Cryptocurrencies

What is Decentralized Finance (DeFi)? – Cryptocurrencies

Have you heard of decentralized finance and wondered why all the hype? You have come to the perfect place. In this article, we will answer all your questions:


  • What is decentralized finance?
  • How is decentralized finance different from traditional finance?
  • How to evaluate DeFi tokens?
  • How to get started with DeFi?
  • And finally, what are the examples of DeFi applications?

Having explained what “Yield Farming” is, and glimpsed the potential of new passive income generation devices offered by the crypto industry, now is the time to get down to business. We therefore continue to understand this new crypto continent by learning the fundamentals in this new chapter of the Decentralized Finance Tribune.

This content is offered to you as part of a partnership with CryptoTesters.com, a platform specializing in comparisons and analyzes of DeFi services and about which you will learn a little more at the end of the article.

What is decentralized finance (DeFi)?

Decentralized finance is one area of ​​cryptography that is currently receiving special attention. In its greatest ambition, DeFi aims to recreate the financial system we use today, but in a way that would remove all trusted intermediaries like banks.

Bitcoin, the first decentralized network, to have laid the foundation for this movement by facilitating trustless peer-to-peer payments. This means you can send bitcoin to anyone in the world without knowing or trusting that person AND without using a third-party service like a bank. In addition to these features, bitcoin has other attributes hard-coded into its protocol. Probably the most important is the supply cap, which foresees that there will be no never more than 21 million bitcoins in total. This scarcity explains why bitcoin is often called “digital gold“.

Once people recognized the power of the Bitcoin network, they immediately began to think about how it could enable more use cases beyond simply storing bitcoin ownership status.

Determined to find a solution to this problem, a young Bitcoin enthusiast named Vitalik Buterin set out to create Ethereum in 2013. Technically, Ethereum is a kind of “world computer” that can store both code and data. Like a normal computer, Ethereum can execute code and it uses the Ethereum blockchain as a hard drive. Every time code is executed and data is changed, the status of the blockchain is updated. However, unlike a traditional computer, Ethereum’s state changes are governed by consensus rules and the state is distributed globally, meaning that data is collectively held by thousands of nodes.

These building blocks make Ethereum the ideal candidate for hosting new types of applications. Applications which are:

  • Decentralized – Applications which can function without a single central entity controlling them and which are governed by their users.
  • Resistant to censorship – Applications which cannot be hindered by a government or by another actor.
  • Without authorization – Applications that can be built and used by anyone in the world without any geographic limitation.

While in theory Ethereum can accommodate any type of application, decentralized finance is the area that is currently the most explored. Decentralized finance encompasses a wide range of applications that aim to replace banks and other financial institutions, that is, applications that revolve around trade, lending, borrowing and investing.

What are the differences between traditional finance and decentralized finance?

In traditional finance, when you visit your banking institution’s website or your mobile application, all the logistics of the application are hosted on a server controlled by your bank. Your bank account balance and your personal information are also stored in a database controlled by your bank. Decentralized finance upsets this logic. We’ll take a look at some of the differences between using a bank account and using a DeFi app.

Deposit and storage

In decentralized finance, your assets are stored in a blockchain account rather than in a database. While your bank can freeze your holdings at any time, no one can prevent you from accessing your holdings on the blockchain. There is no single server that can be shut down. To deprive you of your assets, someone would have to shut down the entire blockchain, which is almost impossible given that it is managed by thousands of computers spread across the world.

Your account is not represented by a name and a bank account number, but by a pair of public and private keys. The public key is … public and identifies you on the network (for example when you want to receive funds from a friend) and the private key is the one you need when you want to send funds to another Ethereum account. The minors verify all transactions and only validate those with genuine digital signatures.

Opening an account on the blockchain is completely free. If you’re tech-savvy, you can spin a node and generate as many addresses and accounts as you want. However, most of the users use an Ethereum wallet to create an account. Wallets are interfaces that allow you to interact and communicate very easily with the Blockchain. When you download a wallet and set it up, the wallet automatically generates a public key and a private key. When you send credit notes to another address, your wallet produces the necessary signatures and submits the transaction to the blockchain, where it is then processed and validated. In short, the wallet is your ticket to the existing financial system on the Ethereum blockchain.

Unlike a bank account where you have to log in, no one will deny you an Ethereum wallet. They are all free and open-source.

Frictionless

Another difference between an Ethereum account and a bank account is that the former gives you complete freedom over which interface you want to use.

You can download an Ethereum wallet, copy its private key, then import it into another wallet app, and you will see your balance immediately appear in the interface. Imagine that you could import your bank account into the banking application of your choice and switch from Societe Generale at Boursorama in a few seconds. This is a reality in the crypto world, because a wallet is just an interface that reads the blockchain. This blockchain is public and accessible to everyone.

Switching from one DeFi application to another is just as seamless. The concept of “signing up to a website” and having an unwavering link with a supplier does not exist. If you want to use a DeFi app, you need to go to the website where the app is hosted. As soon as you have connected your wallet, you can use the application. You are “identified”. The only difference is that no personal data is stored. You can switch from one application to another in seconds.

Compound Wallet – Connecting your wallet is just one click away

Without authorization

What’s more, on Ethereum, developers can start building whatever they think of. They don’t have to ask for permission and there is no paperwork. In traditional finance, it is extremely difficult to build a product. Especially if you are trying to build something new. It has stifled innovation in finance over the past decades.

On Ethereum, literally anyone can create an app. Developers who have an idea of ​​how to build a more efficient exchange, synthetic dollar, or options market than existing markets, can simply do it. For the first time in history, developers around the world are joining forces and building on the same platform. While the traditional financial system is extremely fragmented, Ethereum provides a global settlement platform that transcends borders and nationalities. A sandbox for innovation.

Interoperable

Another key feature of decentralized finance is that all smart contracts are public, readable and available on the channel. Open source by default. Anyone who knows how to code can trigger the functions of these smart contracts. Therefore, anyone can also interface with these smart contracts.

For example, the team behind Uniswap, a decentralized exchange that allows users to exchange tokens, has developed an interface that users can visit on uniswap.exchange but there are many other interfaces that are hosted by other teams and individuals. This means that not only the backend of these applications – i.e. smart contracts – cannot be dismantled, but that even frontends / interfaces resist censorship and are decentralized. The teams behind smart contracts are even encouraging this by making the frontend code public as well.

Uniswap – One protocol, multiple interfaces

But there is another interesting feature of these smart contracts. Because they are public and they exist on the same IT platform, they can talk to each other. That’s what we call interoperability. This basically means that if I build a new app, I can integrate all the existing smart contracts into my app.

Let’s say I create a loan protocol (lending protocol). The loan protocol has two main functions. Users can Deposit money in a common fund and derive interests. And borrowers can borrow assets from that same pool. However, to secure the loan, they will need to deposit assets as collateral for the loan. This procedure is similar to that used for loans in the traditional finance sector, which are guaranteed by a mortgage or some other guarantee.

But what happens when the value of the crypto currencies held as collateral for the loan by the protocol drops to 0 and the borrower does not repay the loan? To ensure that this could not happen, the protocol would need a liquidation mechanism by which it would sell the risky collateral of borrowers in the market and repay lenders. Instead of having to build an exchange from scratch, as well as a Loan platform (lending market), I can simply integrate Uniswap into my protocol. Whenever collateral is at risk, the protocol grabs it and sells it on Uniswap. Proceeds from the sale go directly into the protocol pool and guarantees its solvency.

Interoperability is a powerful notion because it means that every new application being built can benefit from existing ones. With each app being built, Ethereum as a whole becomes more useful and powerful. This is the reason Ethereum is so dominant. No developer wants to build on a Blockchain without apps. Even if it promises millions of transactions per second.

Governance

In the traditional world, companies (like your bank) are managed by frames, usually supervised by a board of directors and ultimately belonging to shareholders.

The vast majority of companies are private, which means stocks are not publicly traded and the average citizen cannot buy a share of property. Those that are public are relatively expensive when listed on the stock exchange. By the time a company like Facebook goes public, venture capital funds have already made their profits. They invest in companies when they are very cheap and sell their shares to the public years later at prices reaching billions of dollars.

On the other hand, most protocols are owned and governed by their community. Anyone can submit proposals or code changes to a protocol, which are then accepted and implemented or rejected by the community. To participate in the decision-making, users must purchase the governance token. Token holders also usually receive a portion of the fees the protocol collects for its services.

Pub

Cryptoassets are highly volatile unregulated investment products. No EU investor protection. Your capital is at risk.

In this sense, they constitute a new category of assets. Similar to actions but different in that they give the holders ownership of a protocol, not a legal entity. Since the cash flows generated by these protocols are public, anyone can make informed decisions, without having to wait for a company to report profits quarterly (and without being sure that the reported profits are accurate).

Through a transparent mechanism for calculating the benefits of a protocol (“Earning Protocol -PE“), We can apply one of the old metrics for valuing fixed assets in traditional finance: the private equity ratio. Simply put, the private equity ratio is a way to understand how the market values ​​an asset relative to the amount of income it generates. For example, Compound’s protocol token ($ COMP) has a PE ratio of 40. This means that investors are willing to pay $ 40 for every dollar earned by the protocol today. If you want to know the PE ratio of the most popular DeFi applications, the site Token Terminal does a great job of providing accessible data.

Annualized earnings of the best DeFi projects, August 2020

How to get started with Decentralized Finance – DeFi?

To get started with decentralized finance, you will need some Ether and a wallet.

to buy Ether, you must go to a centralized crypto exchange (such as Coinbase or Kraken). Exchanges allow you to convert your fiat currencies into cryptocurrencies. Once you have acquired Ether, you must transfer it to an Ethereum Wallet.

1. Buy Ether (ETH)

To buy ETH, we recommend Coinbase, Blockchain.com or Kraken. If these exchanges do not work in your country, see our major platforms page for a more complete overview.

2. Get an Ethereum wallet

For a good Ethereum wallet suitable for DeFi, we recommend Money, Metamask or Authereum.

Metamask is the most popular wallet. It works as a browser extension and appears when you need to connect your wallet to an app or sign a transaction. You can download it here.

Associated image

Money is a sleek and incredibly user-friendly mobile wallet. It natively integrates many DeFi features into its mobile app, but you will be slightly more limited in terms of choice than with Metamask. Ultimately, this is a matter of personal preference as Metamask is preferentially used on the desktop / web while Silver is used on mobile (iOS / Android).

3. Withdraw your ETH from the exchange

As long as your ETH is in your trading account, you don’t really own it. To start evolving in DeFi, you need to transfer it to your Ethereum wallets.

4. Start using DeFi

A good starting point for your journey to the heart of DeFi is to go to uniswap.exchange and exchange part of your ETH for tokens. You can, for example, exchange Ether for the USDC, a dollar stablecoin. Once you have USDC, you can go to Aave and deposit it on the platform to collect interest.

Examples of DeFi applications

The DeFi ecosystem continues to grow with the emergence of new protocols and applications almost every day. To give you an idea of ​​the kind of financial apps that are already being built today on Ethereum, we’re going to cover some of the more interesting projects that exist today.

The DeFi ecosystem

What is MakerDao?

Of course, for these apps to be useful, they must work with dollars and not just with crypto currency. The dollar is the most stable currency in the world. There are many who wish to expose themselves but cannot because they live outside the geographic borders of the United States. This is why “stablecoins” or “crypto-dollars” appeared very early in the history of crypto.

Stablecoins like Tether or theUSDC are tokens that exist on the Blockchain and are pegged to the value of the US dollar in a 1: 1 ratio. They are issued by private companies (often crypto exchanges) which guarantee that they hold the equivalent of dollars in bank accounts. However, to exchange these tokens for real dollars, holders must go through a procedure of KYC. Issuers must comply with applicable anti-money laundering regulations. The market capitalization of stable tokens on Ethereum recently exceeded $ 12 billion and continues to increase.

However, these rooms are not decentralized. While they can be traded freely in the Ethereum ecosystem, to actually redeem them for fiat dollars, individuals must identify themselves with stablecoin issuers. In addition, the smart contracts that power these stablecoins have special built-in functions, which allow issuers to blacklist certain addresses or freeze assets.

The purpose of the protocol MakerDAO is to create stablecoin coins without any of these limitations. A coin that is not issued by a corporation. A truly decentralized currency, governed by protocol and held stable against the dollar by collateralising with ETH.

The main function of the MakerDAO protocol is to issue the DAI, a stable token that always makes it worth a dollar.

However, DAI is not backed by real dollars in a bank account, so the value of DAI (expressed in dollars) can sometimes fluctuate slightly. Instead, DAI is secured by Ether and generated by a process in which anyone can send Ether into a smart contract (called a “Vault”) where it is temporarily locked. In return, the user receives DAI. For example, if a user sends $ 150 worth of Ether, they will receive 100 DAI, that is, “Ether stuck in the smart contract as collateral.

How MakerDAO Works

Then the user can send their DAIs to anyone in the world or sell it and buy something with it. In fact, the user borrowed the DAI from Maker Vault, but since the smart contract holds the user’s Ether as collateral, there is no risk of failure. When the user wants to get the Ether back, he must repay the loan principal as well as the interest accrued during the term of the loan.

Of course, not everyone needs to go through this process to get DAIs. Only users who need funding or want to take a long position actually generate (they say they “mint”) DAI. Most users simply buy DAI from exchanges. In most cases, they will pay exactly one dollar. Like any currency traded on free markets, DAI derives its value from supply and demand.

If too many people sell DAI to buy other crypto for example, the value of DAI can drop below $ 1. In this case, two forces bring the market price down to $ 1.

  • 1) Arbitration – On the one hand, people who have taken out a loan will take the opportunity to repay their debt at a discount, buy DAIs at low prices in the market (eg $ 0.95) and close their debt position. The 100 DAI that was originally borrowed will be worth only $ 95 now, so there is an arbitrage opportunity to seize. This increases the demand for DAI in the market and at the same time the supply of DAI is regulated because DAI is paid back to smart contracts and is burned (destroyed) there.
  • 2) Interest rates – If market forces are not enough to bring the price down to a dollar, the Maker Organization, which is run by thousands of individuals who collectively vote on policies, may also raise the interest rate. By making borrowing more expensive (or less expensive), users will close (or open) the Vault, which will reduce (or increase) the supply.

In other words, these smart contracts function like a decentralized “central bank” that strikes the currency, adjusts incentives, and ensures that DAI tokens are always backed by a sufficient reserve of ether to keep their value stable.

What is Compound?

The “Compound” is a decentralized lending protocol that allows people to borrow and lend assets by providing a liquidity reserve (“Liquidity Pool”, LP) that anyone can borrow or lend. Users who wish to lend money can send their assets to the cash reserve and immediately start earning interest. Interest generated from the entire reserve is distributed among all vendors, so even when funds are not used, vendors receive their share of interest.

Users who wish to borrow money from the liquidity reserve must provide collateral, as in the MakerDAO system, which guarantees the security of the loan at all times. Interest rates are algorithmically set based on supply and demand, which means they fluctuate. If a large amount of DAI is supplied to the pool and there is not enough demand to match it, the DAI interest rate will be lowered. In contrast, low supply and high demand for borrowing will cause the interest rate to rise.

Compound works not only with DAI but also with many other tokens that exist on the Ethereum network. Each token has its own cash reserve and its own interest rates. At the time of writing, Compound supports lending and borrowing of Ether, WBTC, BAT, USDC, DAI, and several other assets.

What is Pool Together?

To show how modular these different DeFisystems are, we will end by explaining PoolTogether, a lossless lottery that uses both DAI and Compound in its product. It allows users to pool their funds and invest collectively in the DAI pool of the Compound protocol. When money is placed in the compound’s pool, it generates interest, which is paid in the form of a weekly prize to a random wallet address. For every DAI users contribution to the pool, they receive a lottery ticket in the form of a token.

pooltogether

This is because users have a chance to win the weekly prize without the risk of losing money. They are free to withdraw the amount they have invested at any time. Two other advantages of PoolTogether over the traditional lottery:

  • 1) the code is fully open-source and verifiable, which assures users that the prize distribution is not rigged
  • 2) PoolTogether has contributed over $ 300,000 of its own money to the prize pool, which generates the most money but is not eligible to win.

summary

These are just a few examples of decentralized financial applications. More and more apps are joining the list every week, developed by young developers around the world. The magic of decentralized finance is that it is global by definition and can be used by anyone in the world with a smartphone – even by the 1.7 billion people without a bank account. DeFi apps are powered by open-source code that can be verified by anyone. Compare that to the highly centralized, opaque, profit-seeking financial system we live in and you will see why this vision fascinates the crypto community.

Pub

Cryptoassets are highly volatile unregulated investment products. No EU investor protection. Your capital is at risk.

This article is taken from the excellent Cryptotesters blog. The Berlin-based team presents the meaning of its approach as follows:

“The crypto space is a place of permissionless innovation, a dream for builders and hackers who bring new products to market every week. […] This abundance of choice unfortunately makes the space extremely complex for people who have never sailed it to navigate. At cryptotesters, we want to help people who are new to crypto by recommending the best products to them. We further believe that exchanges are not the place to start your Blockchain adventure. […] Our vision does not end there. We expect the crypto space to continue to evolve. We are only at the very beginning. Eventually, there will be endless variety of crypto products to choose from in different industries (think insurance, loans, etc.) and our goal is to help users choose the best of each. “

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