One of the most important topics in cryptocurrency is decentralized finance or DeFi. DeFi’s goal is to build a completely new financial system that is completely separate from the traditional financial (TradFi) economy. This goal is being funded with billions of dollars and the efforts of thousands of developers all over the world.
This is the first entry of our DeFi series. The goal of this series is to give financial advisors a deep dive into this space so that we can better understand it and build a bridge to connect the TradFi world we work in with the new and innovative DeFi space that is emerging.
So, What is the DeFi Ecosystem, exactly?
Financial services provided by public blockchains, most notably Ethereum, are referred to as DeFi (short for “decentralized finance”). With DeFi, you can invest, borrow, lend, buy insurance, trade derivatives, exchange assets, and more. However, it is quicker and does not require any paperwork or a third party. DeFi, like crypto in general, is global, peer-to-peer (directly between two people, not through a centralized system), pseudonymous, and open to anyone.
What is the mechanism of DeFi, and how does it work?
DeFi smart contract foundation is blockchain technology, which has two characteristics:
- It’s mostly automated and tamper-proof.
- It can be programmed to work with cryptocurrencies.
Because of these characteristics, it is possible to create decentralized applications (dApps) that automatically interact with money in various ways without the use of banks or other intermediaries.
Introduction of Ethereum and Defi Ecosystem
Following his work on Bitcoin in 2013, programmer Vitalik Buterin co-founded Ethereum as an additional cryptocurrency project. Ethereum differs from Bitcoin in that it is designed to be a blockchain with multiple functions: digital money, global payments, and the ability to run blockchain applications on top of its code. On top of Ethereum, there is currently an entire digital economy, one of which is the DeFi ecosystem.
DeFi is a cryptocurrency movement based on ether that is open to anyone in the world (with an internet connection). DeFi is a trustless application, which means it is not controlled or hosted by a central authority like a bank or government. Cryptography, smart contracts, and blockchain technology are all aspects of cryptocurrency that allow this decentralized finance system to exist for the global community to use.
Ethereum makes use of Solidity, a powerful smart contract programming language that allows all of the logic required by financial contracts to be included in the application code. Many other cryptocurrencies, such as Avalanche, Terra, Fantom, and others, now compete with Ethereum to run DeFi applications, but it’s important to remember that Ethereum is the largest network and was the first project to use DeFi.
MakerDAO, the first DeFi project, was created on the Ethereum blockchain in 2015. MakerDAO enables any user to lock ether or ETH through smart contracts and generate dai, a stablecoin pegged to the U.S. dollar. Dai is frequently used in MakerDAO’s Oasis savings platform, effectively creating a decentralized bank. Oasis built a lending and borrowing platform for its users utilizing the power of stablecoins and smart contracts.
Borrowing and lending inside the DeFi ecosystem
Platforms for lending and borrowing have become an integral part of the DeFi ecosystem. Users can lock crypto positions into smart contracts and borrow against them. Other users can lock crypto positions into a smart contract and earn interest by lending their coins to borrowers.
It is remarkable that the yields generated by lenders in the DeFi ecosystem are significantly higher than those generated by the traditional financial system. Operating a smart contract is significantly less expensive than operating a conventional bank; consequently, nearly all of the yield generated from lending money is returned directly to the lender via the smart contract.
Many individuals have faith in these transparent smart contracts and are able to generate substantial income through their use.
In a world of ultra-low interest rates, smart contracts provide an efficient technological solution to this issue. Many people are dissatisfied with central bankers for allowing interest rates to remain so low, and the solution is not found through political views but rather through technology, which has once again created an opportunity for borrowers and savers.
What is the collaborative factor of a DeFi ecosystem?
As a result, we now have a new, open, permissionless, and mighty Internet-based financial system consisting of countless decentralized applications (dApps).
On the other hand, what keeps its growth and prevents its decline? A circular economy and blockchain technology are the two Essential Components.
Why do DApps built on blockchain technology perform so well and integrate so easily? They are completely transparent, according to this. Anyone can examine their programming to learn how it works and how it joins them together.
As a result, dApps can instantly trust one another and start doing business without having to hire lawyers, sign contracts, or go through other formalities. The Ethereum blockchain is now the most popular blockchain fabric, serving a wide range of DeFi dApps.
A circular economy
It’s one where everything is connected to everything else.
The first bit of thing that keeps DeFi together is the mutual drive of value. In other words, money keeps working as it circulates.
In the above scenario, the swap dApp might pay a service fee to both the pricing oracle and the liquidity pool in exchange for their services, which they can then resell to others. For example, the pricing arbiter may invest in network security, while the liquidity pool may pay interest on deposits.
Two sources provide new value to the system:
Deposits: People put money into the DeFi system in order to earn interest by working there. They earn interest in bank savings accounts by putting their money to work in the old financial system, in a similar way.
Practical blockchain applications: Data marketplaces, games, accounting software, distributed computing services, and a variety of other applications are all part of the DeFi ecosystem and can charge fees for their services.
In this way, the DeFi ecosystem’s never-ending quest for value aligns everyone’s incentives around developing and supporting the most genuinely beneficial dApps.
The connection between cryptocurrencies and DeFi
Cryptocurrencies are digital tokens that can be used in decentralized networks. The most well-known are Bitcoin and Ether (the native currency of the Ethereum blockchain). Others, on the other hand, are designed specifically for use in dApps.
The most common types of cryptocurrency and tokens are as follows:
Tokens of government These allow holders to participate in the governance of a dApp.
Both admission and gas tokens are viable options. These are used to pay for services or gain access to specific dApps.
Tokens are security tokens. These are securities, such as stocks or derivatives, that have been tokenized for use in DeFi.
Tokens that are backed by assets. Art, vehicles, real estate, gold, frequent flyer miles, and coupons are among the assets that have been tokenized for use in DeFi.
CBDCs. Central bank digital currencies (CBDCs) are digital currencies issued by central banks.
When an extra layer of security is required over the underlying blockchain fabric, token staking is used as a blockchain resource.
Stablecoins. These are meant to be used in recurring payments and have a predetermined price, such as $1 each. They are usually supported by some security.
Why is the DeFi Ecosystem the Future of Finance?
The financial system is democratized by DeFi’s agile and transparent nature. Ensure that everyone, regardless of who they are or where they live, has equal access to financial services.
It gives people unprecedented control over their financial future while also limiting traditional financial institutions’ authority. Ordinary people can now earn a decent return on their investments.
This is especially appealing given current inflation expectations and bank savings account interest rates near zero. Thanks to DeFi, people now have an option other than going backward in real terms with their savings.
Do you want to join on a DeFi journey?
The following items are required:
A basic introduction to Ethereum and how it works.
It is critical to have a personal cryptocurrency wallet and to know how to use it properly. A combination of a Ledger Nano X hardware wallet for security and MetaMask for usability could be beneficial for getting the most out of DeFi.
Some cryptocurrency is required because it is the Internet’s native currency. Because the Ethereum blockchain houses the majority of the DeFi ecosystem, having a large number of ETH tokens on hand to pay gas fees is beneficial. Fortunately, buying ETH is a simple process.
DeFi ecosystem: Game-changing Technology
The rise of the DeFi ecosystem, as you might expect, will be a watershed moment in financial history. Some of the ramifications are self-evident: near-instant transfers with low or no transaction costs will become the norm, and you can expect to earn higher interest rates on your money.
If your bank refuses to pass these benefits on to you, you can bypass the system and get them through the dApp directly.
Other changes, on the other hand, are more difficult to predict. DeFi may level the playing field for all currencies, casting doubt on the future of fiat currency in this arena, as it helps to break down barriers between asset classes, allowing consumers to realize the value stored in other assets such as home equity.
DeFi combined with the current economic crisis could spell doom. Cryptocurrencies have the potential to quickly become the currency of choice for people all over the world, as the “real” economy suffers and a completely new internet economy thrives.
Are you ready for the upcoming transformation? If you believe you are ready to implement the changes into your app or ideas, Contact Suffescom Solution, a reputable and reliable Blockchain development company in US. A firm that can assist you in furthering your decentralized journey by providing top-tier blockchain development services.