With advancements in computer science and mathematics, a group of people discovered a new type of financial system known as Decentralized Finance or Defi.
Defi is a type of finance that is based on blockchain technology. It foregoes the usage of central intermediaries such as banks in favor of digitalized contracts, otherwise known as smart contracts.
In a lot of ways, defi has outclassed the current system of finance, cefi ( centralized finance).
In this article, we are going
to cover the six main components of Defi;
Lending/borrowing,
Stablecoins, decentralized exchanges, derivatives, margin trading, and
insurance.
1. Lending/Borrowing
We can start with an example.
John deposits Fiat money
through a decentralized application to earn interest.
Alex on the other hand has
Ether which he does not want to sell, but he needs money. Hence, he deposits
his Ether as collateral and borrows money in return.
These transactions are done
via smart contracts, meaning no middlemen are required.
This process saves the time
we spend on long paperwork and hence, is a lot faster than traditional
intermediaries.
Moreover, these transactions
are in a peer-to-peer format so the interest rate would be less as compared to
the bank.
A few examples of Defi
applications that allow lending and borrowing include Compound, AAVE, and
MakerDao.
2. Stable coins
Stablecoins are a type of
cryptocurrency that is a lot more stable than other cryptos as they are pegged
to an outside asset such as fiat money, gold, or other cryptocurrencies.
Stablecoins aim to tackle
price fluctuations.
People who prefer to play it
safe in a long-term investment would prefer this coin because it is not as
volatile as other coins such as Bitcoin or Ethereum.
When a country's economy is
seen depreciating, many people tend to invest in stable coins that have been
backed by another country's currency to preserve their wealth.
While stable coins offer
stability, they come with their own set of risks.
Widely known stable coins are
Tether, DAI, Binance USD.
3. Decentralized Exchanges ( DEX)
Decentralized exchanges offer
a peer-to-peer mechanism that promotes the non-reliance of a central
intermediary such as banks and instead, uses smart contracts to facilitate
trading.
Some of the major benefits of DEXs are:
1. Lack of central authority
2. Anonymity
3. High Security
4. Low Trading Fees
4. Derivatives
In Defi, Derivatives are contracts
in which values are determined by the performance of an underlying financial
asset.
Stocks, interest rates,
bonds, market indexes, currencies are a few examples of derivative
assets.
One of the key distinctions
between Cefi and Defi derivatives is that a Cefi derivative can only be created
by a central authority, whereas a Defi derivative can be established by
anybody.
Moreover, Defi derivatives
are easily accessible because they do not require
proof/identity/eligibility.
BitMex is considered an
established decentralized platform for derivative trading.
5. Margin Trading
Margin trading is the process
of borrowing money from a third party to trade assets that we previously
couldn't afford.
Margin accounts enable
traders to invest in assets with higher sums of capital, effectively doubling
their profit. A quick drop in the price of a coin, while also being true, can
result in significant losses for a margin trader.
Margin trading found its
popularity in low-volatile markets, such as the International Forex Market.
A few of the best crypto margin trading platforms in India are:
1. Binance
2. FTX
3. Kraken
4. Bitmex
5. ByBit
6. Insurance
Crypto insurance fulfills the
same objective as centralized financial insurance.
Cryptocurrency insurance
allows investors and organizations to protect their digital assets against a
variety of dangers.
Every week, millions of
dollars in digital currencies are stolen, leaving investors and business owners
powerless because the anonymous nature of this industry effectively masks the
perpetrators' trail while leaving the investor out of money.
Popular Defi insurance
projects include Nexus Mutual and Open.
Benefits:
1. Permissionless: Anyone with the internet has access to use apps( or decentralized apps).
2. Pseudonymous: Because there is no single entity in charge, you do not need to provide your name, email address, or any other personal information to anyone.
3. Hassle-Free: Since there are no physical intermediaries involved, there is no need to wait for any advancement that you have made. There is no need to wait for permission to move your assets, or long transfers to finish.
4. Fast: Transactions can be pretty fast as everything is done automatically via software. Updates are provided regularly.
5. Transparent: Unlike in centralized finance, every transaction is made transparent to the participants.
Downsides:
2. Lack of insurance: In the event of a hack or other fraudulent activity, insurance protects investors. In centralized finance, insurance is quite significant, but it is considerably less common in Defi.
3. Responsibility: Among all of Devi’s benefits and drawbacks, the shared accountability component is negative for users. The Defi projects are not liable for the mistakes made by its users.
All they do is remove the middlemen, leaving the users to be responsible for their funds and assets. As a result, the Defi space needs solutions that can prevent human errors and mistakes.
Decentralized finance is slowly gaining acceptance as a much safer, transparent, and efficient financial option. By removing the need for centralized financial institutions, we create a more transparent and trustworthy financial system that is also far more accessible.
The risk of fraud,
corruption, and mismanagement of your assets is reduced with decentralized
finance, which is safeguarded by blockchain technology.
There will be no overdraft fees, no wire transfer costs, and no need to wait for a transaction to be validated during banking hours, making financial management much more affordable and efficient.
Written By - Karthik Krishna
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