What is DeFi and What are the its Best Use Cases?

What is DeFi?

DeFi stands for Decentralized Finance. It is a permissionless, trustless system that is built on smart contracts and automates the borrowing and the lending processes. It is a new concept that has become popular in the world of crypto since 2020.

Introduction

It works similarly to Traditional Finance (TradeFi such as banks and other centralized institutions) with the difference that it removes the need for any third parties or intermediaries that are an indispensable part of centralized finance (CeFi).

You want to open a bank account, so you visit one of its branches. The bank requests you to submit your KYC information. After the bank has verified your KYC, you need to wait for a few days before your account is opened. You may need to get a loan from this bank for which there is an arduous process of providing documents, the bank checking your eligibility, and the capability to pay off the loans. Post all that, and you may or may not get the loan.

It is just the magic that filters out all the hassles associated with a CeFi. As it removes the need for any bank or centralized authority, lending and borrowing become far easier and quicker. As it is a decentralized system, no single person or organization can have authority over it. It is because of the absence of any third parties, the process is also known as “disintermediation”. Banks may bother you with the need for physical documents, may discriminate against you based on your economic condition, and may require you to visit their branches again and again. With this, all these bothersome conditions get eliminated. 

No Need for Intermediaries in DeFi

Its protocols are built on top of blockchains such as Ethereum, Polygon, Binance Smart Chain, and others. Several applications (dapps) are created using smart contracts that are deployed on these blockchains. And we know what a smart contract is: it is a piece of code that executes a contract or an agreement when some pre-determined conditions are met.

So, if I want to send you 100 Eth and the smart contract condition says that this transaction must be signed by me from my wallet and I sign the transaction, this condition is met. And lo and behold!! You receive 100 Eth without any third party acting as a middleman or any need of getting approval or permission from some financial institution.

Smart Contracts automate it completely and it is for this reason that they are less time-consuming. As smart contracts are auditable (code can be audited for bugs and vulnerabilities), it ensures that dapps are secure and are protected from hackers (though there is never 100 percent true). 

Difference between DeFi and CeFi

Although the aim of both DeFi and CeFi is the same, i.e. to enable users to do financial transactions or borrow or lend money, both are poles apart when it comes to how they work.

1. Decentralized Finance is permissionless system; you do not need to take permission from anyone to carry out financial activities. As a user need not worry about long queues at banks or seek proper approvals for taking a loan or show some papers before he can lend or borrow, this type of finance makes the user the real controller of his finances.
   
   Centralized Finance on the other hand works with the help of banks, financial institutions, and the government. With CeFi, you need to go through the cumbersome process of approvals, rejections, and endless waiting.
   
2. It is trustless; you do not need a single authority whom you need to trust. Multiple nodes on the blockchain are involved in the ecosystem, thus making it a trustless system, In CeFi, you cannot work without trust. 
   
3. It uses smart contracts that automate the lengthy processes of borrowing and lending. In CeFi, you need to approach a bank or insurance company, or some brokerage firm to get things done. These authorities then may or may not let you carry out the transactions you want to or may/may not give you the loans just because your paperwork is incomplete or you could not repay an earlier loan. In it, you can be the lender, borrower, or liquidity provider (more on that later). 
   
4. As middlemen are removed, the user approaches the marketplace directly, which is DeFi itself!! In CeFi, financial institutions are the marketplace. 
   
5. Its applications are open source. Anyone can create them or view the ones created by others. The codes are transparent and all the apps are created on top of one another. It is not the case with banks that may like to work secretly, without the need to share with other banks the transactions that it carries out or any other data. 
   
6. As it is developed on the blockchain, Decentralized Finance is decentralized (no central authority can control it). CeFi is completely centralized.
   
7. Its protocols are censorship-resistant. Once confirmed on a blockchain, no one can change a transaction. Also, anyone is free to use it. In Centralized one, transactions can get reverted or canceled by banks or insurance companies. 

Please note that the above differences are also the characteristics of this finance which are permissionless, trustless, automated, non-custodial, and secured by Smart Contracts. 

Most of the apps these days are mostly on second-generation blockchain networks like Ethereum, Solana, Cardano, Polygon, Binance Smart Chain, and many more. These blockchains support the creation of smart contract code which is then deployed on these chains and automates borrowing-lending protocols. 

DeFi Use Cases

A. Yield Farming: Yield Farming is a process by which users can lend or borrow, or stake crypto assets to earn rewards. Users may have to pay a small transaction fee or pay interest on the loans they take from other users. The main purpose of yield farming is to maximize the yield; users can shift their assets from one platform to the other to get high returns. 

1. Lending and Borrowing:  It is one of the most prominent use cases. Platforms like Aave and Compound are the big names when it comes to providing platforms for borrowing and lending to the users. Most of these platforms support at least one blockchain network. These platforms provide the users with the crypto assets or tokens that live on these blockchain networks.
   
   How Lending Protocol Works? Suppose we have a lender A and a borrower B. Both want to make use of the lending protocols provided by the lending platforms. So, both of them connect to these platforms (through their wallets). The Lender is keen to lend some stablecoins such as USDT or USDC, which the borrower is seeking. So, the lender deposits his USDT on the platform. But to borrow these USDTs, a borrower may need to keep some other coin as collateral. Suppose he has Ethereum in his wallet which he keeps as collateral on this platform to get USDT from the lender. Everyone is happy as they get what they need in no time.
   
   Now when it comes to repaying the loan, borrower B needs to pay back the loan along with some interest to the lender and by doing so, he can receive back the other crypto tokens that he had deposited as collateral. Once he gets the loan, he can go to any exchange and get cash in USD. If the borrower is not able to repay the loan for some reason, his collateral will get liquidated and that too will be an automated process. In the wink of an eye!!
   
   It is worth noting that the value of the collateral that a borrower keeps in a smart contract is always higher than the actual loan. This is to make sure that the collateral would indeed cover the loan and also makes sure that if the collateral is of higher value, the user will indeed pay back the loan to get his collateralized token back. But it is the world of crypto and the value of the collateral may diminish over time.
   
   If the value of the collateral falls below the value of the loan, the borrower may need to deposit more collateral to keep things up and running, otherwise, the collateral would get liquidated. This way, the lender’s money is protected. Smart contracts working underneath can also put the collateral on sale, i.e. giving it at discounted prices to the other market participants that form part of the ecosystem.
   
2. Liquidity Providers: Under this type of yield farming, a user can deposit tokens (act as liquidity provider) to add liquidity to a pool of assets. In return for adding liquidity, these users are provided with additional tokens which users can add further to other liquidity pools to gain further rewards. A few liquidity pools reward the providers with LP (Liquidity Provider) tokens. Different blockchain networks support yield farming based on different tokens. For example, Ethereum supports ERC-20 tokens that form part of the liquidity pool.
   
3. Staking: Staking is one of the use cases that involves depositing crypto assets that get locked in a smart contract and getting more tokens in form of rewards. These rewards can then be re-staked in the smart contract to generate even higher rewards. By locking their assets, a user becomes a validator and in a way, helps in securing the protocol. Like other forms of yield farming, staking is also fully-automated. Staking is facilitated by Proof of Stake (POS) based blockchains.
   
   Yield farming returns are calculated with what is called APY (Annualised percentage Yield) which calculates the rate of return for various activities that users perform under yield farming (lending, borrowing, staking, adding liquidity, etc.). APY includes the factor of compounding the return in the account. A related term is APR (Annualised Percentage Rate) which is the percentage of the return that you receive without taking into account the effect of compounding.

B. DeXs: DEX, as we know, stands for Decentralized Exchange. The biggest DEX names include Uniswap, Curve, PancakeSwap, SushiSwap, Orca, Balancer, and others. The tokens that form part of the protocols of these exchanges are termed governance tokens which are used to reward the users that act as liquidity providers to the pools run by these DEXs. And like centralized exchanges, users can trade crypto assets on DEXs too. The decentralized exchanges are automated by AMM (Automated Market Makers), which run like stock markets and allow the crypto to be bought and sold at market prices.  

C. DeFi Bridges: It is one of the other use cases that are increasingly becoming popular. A bridge is a technique that allows interoperability between various blockchain networks. If you have ETH on the Ethereum blockchain and you want to transfer this ETH to the Polygon Network, it can be done with the help of a bridge. As different blockchains have different consensus mechanisms, they cannot be integrated well. It is when bridges come to our rescue.

Let’s see how bridges work. If you have USDT in your Ethereum wallet and you want these USDTs to send to your Polygon Wallet (which essentially means Polygon Network), you need a bridge for doing so. So instead of sending these tokens directly to Polygon Wallet, you will first send them a bridge supporting multi-chains. The bridge verifies if you have the USDT on Ethereum Smart Contract. If yes, these tokens are locked by the bridge and it mints a new set of USDT tokens (wrapped ones) on Polygon using Smart Contract on Polygon. These wrapped tokens are then sent to your Polygon Wallet. 

D. Yield Aggregation: Yield Aggregation is equivalent to asset management of assets other than crypto. If you have money in a mutual fund, then your cash is being managed by the AMC (Asset Management COmopany) that owns that mutual fund. Likewise, Yield Aggregator is a platform that lets users deposit their money, and then the Aggregator deploys the best strategies to get maximum yield. Yearn Finance, BadgerDAO, and Beefy Finance are a few popular Yield Aggregators. 

The Other Side of DeFi

This technology has so many plus points as we discussed in the sections above. But it is not without its set of cons: 

The technology used is the smart contract code and this code can have bugs and be vulnerable to malicious attacks and you could lose all your money. 

• Impermanent Loss: If you have deposited money in one of the liquidity pools and the price of that asset slashes down, you may face impermanent loss. The tokens are added to a liquidity pool in pairs in a 1:1 ratio and when the price of one of these tokens in the pair goes down relative to the other token, you will suffer a loss when you withdraw from the pool and it will depend upon your % share that you had deposited in the pool. 

• Slippage: Another con of trading on a DEX is slippage. It may happen that if you want to buy a crypto asset at a particular price and by the time, you hit the “Buy” button, the price changes. So, you would not be able to buy the coin at that price. This is called slippage. If the slippage tolerance set for your token is lesser than the % decrease in the price of that token, you would need to raise this tolerance percentage first and then carry out the trade.

• Hacking: Smart contracts can be hacked and this could mean a drain of the wealth you accumulated over time. 

• Liquidation: It is yet another problem that borrowers may face. If you are not able to return your borrowed amount of tokens in time, your collateral would be liquidated.

The use cases are on DEFI are on a steady rise. In the years to come, it is expected to be adopted more and more by crypto enthusiasts and institutions.

Disclaimer

This article is for informational purposes only and is NOT a financial advice. We do not promote, in any form, any smart contract, wallets, defi, blockchain, blockchain firm company, cryptocurrencies or tokens mentioned herein. The content of this article is based on the information available up to the knowledge. You should be aware that investing in any web3 project or defi, cryptocurrency or wallet or blockchain is subject to market risk and you MUST do your own due diligence (DYOR) before you put any money in any of the smart contracts or defi or blockchain companies or wallets or coins/tokens issued by these companies. 

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