DeFi is the abbreviation for “Decentralized Finance”, a generic term for a variety of financial applications in the cryptocurrency and blockchain sector that seek to disrupt the traditional financial markets and intermediaries.
DeFi is inspired by Blockchain, the technology behind the digital currency Bitcoin, which allows decentralized storage of transactions and financial data. Which means it is not controlled by a single person or centralized source. This is important because centralized systems and human monitors can limit and challenge the speed and background of transactions while giving users less direct control over assets. DeFi is essential because it enables blockchain users to move from simple value transfer to more complex financial applications.
Bitcoin and other Digital Assets stand out in relation to legacy digital payment options, such as Visa and Paypal, as they eliminate the need for middlemen in transactions. When you pay for your coffee with a credit card in a cafe, a financial institution sits between you and the cafe, which has control over the transaction and has the authority to stop or pause it and also stores it all in a central, private database. With Bitcoin, these institutions are left out in the cold.
Direct purchases are not the only type of transactions or contracts monitored by large companies; financial applications such as loans, insurance, crowdfunding, betting and many others are also under this control. The exclusion of the middleman from all types of transactions is one of the main advantages of DeFi.
Before it became popularly known as decentralized finance, the idea of DeFi was often called “open finance”.
Ethereum applications
Most applications that call themselves “DeFi” are programmed based on Ethereum. The second-largest cryptocurrency platform, which is very different from the Bitcoin platform because it is easier to use as a foundation for other types of decentralized financial applications. Ethereum founder Vitalik Buterin paid special attention to these more complex financial use cases when he published the Ethereum White Paper in 2013.
This is because Ethereum is a platform for Smart Contracts, which execute transactions automatically when certain conditions are met and therefore offer more flexibility. Ethereum’s programming languages, such as Solidity, are specially designed for creating and deploying smart contracts.
An example of smart contracts would be when a user wants to send money to his friend the next Tuesday, but only if temperatures rise above 30°C according to weather.com. Such rules and conditions can be written into a smart contract.
With Smart Contracts as a core function, there are several DeFi applications that operate on Ethereum. We will explain some of them in more detail below. Ethereum 2.0, an upcoming upgrade of the Ethereums underlying network could give these apps a boost because it improves the scalability of the Ethereum blockchain.
Some of the best known DeFi applications include:
Decentralized Exchanges (DEXs): Online exchanges help users to exchange currencies for other currencies, whether USD to Bitcoin or ether to PEAK. DEXs are a very popular type of exchange because they allow direct exchange of cryptocurrencies on a smart contract basis without the need for an intermediary as a trusted partner.
Stablecoins: A cryptocurrency that is tied to a fixed asset outside cryptocurrencies, for example, USD or Euro, to obtain a stable price. The best-known example is the cryptocurrency USDT.
Lending platforms: These platforms use smart contracts to eliminate the need for middlemen such as banks when granting loans.
“Wrapped” Bitcoins (WBTC): This is an application to send Bitcoins in the Ethereum network so that they can be used directly to be invested in Ethereum’s DeFi applications. WBTCs also allows users to generate interest when they lend out via decentralized lending platforms as described above.
Prediction markets: Various markets for betting on future events, such as elections or sporting events. The goal of the DeFi versions of prediction markets is to offer the same features as traditional betting, but without the need for an intermediary.
Yield Farming: For experienced traders with a taste for risk, there is yield farming. Here, users scan various DeFi projects and tokens to look for opportunities for greater profit. Users move their cryptos back and forth between different lending platforms to maximize profit.
Liquidity Mining: Whenever DeFi platforms need liquidity, they usually provide free tokens to the users as a reward for providing liquidity. Therefore this area is called Liquidity Mining. You get tokens for providing liquidity.
Composability: DeFi apps are open source, which means that the programming code is publicly available to everyone. The codes of the respective DeFi apps can then be used to “compose” new apps and use the existing codes as building blocks.
Money Legos: If you look at the concept of “composability” from a different angle, the current DeFi Apps can be used as Legos (toy building blocks for building houses, statues, cars and much more). DeFi apps can be put together just like Legos. So to speak “Money Legos” to create new financial products.
DeFi FAQ — A few important questions about DeFi answered
How can I earn money with DeFi?
The market capitalization of assets invested in Ethereum’s DeFI projects has increased explosively. Many users report that they have made a lot of profit from it.
By using Ethereum based lending apps as described above, users can generate a “passive income” by lending their cryptocurrencies and earning interest. Yield Farming has a greater potential for greater profits, but also comes with a higher risk. It allows users to borrow and lend in addition to their capital to generate a greater profit. However, these systems are currently still very complex and often lack transparency.
When will DeFi become mainstream?
While more and more people are attracted by DeFi applications, it is hard to say when it will become mainstream. A lot depends on who finds them, and whether they are considered useful or not. Many believe that some of the current DeFi projects may become a kind of new Robin Hoo where thousands of new users invest because financial applications are made easier and more accessible to people who otherwise have no access to traditional markets.
This type of financial technology is new, experimental and not without problems, especially in terms of security and scalability. But it is a great opportunity and the developers of the various projects are working hard to fix the current bugs and create a secure and scalable environment. Ethereum 2.0 could usefully address these issues and lead to a breakthrough for DeFi projects.
How will Ethereum 2.0 change the DeFi industry?
Ethereum 2.0 is not a Holy Grail that will eliminate all problems. But it is a beginning. Ethereum 2.0 wants to offer higher scalability and security by so-called sharding, a kind of splitting the database into smaller parts. Besides Ethereum 2.0 there are other protocols like Raiden or Truebit, which also aim to increase the scalability of Ethereum.
If and when these solutions will become reality and finally be implemented is still open, but if the problem of scalability will finally be solved, Ethereum’s DeFi projects will see an unprecedented boom and most likely become mainstream.
Bitcoin as DeFi
While Ethereum is the number one in the DeFi world, many still see Bitcoin as the reserve currency, eliminating the need for middlemen in financial transactions. Currently, many developers are also trying to perform more complex financial transactions on the Bitcoin protocol.
Companies like DG Labs or Suredbits, for example, are working on a Bitcoin DeFi technology called Log Contracts (DLC). DLC allows ways to enable more complex financial transactions with the help of Bitcoin. A use case of DLC is, for example, to pay out Bitcoin only if certain conditions are met in the future. Similar to Smart Contracts.
We believe that Ethereum will remain the number one in the DeFi sector, but we are excited about the possibilities that will be possible in the future with Bitcoin and Ethereum.
