Beginners Guide to DeFi (Part 2)
In part 2 of the Beginners Guide to DeFi we will dive deeper into what makes the DeFi landscape. Including everything from decentralized lending, exchanges, identification, composition, and risks.
Decentralized lending.
We may start by replicating parts of the present financial system as automated smart contracts utilizing functional stablecoins like USDC and DAI. Borrowing and lending are two of the most basic ideas.
Compound, dYdX, and Dharma are three DeFi platforms that allow for the direct borrowing and lending of Ethereum tokens via smart contracts. The fact that a borrower does not have to look for a lender or vice versa is an appealing feature of these smart contracts. Instead, the smart contract is an intermediary, with interest rates computed algorithmically based on supply and demand.
Decentralized exchange
The goal is to allow two parties to trade various cryptocurrencies.
To better understand the use case, start with centralized cryptocurrency exchanges. Binance and Coinbase are among these exchanges act as a middleman and custodians, allowing two parties to deposit their assets and trade with one another. While centralized exchanges have scaled to facilitate billions of dollars in deals, they create a single point of failure that can be hacked, censor transactions, or restrict certain individuals from trading.
Decentralized exchanges attempt to address this issue by utilizing smart contracts to reduce or eliminate the middleman. The ultimate goal is for all digital assets to be traded peer-to-peer.
Decentralized exchanges can today only manage a fraction of the volume of centralized exchanges and, as a result, cannot transfer large sums of money. Furthermore, many of these efforts are limited to trading Ethereum-based tokens on the Ethereum blockchain, limiting their access to large-cap coins with their chains. Despite this, promising technologies such as atomic swaps may be able to bypass these constraints.
Decentralized identity
One downside of the decentralized lending and borrowing services described thus far is the enormous collateral issue required. This over-collateralization requirement can be a highly inefficient use of capital, especially when many people do not have the extra funds to submit as collateral in the first place.
However, efforts are being made to develop decentralized identification and reputation systems that will reduce collateralization requirements. One of the first applications would be to construct blockchain versions of fiat-based credit agencies such as Experian, TransUnion, and Equifax, which are used by entities such as banks to calculate credit ratings.
Surprisingly, DeFi with decentralized identification systems may provide another option for people who are locked out of traditional financial systems in the long term. One billion people, for example, do not have an official ID, and half of the women in low-income countries do not have one. Many of these people, though, own smartphones. As a result, once decentralized IDs have been demonstrated to operate in the developed world, they may be easily exported to the developing world as a breakthrough technology — much like smartphones.
Composability
Putting together DeFi functions that do different things, similar to how software libraries are put together. For example, if one contract accepts cryptocurrencies and generates interest, the second contract may reinvest that money automatically.
Another example is the 2100 project, which blends DeFi and social media by allowing participants to “mine” new tokens via their Twitter accounts, thereby earning digital dollars from their social capital. Popular accounts can monetize their following by publishing premium content only visible to a certain group of token holders. Then one can do interesting things like wager on specific Twitter accounts becoming more popular.
The PoolTogether project, which combines DeFi and lotteries to create a “no-loss” lottery, is another example. Users purchase lottery tickets on-chain, and all proceeds from ticket sales earn interest on Compound. At the end of the lottery, everyone’s money is returned, but one person receives all of the interest earned on the pooled cash. It’s essentially a method of using lottery mechanics to encourage saving and wealth accumulation.
Risks
While DeFi is thrilling, it is critical to understand its risks. Let us have a look at various risk categories:
Smart contract risk. Many of these systems are brand new and require additional time to be battle-tested. When protocols interact with one another, the risk of smart contracts rises. If a critical smart contract issue exists in one protocol, it can expose the entire system. It would be advisable not to invest too much capital in these systems in their early phases.
Risk of volatility and collateralization
There are additional risks connected with certain forms of collateral used to back loans. Overcollateralization reduces volatility risk, but if the price of the collateralized asset decreases too quickly, a margin call may not reimburse the entire amount borrowed. This should be less risky with a reasonable collateralization ratio and verified collateral types.
Regulatory risk
DeFi platforms have varying degrees of decentralization, and we have yet to see court cases that test all claims. We’ll have to watch what happens here.
Outro
The DeFi market is massive and expanding. Bitcoin worth hundreds of millions of dollars have already been deployed, and the space’s future potential is enormous. There is still a lot of space for new and inventive DeFi applications. We are happy to answer any questions through the comment section.
