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How Decentralized Finance Works and Use Cases

6 mins
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by Rahul Nambiampurath
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Decentralized Finance (DeFi) represents financial services that leverage blockchain technology. It seeks to empower the populace by creating an open, efficient, and all-inclusive financial system. Using smart contracts, DeFi platforms provide permissionless finance, thus enabling financial inclusion for all. DeFi has taken off to include many meaningful use cases. These include decentralized exchanges, lending platforms, prediction markets, and others.

It eliminates the middleman and substitutes smart contracts, thereby establishing trustless protocols. By eliminating intermediaries, DeFi provides access to financial services, especially for individuals excluded from existing systems. Here are some illustrative use cases.

DeFi vs. Fintech

finance computer AI hand

It’s easy to confuse DeFi services with Fintech. Both work via the Internet, and they provide financial services without the need to deal with banks or traditional financial institutions. However, they differ on some fundamental levels.

One of the prominent differences is that while Fintech puts the traditional financial infrastructure on the Internet, decentralized finance is built solely on the blockchain technology into the mix.

Fintech juggernaut Square, is a payment processor that offers faster and cheaper cross-border payments than traditional banks. However, Square’s platform still involves a central authority – Square itself. The company completes transactions on behalf of its customers, and they also require the provision of a valid identification before opening accounts.

In contrast, typical DeFi services differ significantly. For instance, Aave stands out as a decentralized and permissionless DeFi platform where users can seamlessly lend and borrow cryptocurrencies.

Defi lending and borrowing

This is perhaps the most significant use case for decentralized finance. Lending and borrowing platforms provide loans to users without the need for intermediaries like BlockFi. There are also lending protocols in place that pay users interest in stablecoins and cryptocurrencies.

For now, the EOS and Ethereum blockchains are the most popular ones for DeFi lending and borrowing. Some of the most popular lending and borrowing platforms in this racket include Compound, BlockFi, and more.

Popular lending and borrowing platforms

1. Compound

compound price prediction cover

Compound is a versatile money market protocol that facilitates transactions involving a range of cryptocurrencies, including BAT, DAI, ETH, USDC, REP, and ZRX tokens. Central to its operation is the use of its native currency, known as cToken (cBAT), which serves as the fundamental unit for lenders and borrowers engaged within its ecosystem.

One distinctive feature of Compound is its dynamic interest rate structure. Unlike other DeFi platforms with fixed interest rates, Compound’s rates are subject to fluctuation, responding to the ever-changing dynamics of the market. This flexibility ensures that participants in the Compound ecosystem can adapt to prevailing market conditions, making it an attractive option for those seeking to optimize their lending and borrowing strategies in the decentralized financial world.

2. MakerDAO

MakerDAO DAI Stablecoin Supply market capitalization

The Ethereum-based lending and borrowing platform offers support for both DAI and ETH tokens, allowing users to borrow funds in Dai. It distinguishes itself from traditional peer-to-peer models by issuing coins from reserve pools, enhancing liquidity and accessibility within the system.

Furthermore, the platform’s vision encompasses a multi-collateral approach, permitting borrowers to deposit various assets as collateral. This diversification aims to mitigate the impact of price volatility on a single purchase. Notably, MakerDAO stands as the driving force behind the stablecoin Dai, playing a pivotal role in maintaining the stability and functionality of this decentralized financial ecosystem.

DeFi asset management

DeFi asset management tools act as asset custodians but aren’t engaged in any banking or commercial services. In DeFi, asset management tools provide wallet apps and other tools that help crypto holders manage their assets effectively.

New investors might find it difficult to set up wallets or make their way around the space (including diversifying their investments, finding exchanges, etc.), but asset management tools help remove any complexity.

1. Melon

melon meme economy token claim airdrop website

Melon is a DeFi platform offering asset management solutions to its users. Utilizing Ethereum (ETH) and ERC tokens, users can manage both their own wealth and the assets of others within the system. What sets Melon apart is its complete decentralization; the platform’s protocols are administered by the crypto community itself, without the presence of a central authority or a board of governors.

This decentralized approach fosters transparency and autonomy within the Melon ecosystem, allowing users to engage in asset management with a high degree of control and trust.

2. Derivatives

A derivative is a contract between two or more parties that depends on the performance of an underlying asset to get its value. DeFi derivatives are very flexible, as their inherent smart contracts can issue tokenized contracts executed automatically. Generally, derivatives are used to safeguard investors from price fluctuations and to speculate on the performance of an asset in the future. Some examples of DeFi derivatives platforms include:

3. UMA

uma website defi crypto web3

UMA stands as a decentralized contract platform facilitating Total Return Swaps on the Ethereum blockchain, enabling users to gain exposure to a diverse range of assets. Within its framework, an open-source protocol empowers two counterparties to customize and create smart contracts collaboratively, but it’s crucial to note that these contracts are secured through economic incentives.

To ensure the accuracy of these contracts, UMA relies on a price feed oracle, which plays a pivotal role by providing real-time updates on the current prices of the underlying assets. This dependency on a reliable price feed oracle enhances the trustworthiness and functionality of UMA’s decentralized contract platform, ensuring the integrity of Total Return Swaps within the Ethereum ecosystem.

4. Insurance

Crypto insurance remains one of the most sought-after concepts in the cryptocurrency space. Investors will like to have platforms that can help them ensure their private keys and digital assets, especially in the face of exchange hacks, security breaches, carelessness on their part, and fund mismanagement.

DeFi insurance protocols allow users to take out insurance policies on smart contracts and digital assets by pooling funds to cover individual claims. Admittedly, the DeFi insurance market is small. However, as the market grows, players are set to grow as well.

5. Venture capital

Venture capital is a type of private equity financing provided by venture capital firms or funds to startups, early-stage, and emerging companies with high growth potential or that have demonstrated high growth in traditional finance.

The barrier to entry in traditional finance is extremely high. The most lucrative opportunities are reserved for accredited investors. Moreover, these accredited investors have special privileges under financial regulation laws.

In decentralized finance, angel investors can support early-stage blockchain-based businesses, regardless of net worth. These investors can also come together in DAOs to crowdfund projects. A decentralized autonomous corporation (DAC) — also known as a DAO — for venture capital can be thought of as an investment DAO.

Risks associated with DeFi

risks of DeFi man falling red background

DeFi transactions operate without human intermediaries, yet they still face risks associated with smart contracts. These contracts are open-sourced, allowing others to review them. While code reviews provide some reassurance, critical vulnerabilities can be overlooked, potentially resulting in operational errors.

DeFi loans offer permissionless access to financial services, yet they remain capital-inefficient compared to traditional loans. Hence, DeFi loans typically provide less favorable loan-to-collateral ratios. While DeFi evolves, addressing this inefficiency remains a challenge in pursuing more competitive lending solutions within the decentralized finance ecosystem.

Unlocking the potential: DeFi’s explosive growth

DeFi is rapidly gaining prominence within the crypto finance world. It’s on the verge of exponential growth by providing financial autonomy and eliminating intermediaries. In contrast to the traditional financial system’s repeated failures in delivering efficiency and transparency, DeFi spearheads a transformative shift.

Its decentralized nature, powered by blockchain technology, fosters trust and autonomy, making it an attractive alternative. Despite challenges on its path to mainstream finance, DeFi’s resilience and transformative potential are undeniable, offering a promising vision for a more inclusive, efficient, and transparent financial future.

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Jimmy Aki
Based in the United Kingdom, Jimmy is an economic researcher with outstanding hands-on and heads-on experience in Macroeconomic finance analysis, forecasting and planning. He has honed his skills, having worked cross-continental as a finance analyst, which gives him inter-cultural experience. He currently has a strong passion for blockchain regulation and macroeconomic trends as it allows him peek under the global bonnet to see how the world works.
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