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What the Heck is DeFi — A Simple Explanation | by yasi | The Capital | Jul, 2020

What is DeFi, why everyone is talking about it?

yasi

Last year Maker Foundation Announces $27.5 Million MKR Sale to Dragonfly Capital Partners and Paradigm. In 2018, Paxos, the startup behind the Paxos Standard (PAX) stablecoin, said it has so far issued a total of $50 million worth of the U.S. dollar-pegged cryptocurrency one month after its official launch. Compared to the total value of banking services in the world, those numbers are minimal, but the trend is growing and more and more DeFi projects are appearing. Today there is more than $2.28 billion value locked in DeFi projects.

source: DEFI Pulse

But why it is such a hot topic now? And what is so promising about it? You will have a much better understanding of DeFi after reading this article.

Why decentralized finance? Because it is powered by Decentralized Ledger Technology or blockchain technology as many people call it. It covers everything about banking, investing, lending, insurance, and payment. Those movements of money take place on the blockchain, which means it does not go through a centralized organization as we experienced nowadays. When we make a purchase online, the payment goes to the credit card companies, then somedays later they release the money to the merchant after deducting some fees. When we invest in company shares, we transfer money to an exchange, and they will buy the shares for you. When we deposit our money to the bank, our bank collects all the deposits centrally. When we make a big purchase, then there is an escrow service to keep the fund. All the steps in the middle diminish the money in exchange for a service.

On the other hand, the idea of blockchain technology is about decentralization. There is no central organization to process, hold, decide, rather it is a decentralized process based on the blockchain’s consensus mechanisms. Think of DeFi as Finance and Banking on the blockchain, and the process is regulated by the network and there is no room for mistakes or fraud because the network needs to validate transactions, rather than people.

When you hold digital currencies, you are possessing it in your digital wallet. While with traditional banking services, your money is actually with the bank. When you buy cryptocurrencies on Decentralized Exchanges, you are exchanging directly with a seller. While on traditional stock exchanges, you are sending your money to the exchange. DeFi provides direct ownership, transparency, and accessibility with additionally reduced transaction costs.

Up till today, there are more than 200 DeFi projects built on Ethereum, Bitcoin, EOS, and other blockchains. There will be much more in the coming years when the user base is growing and the technology keeps developing.

There are many types of DeFi projects according to defineprime.

  1. Asset Management Tools: Digital asset wallet providers that allow you to store, transfer, and use tokens.
  2. Alternative Saving Apps: projects that allow you to save money or/and lend money to anyone to earn interests.
  3. Derivatives: projects that allow you to bet on interest rates or earn interests based on collateral loans.
  4. Decentralized Exchanges: crypto exchange platforms that are built on blockchain and enable the peer-to-peer transaction.
  5. Margin Trading: projects that allow users to lend or borrow their own cryptocurrencies to do margin trading.
  6. DeFi Infrastructure and Dev Tooling: Protocols and software for building DeFi projects.
  7. Ethreum based DAO Platforms: Various DAO platforms based on smart contracts.
  8. Decentralized Insurance Platforms: using a smart contract to manage risks and form insurance products.
  9. Asset Tokenization: putting real-world assets onto the blockchain, and make them more liquid, transparent, and bankable.
  10. KYC & Identity: managing user data and user verification.
  11. Decentralized Lending: connects lenders and borrowers.
  12. Payment Solutions and Service Providers: payment solutions for cryptocurrencies.
  13. Marketplaces: decentralized marketplaces where people can buy, sell, transfer digital assets directly with each other, so-called peer-to-peer transactions.
  14. Prediction Markets: betting for crypto prices, competitions, sports events.
  15. Stablecoins: almost all the stablecoins to pegged to real currencies.
  16. Analytics: various platforms allow people to discover, analyze blockchain data. This is the beautify of blockchain’s transparency.

You might wonder why there are so many DeFi projects and why we need DeFi. There are many benefits brought by it which come along with the blockchain technology.

  1. Faster transaction: Since transaction on the blockchain is peer-to-peer, there is no involvement in an intermediary, you can transfer your digital assets/cryptocurrencies to the other address as fast as the transaction is validated. However, with banks or other third-party services, it could take days or weeks. Imagine how long does it take for a property ownership transfer by the land registry, and if the transfer takes place on the blockchain, it would be a matter of seconds.
  2. Reduced transaction cost: one of the typical examples is cross border money transfer. If I were to transfer CHF1000 to Australia in AUD, it would be AUD1521 according to the exchange rate. But I have to do it through a bank or Paypal. Then the converted value would only be AUD1469, and if I do it with UBS, it would be AUD1462 not considering other fees. It is about a 3.5% loss in the exchange! With cryptocurrency transfer, it would be equivalent to a few cents or a flat rate of 1 token, depends on the coin. And in a few seconds, the other party will receive the amount. If we do it through the bank, it would take a day or more.
  3. Full ownership: Unlike traditional exchanges or savings account, the tokens you have will be in your own wallet. You send them directly to another party from your wallet. With banks and stock exchanges, you need to send money to them. And you are losing control of your money if something goes wrong. Full ownership also means ownership of your personal data, important document, and information. You do not need to save them with a third party which can subject to data leaks or hacking. But you can share chosen information with the designated parties through blockchain. For example, Ambitorio AG is a Swiss blockchain startup, their solution allows people to send high-value data through blockchain safely.
  4. Transparency: each transaction and address is visible on the blockchain. There are a lot of analytics platforms that allow you to check the addresses or projects, with this information to be public, investors are better informed, transactions are more secured. It enables better price discovery and avoids information asymmetry.
  5. Accessibility: those who are not able to get access to banking services, investment assets are now able to do so. DeFi lowers the entry barrier and makes it more accessible for everyone to participate in capital markets. On the other hand, traditionally illiquid assets can be tokenized and bought by investors which would not be possible without blockchain.

There are however challenges of DeFi. DeFi projects might need to comply with local laws and regulations which are not yet clear for blockchain technology. Most of the DeFi projects are at the moment adopted by a small group and need much more effort in ecosystem building. Some platforms are still not quite user-friendly, thus it puts a barrier to an average user.

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