DeFi-Decentralized Finance
Let’s first understand what a Centralized Finance system looks like-
Government and banks have full control over all your money. It limits you in a lot of ways, there are a variety of problems including really high rates for loans , the government can take all your money, it can shut down the bank, it can print more money. Everything is in control of a centralized authority here on which we can choose to trust or not.
Let’s understand what decentralized finance looks like-
There are no banks in this scenario, instead there are pieces of code achieved through Blockchain technology that act as a bank. Some of the pros of Decentralized system over centralized is that it is censorship resistant, it is much cheaper than traditional methods for taking loan, borrowing and lending. Decentralized finance is made up of- Cryptography, Blockchain and Smart contracts. Considering you know about these topics , let’s move to the 5 pillars of Defi .
5 pillars of Defi-
- STABLECOINS- It refers to a crypto price being matched to a real world asset, for example, DIA and USD coin are examples of stable coins. Buying 1 DIA will mean that 1 USD is minted and withdrawing 1 DIA means 1USD is burned. So , a much simpler way is to just trade them instead of buying. Buying and selling of cryptocurrency will mean paying large fees to the centralized crypto websites like CoinBase which is controlled by the govt. whereas in trading 1 Eth to 1 USD coin using Uniswap , the fees is even less than 0.5 %, and within minutes the trade is completed. Using a decentralized exchange is secure because these are just Smart contracts which are pieces of code and it can’t be tampered with, unlike CoinBase which has even been hacked before.
2. BORROWING AND LENDING- As it is a major part of the current financial situations, there must be a way that blockchain can do it better. The traditional process includes paying some 20% collateral first and knowing the legal rules of not repaying the loans and the govt. can come after you in such cases. This is a disadvantage of crypto, that someone can put 20% collateral and run away with the rest of the money. So how can this be checked?
With smart contracts it is possible to give loans while still owning custody of the money. It needs to have 2 parties, suppose A, who wants to earn some interest on the money and B who wants to borrow some money, A deposits money and gets what is called some tokens plus interest which is calculated using smart contracts and B must overcollateralize his loan, he must pay extra at the starting so that if he runs away, the interest can be paid back to the lender .
3. DECENTRALIZED EXCHANGES- Instead of a foreign exchange trader who takes near about 15% fees just for exchanging currency, decentralized exchanges cost very small fess which is about half percent.
For example- Uniswap is a decentralized exchange which is not controlled by any govt. and where code is the law, it has billion s of dollars in its sale, whereas CoinBase (centralized) only allows 32 cryptocurrency to buy and sell at a time. With Uniswap, nobody can control the dollars, only investors can pull out their money whenever they want to, moreover all the security features of blockchain apply here, it is immutable and everyone has access to the code.
4. INSURANCE- A farmer wants to buy crop insurance, let’s suppose if there are any days in the summer which is more than 50 degree for 4 days in a row, the insurance company will have to pay suppose 10000 amount, but the farmer has to pay suppose 20 amount at the beginning which is also referred to as the premium. So , instead of using 3rd parties for insurance, the farmer can buy crop insurance through smart contracts. Now to answer the questions like how the temperature is measured and from where the insurance money comes.
To connect real world to digital -ORACLE is a trusted source of bridge between both these worlds. This is done by creating an oracle in the city to check temperature and also verified by people, and smart contracts use it as data source. Money is paid out using other people’s premium who can’t claim their insurance and it also comes from the investors who lend out money as explained in the 2nd pillar.
5. MARGIN TRADING- Let’s understand how this is done traditionally. For example you want to buy a stock for 100 dollars, margin is the loan which will automatically sell your stock if it goes below your down payment. The bank will agree to give you a loan if you give suppose 20 dollar as a down payment plus a 5% fees. If the value of the stock goes to 150 dollars, pay 80 dollar loan to the bank (100–20) and you earn a profit of 70 dollars by only spending 20 dollars initially, even though the stock went up by only 20 %. So this is the power of margin. But all this will require you to pay a high fees, prove your identity, and already own a large amount and this is where blockchain acts as a decentralized and cheaper way of doing the same process.
Hope you had a good read and understood how decentralized finance can change the future of finance with the developments in blockchain and cryptocurrency!