. Regulations are absent in this area as the sector is currently off-the-radar for regulators but this may change in the future.
Pallavi Mishra is currently pursuing B.Com. Hons at SRCC, she is always thrilled and curious to learn new concepts. She constantly strives to enhance her skills and standing out of the crowd seems to be her main objective, which she pursues with the help of hard work and perseverance.