Decentralized Finance and how people earn large amounts in interest!
What is DeFi?
DeFi stands for Decentralized Finance. Traditionally, our money and finance are controlled by government entities. They decide what the interests would be, how the exchange value of our holding would differ, and what we can do with our money. Whereas in decentralized finance, you have no limitations. You make decisions for your money (tokens) and eliminate the central entities making you wait for the transactions, limiting you to a maximum transaction amount, and taking taxing you based on the amount you transact which varies if your transaction amount increases, leaving you with a very small return percentage. In simple words, DeFi is the Decentralized alternative for your centralized banks.
Some common terms used
- Stable coin — a coin that isn’t as volatile w.r.t its value as other tokens. In laymen's terms, they are the coins that are backed by FIAT currency to serve as the FIAT representatives in the crypto space. The value of these coins may fluctuate by small margins sometimes if the crypto market capital either exponentially rises or falls in one go (If demand for the Stable coin increases, its value also increases and vice versa). Example: USDT.
- Algorithmic Stable Coin — this is a stable coin as well but it isn’t backed by a real-world FIAT currency. Instead, it is programmed to be equivalent to the value of a FIAT currency. Algorithmic stable coins use various mechanisms such as burning, etc., to maintain the equivalent value. We’ll learn about this more in the upcoming articles! Example: UST.
- FIAT currency — all centralized currencies for various countries are collectively termes as FIAT. Example: US Dollar, Indian Rupee, Euro, etc,.
- APR — Annualized Percentage Rate, used in context with the annual interest rate. APR doesn’t work on compounding interests. It is used to calculate how much interest you’ll get paid on money/tokens you have lent. Here there are chances for the borrower to lose the tokens.
- APY — Annual Percentage Yield, used to calculate the interest earned on investing your money/tokens. Compound interest is one of the factors in calculating the APY.
- TVL — Total Value Locked, The total value of tokens that have been deposited into a smart contract on a chain.
What are the benefits of DeFi?
DeFi helps us to carry out our financial activities with the following benefits:
- Transparency regarding your transactions and other financial activities.
- Security for the transactions you make.
- Amazing interest rates.
- Multiple options for borrowing, lending, and other activities.
- No middle man or centralized entity to control how the system will work and who gets how much interest or returns, its completed automates (smart contracts driven). It’s Decentralized!
What are DeFi protocols?
DeFi protocols are basically Decentralised applications that have smart contracts. Users interact with these smart contracts through a UI on the DApp (Decentralized Application).
These DeFi protocols help the users to perform financial activities like borrowing, lending, participating in liquidity pools, lock tokens as fixed deposits and earning interests, etc.
These DeFi protocols are responsible for making sure that a borrower doesn’t run away with the tokens he/she has borrowed. The borrower is supposed to deposit more collateral value than what he/she wishes to borrow.
👉 Why would someone borrow tokens if they already own more than the desired borrowing value?
If a person holds a certain token for a long time believing that it would increase in value and he/she still wishes to make some trades without selling this token, they can borrow any other tokens like for example USDT, and put their holdings as collateral. They can then trade using the borrowed token and make some money with it. Once they are ready to pay back to the DeFi protocol, they can pay back the borrowed value and get their collateralized tokens. In this way, they have both the profits and their initial holdings. In case they lose the money while trading the borrowed tokens, they’ll either have to put some money to raise the lost tokens in trades in order to reclaim their tokens or they have to let go of the collateralized tokens and keep the remaining borrowed tokens they have. If the borrower doesn’t pay the loan then the smart contract pays the lender with the tokens collateralized by the borrower.
👉 How would the lender be benefitted?
The lender is promised to get certain interest (APY) on lending his/her tokens in the DeFi protocol. In addition to the interest, the lender also gets alternate tokens equal to the value of their lending amount which they can use to reclaim their tokens later. Some protocols also provide rewards to their users in the form of their native protocol tokens.
👉 While we are talking about borrowing and lending, let's see what flash loans are?
So we’ve seen how normal borrowing and lending works in the decentralized finance space. In addition to these, we have something called flash loans. Flash loans are loans taken from DeFi protocols that are paid back within seconds.
👉 Why take a loan if you want to pay it back within seconds?
Flash loans are used by people to buy a token from one exchange (say Binance) and sell it immediately in some other exchange or the same exchange (like Coinbase or Binance) for a higher price. In this way, the borrower will earn some quick bucks and also repay the loan immediately.
👉 Who decides what will be the interest percentage?
As mentioned earlier, everything is decentralized and is controlled by smart contracts, the interest rates, and other rules are also written in the code of the smart contracts and they are automated. No one can change the interest rates manually, hence no human has control over it (immutable).
Some very popular examples for DeFi protocols are:
- Anchor Protocol on Terra
- AAVE on Ethereum
- Compound Protocol
👉 How do I recognize a very good DeFi Protocol?
In order to determine a good DeFi protocol we generally see what is the TVL growth of a project over time. We have discussed what TVL is in the above section. The data for TVL on a protocol or on a chain can be found on many websites. One of the popular websites is DefiLama.
👉 What are the other components in DeFi?
- Decentralized Exchanges
- Liquidity Pools
- Yield Farming
- Margin Trading
- Flash loans
Kudos! Now you know what DeFi basically is. In the upcoming articles, you’ll learn more about the components of DeFi and how they work.
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Up Next: What are Decentralized Exchanges?