What is DeFi? Understanding Decentralized Finance
If you are new to the crypto space the concepts of decentralised finance can seem a bit overwhelming. There are so many new terms to try and understand, it can be challenging to see how everything fits together.
I have been working in the traditional FinTech space for the last 10 years and it has taken me a while to get my head around everything and I am still learning, so you are not alone here.
We are still very early in the web3 crypto space, and many implementations are still quite technical. We are still quite a way off to having mainstream adoption by the general public.
What is Centralized Finance (CeFi)?
Before we try and explain DeFi it helps to understand the system we currently know and tolerate.
Centralised finance encompasses the entire banking system as we know it today.
There are quite a few financial services that have been developed over the last century.
This is a pretty basic service. All banks offer the ability to transfer money from one bank account to another. Over the years we have come up with a few ways of doing this:
- Internal Transfers — transferring between your accounts in the same bank. These transfers are generally instant.
- Faster payments (FP) — transferring money between different supported institutions. This is supported by most banks in the UK (in the US the equivalent is probably ACH or RTP). Generally, transactions are instant but can take up to 2 hours to appear in the target bank account.
- CHAPS/Swift — for larger payments that can’t go by FP we have CHAPS. There is a fee to transfer by CHAPS and transfers can take 3–5 days.
- Transfer Services — On top of traditional transfer services we also have services such as PayPal, Wise, Western Union to name but a few.
If you have ever been abroad you will likely have transferred money into a different currency. Simply converting from one currency to another is one factor the other is trading currencies like stocks and for that we have Forex.
A savings account is usually one of the first accounts you open when you are younger. Put money in a savings account and as a reward for leaving it there, you earn a bit of interest (like a tiny bit).
If you are willing to lock up your money for longer there are also savings bonds where you get a guaranteed fixed interest rate but you can’t access your money for a set period.
Lending and Borrowing
If you need more money than you currently have in savings then you need a loan. A lot of people have loans for things like houses, cars etc.
To be able to get a loan you need to have a good credit score so they can work out how likely you are to pay the money back.
If you need a loan you used to have to go to a bank. However, there are now quite a few loan services offering “payday loans” usually with extremely high-interest rates.
On the other side, there are also services for lending your money and getting interest in return.
Of course, we also have credit cards which are a form of flexible loan that you only pay interest on if you don’t pay back the money on time each month.
Where there is money and risk there is insurance — Me (just now)
In life, there is always a risk. Your house could burn down, you could get into a car accident or someone could steal your stuff. For that we have insurance.
There are thousands of insurance companies that weigh up the risks and decide how much to charge you for peace of mind. In all cases, it is up to the insurance company to decide whether they are going to pay out or not.
We are now getting into the more complex sides of CeFi which you generally have to be into finance to get involved with. So I will explain what these are in case you aren’t familiar.
If you invest £1,000 in stock and the stock goes up 5% you have just made £50. If only you had more money to invest!
Let’s say you borrowed £100,000 instead in this case you would have made £5,000. You then pay back the £100,000 and keep the £5,000. This is what margin trading is.
Of course, it can go the other way, say the stock drops 5% you now only have £95,000 but still owe £100,000.
I am no expert in margin trading so feel free to correct me in the comments :).
Derivatives are a bit like betting. You are betting whether an asset is going to go up (long) or down (short). That is how people make money from stocks going down.
A derivative is essentially a contract between 2 parties to agree to buy or sell at a set price at some point in the future. How much a derivative is worth depends on the value of the underlying asset.
Say for example you want to sell the popular bike you own in 1 months time. You agree to sell your bike to Bob for $1,000 and a contract is written up. In the meantime, the company stops making your bike and everyone is disappointed. The remaining supply of that model is now going for $1,500 in shops.
Now Bob who agreed to buy your bike no longer wants it but knows Alice does. Bob decides to sell the contract to buy your bike to Alice for $100. As a result, Bob has made $100, Alice has saved $400 on that model of bike and you get your $1000 as agreed.
The contract that Bob sold to Alice is a derivative. If Alice wanted to she could have sold it on to someone else before the contract was settled.
There are different types of derivatives such as forward contracts, futures contracts, options contracts and swaps.
In these cases, you are buying the contract and are taking on the profit and loss of the underlying asset without actually owning the asset.
Again, I am not an expert in derivatives but hopefully, that should give you some basic understanding. Feel free to correct me in the comments.
So what is decentralized finance (DeFi)?
Simply, DeFi is creating everything we have in CeFi mentioned above but in a decentralised way.
DeFi solves some of the key issues we have with the centralised system.
- Centralised — the current systems are run by individual companies. Generally, you have to give them your money to be able to do anything with it. The company could go bust, be fraudulent or get censored.
- Closed source — a company can do anything with your money once they have it. No one outside the company knows how the process works and there is no way to validate things are going to work.
- Expensive — Now currently DeFi can be expensive too (e.g. gas fees) but this is only on certain blockchains. It is generally cheaper to send cryptocurrency than it is to send fiat currency.
- Identity/Permission — to do anything with CeFi you generally need to hand over your entire identity in the form of ID cards, Passports, Birth certificates etc. Do you trust all that personal information with every company you interact with?
When I think of cryptocurrency I generally compare it to physical notes (cash) rather than money in a bank account. I can give you a £10 note and you then have that money without having to go through someone else.
Cryptocurrency is internet cash. Keep this in mind while we take a look at the services that make up DeFi.
This forms the heart of cryptocurrency. With all of the different cryptocurrencies, there is always the ability to transfer crypto from one wallet to another with no middleman.
The CeFi alternative is to deposit cash into a bank account, which is a pot of money owned by a company. Which then gets transferred to another bank account which is again owned by a different company. To then withdraw as cash.
With cryptocurrency, the money goes from me to you without anyone else getting involved or having to hand over your personal details in the process.
There are quite a few crypto exchanges now but not all of them are created equally.
However, they are not decentralised. For one, you need to hand over your identity to be able to start buying crypto with fiat. In most cases, your money isn’t sitting in a secure wallet you own. As such it could get hacked or the company could go bust and you would lose your money.
Always move your money out of these services into a wallet you own. Such as a MetaMask wallet or better yet a hardware wallet such as Ledger. I compare MetaMask to the money I keep on my person to allow me to buy things and my hardware wallet as my savings account.
A purely decentralised exchange allows you to move money from one currency to another and is controlled by smart contracts not by an individual company.
Good examples of decentralised exchanges are:
- Uniswap — simple exchange with quite a few supported currencies.
- SushiSwap — a nice interface for doing exchanges
- Kyber — with Kyber you can choose to either lower fees or maximise your return. In some cases, it will even use Uniswap for the exchange if it is preferable.
- DEX.AG — DEX is an aggregator and will help find the best exchange to use.
There are also a few non-decentralised exchanges that work on an order based system such as:
There isn’t a direct comparison with traditional savings accounts in DeFi (feel free to correct me if I am wrong).
The way traditional savings accounts work is a bank acts as a middleman between lenders and borrowers. Banks will give you >1% interest on your savings which they are then lending out to others with an interest rate of 2–19% depending on the type of loan.
You get a higher interest rate on bonds because banks know exactly how long they have your money for and how long they can loan it out.
DeFi is all about removing the middleman as such we will go straight to the next section on lending and borrowing.
Lending and Borrowing
The first lending protocol that was introduced was the MakerDAO smart contracts. MakerDAO introduced DAI as a stablecoin. DAI is pegged to 1 USD, this is done programmatically through the use of smart contracts.
In order to get DAI, you need to deposit another cryptocurrency to use as collateral. In fact, you need to deposit 150% of what you want to borrow.
So why would you want to do this?
Let’s say you want to buy another coin like BAND. So you swap your 1 ETH (currently at ~$4,600) for the equivalent in BAND.
BAND then drops 50%. You now only have $2,300 worth of BAND. In the meantime, ETH has skyrocketed to $8,000 and now you really wish you had kept it in ETH.
Now, let’s say instead you deposited it for DAI. You now have $3,000 worth of DAI (remember you need 150% as collateral).
You do the same thing and buy BAND. It again drops 50% as before. However, your original ETH is still tied up in your loan. If you can get $3,000 DAI plus the interest you can get back your 1 ETH which is now worth $8000.
There are now lots of other decentralised lending platforms that let you lock up cryptocurrency and get back interest in return. Alternatively, you can use it as collateral for taking out a loan. Smart contracts ensure that your collateral doesn’t drop below the loan amount.
If you deposit ETH you will get back cETH with Compound or aETH with Aave. These tokens are pegged against the original amount you deposited and will earn interest every second you hold them.
Even with everything being decentralised there are still risks with crypto. For example, your exchange could get hacked or there could be a bug in the smart contract you are using.
Buying “insurance” works a bit differently from traditional insurance companies. These decentralised insurance providers are owned and run by their members and use Ethereum smart contracts.
With Nexus Mutual members buy NXM and then stake them against smart contracts that they believe are secure. The members then receive rewards when users buy insurance for those contracts and don’t claim on them.
Margin trading is when you borrow money to invest so that you get larger returns. Being decentralised you borrow money from lenders who in return earn interest from you on the money borrowed.
Everything is controlled using Smart Contracts. Borrowing money to buy another asset is called a leveraged position. These leveraged positions are controlled by smart contracts. If the value of your asset you bought drops too much then the leveraged position is automatically liquidated.
Some of these exchanges also have additional insurance in place so that lenders don’t lose their initial investment.
Derivatives work in a similar way as in the CeFi world but the derivatives are managed using smart contracts.
Derivatives in DeFi aren’t just limited to crypto though. You can buy derivatives in the same things you can in the CeFi world. However, the key difference is that derivatives are just ERC-20 tokens and as such can be exchanged for other tokens on DeFi platforms or invested again.
Hopefully, this post gives you a basic understanding of what CeFi and DeFi are and how they differ.
I am not a financial expert so feel free to correct me if something isn’t right. If you know of any other platforms that are worth mentioning in this article let me know in the comments and I will add them.
Originally published at https://blog.alexhyett.com.