By Hidayat Sultanli
On Nov 06, 2020
Blockchain technology becomes wildly available as companies use this technology for various purposes. This technology revolutionizes the traditional way of doing things and offers new ways to apply theoretical ideas. It allows high security and high speed for users. It is for everyone who wants to own and regulate the funds freely rather than trusting other people.
Decentralized Finance, as known as, DeFi is an umbrella term for the financial application of the blockchain. DeFi contains various applications of blockchain. It uses DAapps on the permissionless and transparent blockchain network, and it utilizes P2P protocols. DeFi is mainly on the Ethereum blockchain since it offers many advantages, such as smart contracts. Smart contracts are the blockchain version of conventional agreements. Here, the negotiator is the algorithms. So, smart contracts make sure that each party performs the corresponding actions.
DeFi has three main functions: functioning as a banking service, realizing borrowing and lending on the blockchain network, and adopting various derivatives on the blockchain. These functions play a crucial role in the process. These features help to create diverse types of DeFi.
DeFi lending is most famous among the newcomers to decentralized finance. It is so easy to convert their money to cryptocurrency and lend it to the system. As it is in traditional banks, there is interest earned on your contribution, and there is the interest you pay when you borrow money. Mainly if the utilization rate goes up, then the interest rate goes up linearly and nonlinearly too. The utilization rate is the percentage of dividing the total lending amount by the total borrowing amount. Some lending platforms use linear, and others use nonlinear interest rates. There are many lending platforms available on Ethereum. Currently, Maker is the platform with the most USD locked in. Aave and Compound are following the list. Yield farming became so much popular among users of DeFi users, and most lending services realize it. Yield farming is earning through variable or fixed interest with investing in crypto in the DeFi. However, it becomes not profitable if you invest in low amounts to learn the mechanism because of high gas prices.
DEXes are the decentralized cryptocurrency exchanges on the blockchain platform that offers decentralized operations. You have heard about Binance, Coinbase, and Poloniex probably. These are the centralized exchange platforms on blockchain. Here you can exchange any cryptocurrency you want without any third parties. There is no sign-up process here. They do not require your data, so it is safe from the privacy side. Since it is decentralized, it is hard to hack the system. So, it is more secure than centralized exchanges, which we get news about theft and breach of accounts. Also, as with every decentralized finance, you have complete control over your funds. It has drawbacks too. The main disadvantage is a low speed, which can hinder your benefit from urgent deals. To be in the next block, as soon as possible, you have to pay for gas, and gas prices are getting higher as many people engage in those activities. Gas is the fee that you pay for your transaction to miners include it in the blockchain. The most famous DEXes are Uniswap, Curve, and Balancer. Currently, Uniswap is the platform that most USD locked in it $2.31 billion. All of them are on the Ethereum platform.
A derivative is a financial instrument that derives its value from the underlying asset, index, or commodity. With the help of smart contracts, you can trade easily without third parties. DeFi takes the legal contracts or derivatives, converts them into smart contracts, and put them on the blockchain. Considering the free access to the network, you can reach derivatives restricted to some groups of people. There are mainly four types of derivatives; futures, forwards, swaps, and options. People use derivatives to avoid the risk of fluctuations in the price of an asset. The most famous platform for derivatives is Synthetix.
Payment platforms in the DeFi are the ones that realize the payment without banks or central bodies. They offer debit, credit, and cash transactions. Payment systems usually provide many cryptocurrencies. Maybe it is the most straightforward type of DeFi. The significant player here is Flexa. Lightning Network is also a payment platform that is on the bitcoin blockchain. Another one is xDai Chain is a stable payments blockchain designed for fast and inexpensive transactions.
DeFi has become popular with the ideas which serving decentralization in the processes. This flood of new ideas is still in its beginning stage. For that reason, you have to be careful while using DeFi. As we mentioned, smart contracts are the core of DeFi, and they can have weaknesses. History shows that there were cases that others can find those holes and use that against you. The people in the business recommend you begin with a small amount of money, in any case, to bear the losses of something that happens. Next, you must not fall into the decentralized characteristics of DeFi because some services are not fully decentralized, or they are partially centralized. Many blockchains are on cloud-based platforms, such as AWS (Amazon Web Services), and there is a debate that does these platforms play a centralized role in the process? Finally, before investing in some DeFi platforms, analyze thoroughly be sure that you understand how does that works.