Decentralized Finance (DeFi) Overview

Jul 11, 2022 | Learn DeFi

DeFi (Decentralized Finance)

Overview of Centralized Finance

To better understand DeFi, we must review the characteristics of centralized finance:

  • A central authority controls the flow of money and its minting
  • A central authority controls who can and can’t hold funds (have a bank account, access financial instruments)
  • A central authority sets rates and can change them at will
  • Their main purpose is to profit off of their customers

Overview of Decentralized Finance

Decentralized Finance takes a drastically different approach to financial instruments.

  • Money flows directly between users
  • Anyone is able to participate, provided they have a wallet and funds
  • Rates are set by market demand (i.e., users themselves)
  • DeFi applications are normally transparent and benefit the user

DeFi in Depth

Low Level – Technology

Decentralized finance applications are built on smart contracts. ****A smart contract is simply a program that defines logic for what a user can do, and how the contract handles money. Smart contracts are very powerful, and form the basis for powerful centralized finance alternatives, such as lending and borrowing apps like Compound, or trading applications like Uniswap or dYdX Exchange.

The language used to program smart contracts varies by blockchain. Here are a few for some popular blockchains.

  • Ethereum: Solidity (Ethereum’s native language)
  • Tezos: Python, LIGO, Michelson (Tezos’ native language)
  • Algorand: Python, TEAL (Algorand’s native language)

Higher Level – Economy

DeFi applications fit together like puzzle pieces to create a market. The parameters of these markets are set by the flow of value between users. For example, on decentralized exchanges (DEXes), prices of assets are determined by how much of a certain asset is in a trading pool pair — if there’s more of Token A than Token B in a pair, Token B’s price will be higher relative to Token B (1 Token B = many Token A, but 1 Token A = a little bit of Token B). In lending/borrowing applications, interest/lending rates are determined by how much of an asset is available to borrow, rather than being determined by a central authority. In most cases, such parameters are governed by simple supply-and-demand principles, however there are algorithms more complex than that.

Applications that provide core functionality to a market are called DeFi primitives or just primitives. Derivative & synthetic markets, along with DEXes and lending applications comprise this group. Anyone may build on top of these primitives to create financial applications with even more value and use. For example, yield aggregation apps build on top of different lending applications, all of which have varying markets. These apps switch lending users’ funds so that they receive the best interest for providing their money to borrowers.

Another important part of any DeFi ecosystem is the ability to realize real-world value. This is achieved with stablecoins, assets whose values are meant to mirror those of their real-world counterparts. Stablecoins can track the value of fiat currencies, like the Euro or US Dollar, commodities like gold or silver, or even stocks. Usually, fiat stablecoins, and sometimes commodities are their own standalone assets, and are backed with real reserves of their respective assets, and others commodities and stocks are realized through synthetic markets (the synthetic asset isn’t acutally backed by the real-world counterpart, but people agree to trade it at the price it is in real-life).

Decentralized Finance Built-in Four (4) Main Thing/Elements

  1. Cryptocurrency
  2. Cryptography
  3. Blockchain Technology
  4. Smart Contract

6 Pillars of Decentralized Finance

  1. Stable Coin
  2. Lending and Borrowing
  3. Decentralized Exchanger
  4. Insurance
  5. Margin Trading
  6. DAO (Decentralized Autonomous Organization)

By: Wilmina Dela Pena


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