Decentralized Finance (DeFi) – Everything You Need to Know

What is Decentralized Finance (DeFi)?

When you democratize finance by removing the intermediaries and engaging in a direct transaction between lender & borrower, you are utilizing decentralized finance. 

Decentralized finance, or DeFi, aims to eliminate intermediaries in financial dealings. DeFi systems allow direct peer-to-peer transactions between lenders and borrowers using blockchain technology and smart contracts without using traditional financial institutions. This financial democratization makes money more accessible, lowers expenses, and gives people more financial control. 

DeFi, or decentralized finance, encompasses financial services built on public blockchains, primarily Ethereum. Unlike traditional banking, DeFi platforms offer a faster, paperless way to earn interest, borrow, lend, buy insurance, trade derivatives, and more directly between users without intermediaries. This global, peer-to-peer system operates pseudonymously and is accessible to anyone. 

Scenario of Existing CeFi (Centralized Finance)

Traditional finance is centralized and heavily regulated. Banking, lending, and trading are controlled by governing bodies and intermediaries. Consumers rely on a complex network of financial institutions for services ranging from mortgages to stock trading. 

The Reserve Bank of India (RBI) oversees these centralized financial entities in India. This centralized structure creates a barrier for consumers to access capital directly. Individuals must engage with intermediaries like banks, exchanges, and lenders to participate in financial markets, which often incur fees.

Importance of DeFi in Finance

DeFi builds upon Bitcoin’s concept of digital currency to create a complete digital alternative to traditional finance. By eliminating the need for intermediaries and their associated costs, such as physical infrastructure and high salaries, DeFi aims to establish more open, accessible, and equitable financial markets for anyone with internet access. 

DeFi’s Working Architecture

DeFi users interact primarily through decentralized applications (dApps) hosted on the Ethereum blockchain. Unlike traditional banks, DeFi eliminates paperwork and account setup processes. 

Everyday DeFi activities include: 

Lending: You can continuously earn interest on their crypto assets. 

Borrowing: Quick loans, including innovative options like flash loans, are available without paperwork. 

Trading: Peer-to-peer crypto trading occurs without intermediaries. 

Saving: You can generate higher interest rates on your crypto savings than traditional banks. 

Derivatives trading: Speculating on asset prices is possible through crypto-based derivatives. 

Benefits & Risks of DeFi

DeFi offers significant advantages: 

• Speed and Efficiency: Transactions are processed rapidly without intermediaries. 
• Global Accessibility: Financial services can be accessed from anywhere with an internet connection. 
• User Control: Individuals maintain full ownership and control over their funds. 
• Innovation: DeFi supports creativity and new financial products. 
• Potential High Returns: Certain DeFi activities can yield substantial profits. 

However, DeFi also presents considerable risks: 

• Market Volatility: Fluctuating crypto prices can lead to losses and liquidation of loans. 
• Complexity: Understanding DeFi can be challenging for newcomers. 
• Security Risks: Users are solely responsible for safeguarding their funds and against scams. 
• Regulatory Uncertainty: The legal landscape for DeFi is still evolving. 

How & Where DeFi is Used? 

Decentralized applications (dApps) and protocols power DeFi, primarily operating on Bitcoin (BTC) and Ethereum (ETH). While Bitcoin is more widely recognized, Ethereum’s versatility drives the majority of dApps and protocols. 

DeFi’s applications span various financial activities, including payments, securities trading, insurance, lending, and borrowing. Decentralized exchanges (DEXs) offer peer-to-peer trading, granting users greater control over their funds than centralized platforms like Coinbase. DeFi developers also construct independent digital wallets to access cryptocurrencies and blockchain-based games. 

To address cryptocurrency volatility, stablecoins maintain value by linking to fiat currencies like the US dollar. DeFi has also introduced yield farming, allowing investors to lend crypto and earn substantial returns through platform-issued tokens. Additionally, non-fungible tokens (NFTs) transform unique digital assets, such as videos or tweets, into tradable commodities. 

Flash loans offer a revolutionary approach to borrowing and repaying cryptocurrency within a single transaction. These loans rely on Ethereum smart contracts to execute transactions and automatically return funds if unsuccessful. Successful transactions generate profits for borrowers minus fees and interest. 

The DeFi market measures adoption through “locked value,” representing the total funds invested in various DeFi protocols. Currently, this value approaches INR 3 trillion. Blockchain technology underpins DeFi’s rapid growth, enabling global accessibility for dApps. Unlike traditional financial systems bound by regulations, DeFi operates without these constraints, offering higher potential rewards and increased risks. 

Popular Practical Use-case of DeFi

1. Stablecoins 

These are cryptocurrencies tied to a fiat currency like the US dollar, providing a reliable unit of account & medium of exchange for trades and investments, which is essential to DeFi. Types include fiat-backed, algorithmic, and collateralized stablecoins, with famous examples being USDT, USDC, DAI, and BUSD. 

2. Insurance 

Due to DeFi’s nascent stage, risks from smart contract issues and breaches exist. New insurance options have emerged to address liability reduction, DeFi overage reduction, and property preservation. 

3. Synthetic Assets 

Synthetic assets, backed by tokens locked in Ethereum smart contracts, offer exposure to investments like gold, cryptocurrencies, and fiat money. DeFi simplifies the combination of various smart contracts for these assets. 

4. Decentralized Exchanges (DEXs) 

DEXs enable decentralized, trustless, and transparent cryptocurrency trading. Smart contracts facilitate trade, eliminating intermediaries like centralized exchanges. DEXs offer enhanced security, privacy, and asset control. Popular DEXs include Uniswap, SushiSwap, and Curve, providing low-fee cryptocurrency trading without KYC/AML requirements. 

5. Tokenization 

Tokens, digital assets created and managed on blockchains, are fundamental to DeFi. They fuel network operations and unlock economic possibilities. These digital alternatives enable global access, trading, and value storage. 

6. Analytics & Risk Management 

Decentralization and transparency empower users to analyze vast amounts of data, leading to informed business decisions, new financial opportunities, and effective risk management strategies. Blockchain-based tools, dashboards, and DeFi initiatives like DeFi Pulse and CoDeFi Data provide valuable analytics and risk management solutions. This agility will significantly impact DeFi use cases. 

7. Liquidity Provision 

Liquidity providers act as intermediaries by trading short-term holdings. They issue market orders based on asset pricing knowledge and transaction risk. Diversity among liquidity providers is essential for efficient risk transfer and matching buyers and sellers. 

8. Infrastructure Tooling 

Composability, a core DeFi feature, enables interoperability between system components. Infrastructure tools are crucial for connecting interconnected DeFi projects. 

9. Digital Identification 

Blockchain-based digital identity systems are gaining traction. Combining DeFi protocols with digital identity simplifies access to the global economic system. This enhanced digital identity allows data access from any location with internet connectivity. 

10. Complying with AML & CFT 

To address the conflict between KYC guidelines and DeFi’s privacy focus, the Know-Your-Transaction (KYT) mechanism has emerged. KYT monitors transactional behavior while preserving user privacy, making it a significant DeFi use case. 

Famous DeFi Projects

Before listing out popular DeFi projects, let’s give you a few interesting facts about the industry: 
 
👉 Perpetual LP Pools: Traders are diving into perpetual LP pools for actual yield and leveraged liquidity. 

👉Intents-Based Architecture: DeFi is getting smarter with intents-based architecture, making transactions a breeze. 

👉Liquid Staking Protocols: Keep your assets liquid while staking with the latest liquid staking protocols. 

👉Cross-Chain Bridging: Seamlessly move assets across blockchains with cross-chain bridging. 

👉Real-World Assets (RWA): DeFi is now integrating real-world assets for stable and secure yields. 

1. Lido Finance (LDO) 

Token: LDO 
Category: Liquid Staking 
Market Cap: $947.67 million 
TVL: $34.57 billion 

Lido Finance leads the liquid staking sector by enabling users to stake assets while retaining liquidity. Users deposit assets like ETH and receive stETH tokens in return, representing their staked assets and earned rewards. This system allows users to trade their assets freely, combining staking benefits with liquidity. 

2. Uniswap (UNI) 

Token: UNI 
Category: Decentralized Exchange (DEX) 
Market Cap: $4.9 billion (approx.) 
TVL: $4.45 billion (approx.) 

Uniswap dominates the decentralized exchange market. It employs an automated market maker (AMM) system, allowing users to trade ERC-20 tokens directly from their wallets. A user-friendly interface and ample liquidity make Uniswap a popular choice for decentralized trading. 

3. Aave (AAVE) 

Token: AAVE 
Category: Lending and Borrowing 
Market Cap: $1.3 billion (approx.) 
TVL: $6.3 billion (approx.) 

Aave stands as a leading lending protocol within the DeFi ecosystem. It offers diverse lending and borrowing options with competitive interest rates. Aave distinguishes itself from other DeFi lending platforms through unique features, such as flash loans, which allow users to borrow uncollateralized funds for a single transaction, provided they repay the loan immediately. 

4. MakerDAO (MKR) 

Token: MKR 
Category: Stablecoin Protocol 
Market Cap: $610 million (approx.) 
TVL: $6.45 billion (approx.) 

MakerDAO underpins the stability of the DAI stablecoin. Users create DAI by pledging assets as collateral, ensuring DAI’s value mirrors the US dollar. This stability is crucial for numerous DeFi applications, making MakerDAO a foundational pillar of the DeFi landscape. 

5. Curve Finance (CRV) 

Token: CRV 
Category: Stablecoin Trading 
Market Cap: $890 million (approx.) 
TVL: $4.1 billion (approx.) 

Curve Finance excels in stablecoin trading, offering low slippage and fee-efficient swaps. The platform specializes in stablecoins and caters to users seeking efficient stablecoin trading. Curve’s liquidity pools optimize for minimal price fluctuations, which is essential for successful stablecoin transactions. 

Does DeFi Hold Any Value For You? 

Although decentralized finance (DeFi) offers a potentially profitable opportunity, most people find it risky due to the market’s infancy. Although there is a chance for significant losses, sizable rewards are also attractive. 

The tiny amount currently invested in cryptocurrencies and the hype-driven price volatility highlight DeFi’s speculative nature. Investors looking to build wealth or secure returns for retirement might consider this market, but they should proceed cautiously when dealing with DeFi. Because of its novelty and volatility, the industry is not a reasonable basis for long-term financial planning. 

Traditional Finance vs. Decentralized Finance

We have compared the two systems in detail based on recent trends and technological advancements in 2024. 

Aspect	Traditional Finance (TradFi)	Decentralized Finance (DeFi)
Control & Governance	It is centralized and controlled by banks, governments, and intermediaries.	Decentralized, operated on peer-to-peer networks with no central authority.
Global Accessibility	Limited by geographical boundaries and local regulations.	Globally accessible to anyone with internet access.
Inclusion of the Unbanked	Often excludes those without banking history or access to services.	Provides financial services to the unbanked and underbanked populations.
Transaction Speed	Can be slow, especially for cross-border transactions.	Generally faster due to blockchain technology and instant settlements.
Cost & Fees	Higher costs due to intermediaries and operational overheads.	Lower fees with reduced intermediary involvement.
Transparency	Often, it needs more transparency, leading to potential mistrust.	High transparency with all transactions recorded on a public ledger.
Regulatory Oversight	Subject to extensive regulatory frameworks ensuring consumer protection.	Operates in a less regulated environment, boosting innovation but increasing risks.
Innovation Pace	Slower due to regulatory constraints and legacy systems.	Rapid innovation with open-source development and permissionless innovation.
Collateral & Lending	Involves complex credit checks and traditional collateral.	Utilizes crypto assets as collateral without traditional credit checks.
Counterparty Risks	It is managed by established institutions but is still present.	Minimized through decentralized protocols and smart contracts.
Smart Contracts	Rarely used, it relies on manual processes and intermediaries.	Uses self-executing smart contracts for automated and programmable transactions.
Security Measures	Includes regulatory safeguards and insurance.	Secured by cryptographic techniques but vulnerable to smart contract bugs.
Interoperability	Often siloed with isolated systems.	Interoperable, allowing different DeFi protocols to work together.
Yield and Returns	Generally offers lower, stable returns.	Potentially higher but more volatile returns through mechanisms like yield farming.

What the Future Holds for DeFi?

Like other blockchain and cryptocurrency endeavors, decentralized finance (DeFi) is characterized by exaggerated hype and false information intended to entice investors. The price fluctuations of the entire Bitcoin ecosystem, encompassing blockchain technology, are extreme. 

In contrast to what is frequently believed, bitcoin exchanges do not handle nearly as much money. The great majority of individuals continue to use conventional banking institutions. Hardly 0.56% of global assets are allocated to DeFi and cryptocurrencies. This sobering fact highlights the importance of conducting an in-depth study before using DeFi platforms, apps, or cryptocurrency. 

The cryptocurrency market gets hit by “crypto winters,” defined by protracted and sharp price drops. The most recent cryptocurrency winter happened in 2022–2023 after values spiked during the COVID-19 epidemic. While many attributed Bitcoin’s price increase to its inherent value, it’s more likely that investors’ enthusiasm and self-fulfilling prophecies drove the market upward. 

Top-tier DeFi development companies are gearing themselves for the next generation of Web, offering services such as DeFi smart contract development, DeFi token development, DeFi application development, DeFi wallet development, and more.  

If you are looking for a comprehensive DeFi development company for your next project, contact our industry experts at info@webmobinfo.ch, and let’s create a roadmap to success.