DeFi -Decentralized Finance on dark blue abstract polygonal background.

Decentralized finance, or DeFi for short, replicates traditional financial functions through smart contracts on a blockchain. DeFi provides a peer-to-peer method for lending, borrowing, fundraising and trading digital assets without intermediaries. But why would someone want to use what basically amounts to a decentralized banking system?

DeFi has something to offer for an assortment of users. For 2 billion of the world’s unbanked, it provides much-needed services. For others, it is about convenience. Transactions over DeFi take seconds or minutes to settle as opposed to days, and there is no need to involve your bank to send or borrow funds. Some prefer self-custodied digital assets on a blockchain because they operate peer-to-peer and are not subject to restricted access from banks or national capital controls.

Another aspect is the potential for passive earnings. DeFi offers yield-bearing strategies that tend to be at higher rates than those in traditional financial markets. That does not mean that yield-bearing strategies in DeFi do not carry risks– but more on this later. Traditional rates to DeFi have also been catching up due to central banks tightening their monetary policies in 2022.

At its core, finance is the interaction between savers and spenders. Savers are those who do not need their money any time soon. They can hold cash, lend it out with interest or invest it. Spenders can borrow money or raise funds in the pursuit of entrepreneurial endeavors. DeFi attempts to make these interactions frictionless and permissionless when compared with traditional finance.

Protocols such as Aave
, Compound
, and Maker
allow you to borrow and lend, with crypto used as collateral. Lenders deposit their crypto in a lending pool for a posted annual percentage yield (APY
). APYs tend to increase as borrowing activity rises.

Borrowers can post collateral in their preferred tokens to receive a crypto loan. DeFi protocols historically have a high loan-to-value ratio (LTV), compared with traditional bank lending. The LTV ratio defines the maximum amount of crypto someone can borrow against their posted collateral. If a position becomes undercollateralized, the borrower will have to post more to avoid liquidation of the funds already provided.

Sticking with the examples above, the Aave platform currently has over $4.7 billion of value locked in smart contracts, which automatically execute complex sets of transactions when certain conditions are met. Users with Aave tokens get governance rights in addition to interest payments. Those rights allow them to propose and vote on protocol updates. As you can see, DeFi protocols are user-owned and smart-contract-based.

A decentralized exchange, or DEX, allows users to trade crypto tokens without using a broker. Three popular DEXs are Uniswap, PancakeSwap
and dYdX
. DYdX even allows users to trade with leverage, providing an insurance fund and smart contracts to automate liquidations.Automated market making is the innovative feature that allows a DEX to operate. A traditional centralized exchange, like the New York Stock Exchange, uses a central order book model to match buyers and sellers. A DEX uses an automated market maker (AMM) structure. With an AMM, savers seeking yield can deposit one of two or three tokens in a liquidity pool. Users who want to buy ether with tether will have to interact with that pool to conduct the trade. Fees from that transaction generate yield for the depositor. In essence, users provide the funds for other users to borrow.

An initial coin offering (ICO), is facilitated by smart contracts. ICOs allow anyone to fund and launch a crypto-based project without borrowing from a bank or investors. If an investor likes the project, he or she can send funds to the smart contract that returns the project’s tokens during the specified time.

ICOs changed the nature of fundraising and early-stage investing. Though ICO smart contracts usually interact with a project’s web page directly, centralized and decentralized launchpads exist to connect those seeking financing from potential early-stage investors.

These three terms get tossed around frequently, so it’s worth differentiating them. In DeFi applications like Uniswap and Maker, users connect their crypto wallets to the application and interact through smart contracts. The environment is permissionless and runs on a blockchain.

In centralized finance (CeFi),users can still take out loans with crypto collateral or deposit digital currencies for yield. However, the process is managed by a centralized institution rather than smart contracts. Though not FDIC insured, some users feel more comfortable with this process being managed by a company rather than computer code. They also prefer the option to deposit crypto and receive a fiat-currency loan to their bank accounts.

TradFi is short for traditional finance and is often used as a basis of comparison for DeFi or CeFi. Think of the traditional network of banks, stock exchanges and other financial institutions that connect savers and spenders in the physical world.

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