DeFi Key Categories
The prices of cryptocurrencies are known to be extremely volatile. It is common for cryptocurrencies to have intraday swings of over 10%. To mitigate this volatility, stablecoins that are pegged to other stable assets such as the USD were created.
Tether (USDT) was one of the first centralized stablecoins to be introduced. Every USDT is supposedly backed by $1 in the issuer’s bank account. However, one major downside to USDT is that users need to trust that the USD reserves are fully collateralized and actually exist.
Decentralized stablecoins aim to solve this trust issue. Decentralized stablecoins are created in a decentralized manner via an overcollateralization method, operate fully on decentralized ledgers,
are governed by decentralized autonomous organizations, and its
reserves can be publicly audited by anyone.
While stablecoins are not really a financial application themselves,
they are important in making DeFi applications more accessible to
everyone by having a stable store of value.
2. Lending and Borrowing
Traditional financial systems require users to have bank accounts to utilize their services, a luxury that 1.7 billion people currently do not have. Borrowing from banks comes with other restrictions such as having a good credit score and having sufficient collateral to convince the banks that one is credit-worthy and able to repay a loan.
Decentralized lending and borrowing remove this barrier, allowing anyone to collateralize their digital assets and use this to obtain loans. One can also earn a yield on their assets and participate in the lending market by contributing to lending pools and earning interest on these assets. With decentralized lending and borrowing, there is no need for a bank account or a credit-worthiness check.
To exchange one cryptocurrency to another, one can use exchanges such as Coinbase or Binance. Exchanges like these are centralized exchanges, meaning they are both the intermediaries and custodians of the assets being traded. Users of these exchanges do not have full control of their assets, putting their assets at risk in case the exchanges get hacked and are unable to repay their obligations.
Decentralized exchanges aim to solve this issue by allowing users to exchange cryptocurrencies without giving up custody of their coins. Without storing any funds on centralized exchanges, users do not need to trust the exchanges to stay solvent.
A derivative is a contract whose value is derived from another underlying asset such as stocks, commodities, currencies, indexes, bonds, or interest rates.
Traders can use derivatives to hedge their positions and decrease their risk in any particular trade. For example, imagine you are a glove manufacturer and want to hedge yourself from an unexpected increase in rubber price. You can buy a futures contract from your supplier to deliver a specific amount of rubber at a specific future delivery date at an agreed price today.
Derivatives contracts are mainly traded on centralized platforms. DeFi platforms are starting to build decentralized derivatives markets.
5. Fund Management
Fund management is the process of overseeing your assets and managing its cash flow to generate a return on your investments. There are two main types of fund management—active and passive fund management. Active fund management has a management team making investment decisions to beat a particular benchmark such as the S&P 500. Passive fund management does not have a management team but is designed in such a way to mimic the performance of a particular benchmark as closely as possible.
In DeFi, some projects have started to allow for passive fund management to take place in a decentralized manner. The transparency of DeFi makes it easy for users to track how their funds are being managed and understand the cost they will be paying.
As DeFi continues to evolve, creative and disruptive financial applications will emerge, democratizing accessibility and removing
intermediaries. Putting a DeFi spin onto lotteries allow for the removal of custodianship of the pooled capital unto a smart contract on the Ethereum Blockchain.
With the modularity of DeFi, it is possible to link a simple lottery Dapp to another DeFi Dapp and create something of more value. One DeFi Dapp that we will explore in this book allows participants to pool their capital together. The pooled capital is then invested into
a DeFi lending Dapp and the interest earned is given to a random winner at a set interval. Once the winner is selected, the lottery purchasers get their lottery tickets refunded, ensuring no-loss to all participants.
A key role of cryptocurrency is to allow decentralized and trustless value transfer between two parties. With the growth of DeFi, more creative payment methods are being innovated and experimented.
One such DeFi project that is explored in this book aims to change the way we approach payment by reconfiguring payments as streams instead of transactions we are familiar with. The possibility of providing payments as streams open up a plethora of potential applications of money. Imagine “pay-as-you-use” but on a much more granular scale and with higher accuracy.
The nascency of DeFi and the rate of innovation will undoubtedly introduce new ways of thinking on how payments work to address many of the current financial system’s shortfalls.
Insurance is a risk management strategy in which an individual receives financial protection or reimbursement against losses from an insurance company in the event of an unfortunate incident. It is common for individuals to purchase insurance on cars, home, health, and life. But is there decentralized insurance for DeFi?
All of the tokens locked within smart contracts are potentially vulnerable to smart contract exploits due to the large potential payout possible. While most projects have gotten their codebases audited, we never know if the smart contracts are truly safe and there is always a possibility of a hack which may result in a loss. The risks highlight the need for purchasing insurance especially if one is dealing with large amounts of funds on DeFi.
1. A Beginner’s Guide to Decentralized Finance (DeFi) (Coinbase)
2. The Complete Beginner’s Guide to Decentralized Finance (DeFi)