What is DeFi?
By definition, decentralization is the process of distributing functions and power from a central authority to several smaller groups. DeFi is a new financial system that uses blockchain, smartcontracts and cryptography to shift financial control from one central authority i.e financial institutions to everyone. DeFi creates an open, permission-less and trustless financial system by eliminating third parties and intermediaries and replacing them with blockchain or distributed ledgers.
Components of the DeFi Ecosystem
The Defi ecosystem consists of the following components:
- Lending and borrowing
- Decentralized exchanges
- Margin trading
These are cryptocurrencies that are created using smartcontracts and whose price is pegged on a reference asset such as the US dollar. Due to the high volatility nature of cryptocurrencies, there developed a need for creation of a stable variant of crypto. Stablecoins can be divided into two categories:
- Algorithmic stablecoins
- Non-algorithmic stablecoins
Algorithmic stablecoins can also be referred to as non-collateralized stablecoins. This means that they do not have any associations with collateral. They are decentralized and market price stability is achieved though pre-programmed supply for matching asset demand. Algorithmic stablecoins increase supply of the coins with high demand and consequently decreases supply with the reduction in purchasing power. Thus they are decentralized, smart and responsive cryptocurrencies. Examples of algorithmic stablecoins are: DAI, Frax, Ampleforth and ESD.
Non-algorithmic stablecoins are collateralized thus are minted and burned when assets are deposited or withdrawn from their reserves. For example, USDT is pegged to the US dollar therefore for every 1 dollar that is deposited to the reserve, 1 coin is minted and for every 1 dollar that is withdrawn from the reserve, one coin is burned. These stablecoins require liquid assets that can be quickly traded in order to respond to changes in supply and demand. Other examples of stablecoins include: USDC, EURST and PAX.
These are peer-to-peer marketplaces where people can trade cryptocurrencies in a non-custodial manner without the need for an intermediary to facilitate the transfer and custody of funds. They substitute intermediaries; traditionally, banks, brokers, payment processors, or other institutions; with blockchain-based smart contracts that facilitate the exchange of assets. Compared to traditional financial transactions (centralized exchanges), which are opaque and run through intermediaries who offer extremely limited insight into their actions, the decentralized exchanges offer complete transparency into the movement of funds and the mechanisms facilitating exchange.
There are two types of decentralized exchanges:
- Liquidity pool based decentralized exchanges
- Order book decentralized exchanges
Liquidity pools are a collection of tokens or digital assets locked in a smartcontract that provide essential liquidity to decentralized exchanges. Users can pool their assets in a decentralized exchange’s smartcontracts to provide asset liquidity for traders to swap between currencies. Liquidity pools provide much-needed liquidity, speed, and convenience to the DeFi ecosystem. Examples of liquidity pool based exchanges include: Uniswap and SushiSwap. Ubricoin is currently listed on Uniswap and is readily available for traders to swap their crypto.
In order book decentralized exchanges, users can trade tokens at a desired price through limit order. The success of a particular transaction depends on the pending orders of both the buyer and seller. Order book for decentralized exchanges comprises of order book and the automated market maker liquidity pool with full adoption of the users’ suggestion. Examples of order book decentralized exchanges include: IDEX, DDEX, EtherDelta and Ethfinex.
Lending and Borrowing
DeFi lending platforms bring together lenders and prospective borrowers without a central intermediary such as a bank. The activity takes place on platforms that administer loans following pre-specified rules. On one side are lenders, who deposit or stake their cryptoassets into liquidity pools, earning a deposit rate. On the other side are the borrowers, who receive cryptoassets and pay a borrowing rate. The two rates vary by cryptoasset and are determined by the demand for loans and the size of the liquidity pool, which represents the supply of funds. The process is automated and loan disbursement is nearly instantaneous and associated costs are modest. A key difference between lending in DeFi and in centralized finance is that the identity of borrowers and lenders is hidden behind cryptographic digital signatures. DeFi lending relies on collateral and information such as borrowers’ credit scores or income statements are not relevant. DeFi lending protocols enable everyone to lend and earn interest on supplied stable coins and cryptocurrencies. This borrowing and lending offers innovations in efficiency, access and transparency compared to centralized finance. Anyone can borrow and lend.
Derivatives are contracts with values derived from underlying assets. These securitized contracts give investors a way to interact with an asset without holding it. Additionally, derivatives let investors hedge positions, speculate on directional movement, leverage their holdings, and transfer risk to other parties. Options, prediction markets, futures, and collateralized loans are examples of derivatives. DeFi derivatives’ values are often tied to cryptocurrency markets. Many DeFi derivatives protocols allow users to create synthetic assets with values tied to underlying real-world assets.
The last component of the DeFi ecosystem is margin trading. Margin trading is trading with borrowed money which results in leveraged payouts. The way margin trading works is that, on one hand, there are lenders who lend out their tokens and receive interest in return; on the other hand, there are margin traders who deposit assets as collateral to borrow tokens from the lenders to trade with leverage.