A Beginner's Guide to DeFi

Crypto. DeFi. Blockchains. The buzzwords of 2021 that have seen explosive interest from people of all walks-of-life. I was never really interested in diving deep into the world of Crypto, but the growth and popularization of the cryptosphere has been too big to turn a blind eye to. Even if you have no intentions to add some Crypto to your portfolio, I think it is still worthwhile to have a rough understanding of this booming space that is bound to affect our day-to-day life in the future.

Warning: This article is tailored for beginners. Scroll away if you’re a Crypto bro, but feel free to correct or elaborate on any of my points to help the fellow beginners in the community unpack the world of crypto.

What is DeFi?

Decentralized Finance (DeFi) is a blockchain based form of finance that does not rely on central financial intermediaries (eg. Banks, brokerrages, exchangers). Instead, it relies on smart contracts on blockchains (the most common one being Ethereum), which are essentially the building blocks of DeFi.

Decentralized Finance (DeFi) vs Traditional Finance (TradFi)

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Traditional Finance refers to our current financial service landscape that we are used to. The key difference between DeFi and TradFi is the elimination of the Middle Man which is often seen as inefficient and costly. Who are these ‘Middle Men’ you may ask? They can be your bankers, insurance agents, stock brokers, fund managers etc. Banks are probably the most intuitive example of a centralized authority that controls the flow of money. In DeFi, there is no central authority, instead there are pieces of code that run and act like a “bank”.

Why did DeFi come about?

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DeFi aims to overcome the shortcomings of centralized, traditional finance - hefty fees, risk of human error and accessibility to financial services to name a few.

In our current financial landscape, these centralized intermediaries take a cut for helping you to execute your financial transactions/decisions. This makes traditional finance really expensive, but we still pay them because we don’t really have a choice, or at least that was before DeFi came about.

Let’s say you want to send money over to your friend in the UK: Both your banks act as a trusted middleman between the lender (you) and borrower (your friend) and in return, they take a cut of the transaction for facilitating the transaction.

People were also frustrated with the low interest rates offered by bank savings accounts, which is ever so prominent now in view of the Covid-19 pandemic which has propelled many of the banks to further lower the already petty interest rates. Compared to historic inflation rates of 2-2.5%, we are still losing out even if we’ve got our money parked in the account with the best interest rates (that is if you’re still leaving your hard-earned money in the bank). If you didn’t already know, the banks are given the power to generate their yields. The problem with this is that while the banks are using your money to participate in their own transactions for financial gains, they take a huge cut of the profits thereafter and leave with you only crumbs of the pie. This process is known as rehypothecation. The saddest part of this is that because all the banks are doing this, the interest rates become ‘normalized’ such that it just becomes accepted by the general public.

The current financial system is heavily reliant on human beings and with it comes the risk of human errors, malfeasance and negligence (eg. insider trading, discrimination, fraud…)

New business owners also face a high barrier of entry if they are intending to take a loan to fund their new business. The banks have the power to not only reject the applications, but they can also limit the business owners from bringing in money to their bank, which handicaps them from investing their money or even just storing it somewhere safe.

How is DeFi able to do what it does?

DeFi does so by leveraging on Cryptography, Blockchain and Smart contracts.

Smart Contracts - The main building block of DeFi

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The term Smart Contract was first established by Nick Szabo, a computer scientist, legal scholar and cryptographer in 1997. You can think of smart contracts as just like any other contract in the real world, just that it is completely digitized. Smart contracts are stored and executed on the blockchain, most commonly on the Ethereum blockchain.

Smart contracts are simply programs that run when the stated conditions are met (think of it as your if { ; } else { ; } statements). This way, participants can be certain of the outcome without wasting time or involving any intermediary in the picture, eliminating the risk of human error.

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Benefits of Smart Contracts

1) Immutable

Once created on the blockchain, they can’t be altered. With smart contracts, there is no room for discrepancies: You now have financial agreements that can’t be tampered with or argued against, and not to mention everyone has access to them.

2) Distributed

The output of a smart contract is validated by everyone that’s on the network, which makes tampering with smart contracts extremely difficult and almost impossible.

DeFi Components

1) Stablecoins

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Stablecoins are cryptocurrencies that are pegged to the value of a real-world asset (eg. fiat money). True to its name, stablecoins are a more stable alternative to volatile cryptocurrencies such as Bitcoin and Ether. DAI is an example of a stablecoin that is pegged to the USD.

2) Lending & Borrowing

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In traditional finance, lending & borrowing is facilitated by a financial institution, most commonly the banks. On the other hand, transactions In DeFi utilize smart contracts which eliminates the need for a middleman. This helps to reduce fees associated with taking out the loan, reduce the risk of human error and cut down on the time needed for the paperwork to get processed. Compound and AAVE are examples of DeFi projects that allow users to carry out lending and borrowing transactions.

3) Decentralized exchanges

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In DeFi, there is a decentralized exchange (DEX) where you can exchange your coins and tokens in a decentralized & permissionless way. Once again, this is done by employing smart contracts. DEX allows users to carry out transactions via a peer-to-peer (P2P) network without the involvement of a centralized authority. This allows for faster, cheaper and trustless transactions than centralized exchanges. However, DEX is not without its own limitations and drawbacks. One of which being that there is no support - This means that there is no helpline to go to if something goes wrong, at the very most you can only attempt to seek help from the community forum. Some DEXs have low liquidity (though they have come a long way), you also require compatible wallets to use DEXs.

4) Insurance

I think this component is pretty self-explanatory. The insurance aspect in our traditional, centralized finance system can be replicated in the DeFi ecosystem. The most popular applications of insurance are protection against smart contract failures and to protect deposits.

5) Margin trading

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Likened to traditional finance, crypto margin trading in DeFi refers to the practice of utilizing borrowed funds to trade a financial asset (which becomes the collateral for the loan). It allows users to borrow cryptocurrencies on margin by using other cryptocurrencies as the collateral. Additionally, smart contracts can be utilized to include leverage to amplify your potential profits.

No doubt, the DeFi space sounds extremely promising, but it is not without its risks. Though DeFi has seen significant growth and traction over the past few years, it is still a nascent space that has yet to reach wide-scale adoption. While we are hopeful, we still can’t be sure of how things will pan out in the future.

Anyways, this opinion article is catered to help beginners like myself get a brief understanding of the DeFi space so I hope that this simplified article (without too many confusing jargons) has achieved just that. Feel free to share your thoughts and insights!