With the increasing adoption of emerging technologies such as Web 3, Blockchain, Smart Contracts and Cryptocurrency, the concept of Decentralized Finance (DeFi), is gaining considerable attention. DeFi radically changes the way we use financial instruments, making them accessible and boosting opportunities for all.
While the traditional financial system runs on a centralized platform, controlled by government agencies and intermediaries of all kinds, DeFi operates according to a protocol running on a decentralized infrastructure powered by Blockchain. As a result, programmers can develop customized, efficient and secure financial platforms that are open to anyone with access to a computer and internet connection.
3 minutes to understand DeFi, Decentralized Finance
DeFi is undoubtedly the new frontier, as it allows millions of people who, for various reasons, do not have access to traditional financial systems (globally more than 1.7 billion people are unbanked), to be the managers of their finances and can make transactions with the whole world, thanks to Decentralization, promoting equal opportunities and unprecedented economic growth.
The infrastructure of DeFi – Decentralized Finance. It is composed of:
- Blockchain – The backbone for operation of DeFi is a Blockchain that allows to operate transactions with shared data and under various pre-set assumptions. This data is packaged into “blocks” and cryptographically “chained” allowing an audit trail of the transaction history. Blockchains are possible because of a “Consensus Protocol”, a set of rules that determine the types of blocks that can be part of the chain and become the “truth”. Blockchains generally use a “Proof of Work” consensus protocol, or alternative mechanisms such as the “Proof of Stake”.
- Cryptocurrencies – The most popular application of Blockchain is Cryptocurrency, which is a token (usually scarce) that is secured, priced and transferred cryptographically (“taking into account that digital objects are easily copiable”). It is precisely scarcity that guarantees its value; Cryptocurrencies are themselves a Blockchain innovation.
As Eric Schmidt Eric Schmidt | LinkedIn former – Google CEO said “Bitcoin is a remarkable cryptographic achievement, as the ability to create something that is not duplicable in the digital world, have enormous value.”
The pioneering cryptocurrency model is Bitcoin, whose protocol functions almost exclusively as a payment network, with the ability to store and conduct financial transactions worldwide, and in real time, without intermediaries, institutions and control systems. This powerful value proposition gives Bitcoin its high market quotation value (as of today, June 12, 2022, one Bitcoin costs US$27,515.60, with a market capitalization of US$523.6 billion). Although the Bitcoin network is very strong, its technological competitors offer greater functionalities (such is the case of the Ethereum Blockchain that has Ether as its main cryptocurrency and asset, with a cost of US$1,483. 72 and a market capitalization of US$179.7 billion; although it has lost up to 65% of its market value compared to December 2021, Ethereum is innovating aggressively to position itself as the reference Blockchain for DeFi and in general to boost the Web 3.0 decentralized Internet).
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According to visionary Sandeep Nailwal Sandeep Nailwal | LinkedIn, co-founder of Polygon Polygon | Ethereum’s Internet of Blockchains (a firm specializing in building protocols that connect Ethereum-compatible Blockchain networks), between 60% or 70% of the crypto industry currently runs on the Ethereum network. Therefore, does this mean that Web 3.0 will be built on the Blockchain of the second cryptocurrency by market capitalization.
Market price of the main cryptocurrencies (source CoinMarketCap) June 12, 2022.
- Smart Contracts – A crucial component of DeFi, are Smart Contracts. These go beyond representing a payment network (like Bitcoin), as they allow the creation of programming rules for any type of transaction and even create scarce assets with specialized functionalities. Many of the clauses of traditional commercial agreements could be transferred to Smart Contracts. The big difference with traditional agreements, contracts or legal business is that Smart Contracts are created by programming codes of an immutable nature, i.e., once the consent is given, the contract is executed and all the conditions that may occur and the consequences derived from any type of non-compliance are foreseen in the contract. That is to say, the contractual clauses are executed algorithmically (this puts in check a whole series of entities that currently endorse transactions manually, such as: notaries, property registrars, lawyers who certify public procedures and other actors in general).
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Smart Contracts go beyond finance, and have such diverse applications, for example in video games such as the famous Axie Infinity Axie Infinity or the incredible Decentraland Welcome to Decentraland that allow you to create, explore and even do business in the virtual world (Metaverse).
Other applications of Smart Contracts are in data management, the supply chain with powerful IoT, election processes, insurance claims, traceability of containerized goods worldwide, copyright and intellectual property protection, large-scale engineering project management, and many other purposes.
- Oracles – One problem with Blockchain protocols is that they are isolated from the world outside the chain itself. For example, Ethereum’s Blockchain only authoritatively knows what is happening on its own network, and not on other networks or protocols, restricting the applications of Ethereum’s native Smart Contracts and Tokens, thus reducing the utility of the platform. This is known as the Oracles problem.
In the context of Smart Contracts, an Oracle is any data source for reporting information external to the original Blockchain and they represent a huge challenge for DeFi to achieve utility beyond its isolated chain. A clear example of this is the Chainlink Blockchain Oracles for Hybrid Smart Contracts | Chainlink platform, designed on Ethereum, and whose purpose is to solve the problem of communicating outward from the original Blockchain. As of today Chainlink is priced at US$5.90 and has a market value of US$2.7 billion.
- Stablecoins “the place where traditional finance (CeFi) and DeFi meet” – A major shortcoming of many cryptocurrencies is the excessive volatility of their market prices. This can cause friction for users of DeFi applications, because of the low risk tolerance of a volatile digital asset such as Bitcoin, Ether or other cryptocurrency. To solve this, an entire subclass of Cryptocurrencies has emerged called the Stablecoins, which allow maintaining a price parity with some reference asset, such as the US Dollar, Euro, British Pound, Gold, etc. This parity provides stability to investors in the use of DeFi applications; they can even be used to provide a market exposure in the chain of returns of an asset that is outside Blockchain; for example: gold, company shares or ETF’s (Exchange-traded Fund) as can be the VOO – Vanguard which is indexed to the S&P500; or the QQQ – Invesco, which replicates the NASDAQ – 100.
The three main types of Stablecoins are: (1) Trust-backed, (2) crypto-backed, and; (3) unsecured. The largest fiat-backed Stablecoin is Tether (USDT), with a market capitalization of US$72.2 billion, making it as of today, the third largest cryptocurrency behind Bitcoin BTC, and Ethereum ETH.
The second largest stablecoin is USD Coin – USDC, backed by Coinbase – Buy & Sell Bitcoin, Ethereum, and more with trust. Both Tether (USDT) and USD Coin (USDC) are very popular and useful to integrate with DeFi protocols.
Decentralized Applications – dApps are a fundamental component of DeFi. These software applications are similar to traditional ones, except that they run on Smart Contracts platforms. The main advantages are the absence of permissions and the independence with which they operate (without the intervention of controlling entities). The dApps can be developed and used by anyone with good technical and functional knowledge, a computer and internet access.
Without a doubt, Ethereum right now is the “World’s Programmable Blockchain”. The internet as we know it Web 2.0, will change radically with the entry of Web3, and of course it will change the way we live (Metaverse).
Some of DeFi’s products or applications.
While we are in early stages of these technologies; Blockchain, DeFi and Smart Contracts, are creating new opportunities at an incredible speed. For example:
- Credit and mortgage management platforms using cryptocurrencies as collateral, promoting interest rates to be regulated by the market itself, instead of centralized entities such as: governments, the Federal Reserve or Central Banks. Of course there are many risks such as money laundering and/or tax schemes that promote evasion, so governments are actively working on developing regulatory projects based for example on Artificial Intelligence, IoT or other exponential technologies.
- Financing of infrastructure projects, real estate, technology, sustainability and climate change, etc.; through the use of Tokens and Smart Contracts. Anyone can be an investor in large-scale global projects, financed through DeFi’s financial instruments.
- Companies that list their shares in traditional systems such as NYSE, London Stock Exchange, Tokyo Stock Exchange (TSE/TYO) or BOVESPA, will start issuing tokens “a kind of equity shares” that can be acquired in a Decentralized way by users from all over the world, giving the opportunity to access the stock market to a large number of investors of all sizes.
- Large Decentralized Marketplaces, where interested parties can exchange goods or services. Thus we have the incredible market of NFT’S – Non Fungible Tokens and the great opportunities this has for the Orange Economy. For example Open Sea OpenSea, the largest NFT marketplace in the world, the Crypto Punks marketplace Larva Labs or the BAYC – BoredApeYatchClub BAYC (boredapeyachtclub.com). Adidas and other major brands already made their entry into the Metaverse using figures of the famous Apes.
- Other financial and investment products that we do not know yet (futures market, means of payment, investments in digital assets of all kinds, investments in the Metaverse, etc.).
DeFi is growing rapidly. However, it remains immature and volatile, with a number of economic, technical, ethical and public policy issues that need to be addressed. DeFi has the potential to transform global finance, but activity to date has focused on speculation, leverage and generating returns among the community of digital asset owners. Ultimately, DeFi’s success or failure will depend on whether it can deliver on its promise of open, high-trust, unmonitored (custodied) financial services for all.
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