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The future of finance – DeFi

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2nd Dec, 2022
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The future of finance – DeFi

Decentralized finance or Defi has undoubtedly been one of the most significant developments for distributed ledger technology or DLT in recent years. As a result, we decided to provide an introduction to decentralized finance. In this article, we will look at some of the core principles of decentralized finance, such as DAOs, the technology stack, metrics used to gauge Defi adoption, and the numerous related hazards.

Meaning of Decentralized finance

Decentralized finance encompasses various financial steps in a decentralized manner, made possible via blockchains and digital agreements that run on top of the blockchains. Defi eliminates the need for financial intermediaries like investment/commercial banks, insurance firms, brokers, etc. In short, this implies that the customer is not dependent on any third party to gain access to and use financial services.

For example,  In the centrally managed finance world, when a specific organization wishes to take a loan, it is supposed to interact with a consultant and a bank in order to do so. But in  Defi, the organization will interact with a digital agreement, identified as a smart contract rather than a middleman. Investors deposit their digital commodities into a liquidity pool, which collects them and waits for a borrower. Elimination of intermediaries results in higher productivity and effective capital allocation, which results in higher interest rates given to loan holders and lower interest rates given by borrowers.

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What distinguishes Defi?

The most appealing aspect of adopting blockchain technology to revolutionize finance is how the market may become open-source and available to everybody. Another benefit of the idea is composability, which means anyone can combine any existing Defi service to create a new one. The modularity of such a network, made up of interlocking blocks, also means that subsequent developments and demands in the finance arena may be readily created on top of the network and patched together, with everything controlled by digital contracts.

Decentralized Autonomous Organizations and liquidity mining

DAO or Decentralized Autonomous Organization is the next stage of Defi activity. The concept came into existence in 2016 and has received attention with the launch of Defi. 

Tokens are used to vote in a DAO meeting during the decision-making procedure, similar to how shareholders vote at a shareholder meeting. The more tokens you own, the greater the weight of your vote is. Currently, DAO tokens are used mainly to change various parameters within Defi systems, such as voting on what occurs with the deposit within the compound. 

For example, DAO tokens can be allocated in several ways. One of them is an investment, where assets are swapped for management tokens which are the same as any other investment.

Another example of DAO is liquidity mining, compensating capital providers and customers who deposit digital assets into a liquidity pool with DAO tokens. Furthermore, users using the system to loan from the liquidity pool can be rewarded in DAO tokens as cashback. The concept is novel and straightforward. By compensating consumers on the supply and demand sides of the system with administration tokens, you give them the authority to make choices for different systems. 

There are numerous liquidity mining systems, each with its own set of barter and flexibility. Some just distribute a predetermined number of DAO tokens regularly, while others use liquidity mining rewards to increase liquidity in a specific system area. 

Tech Stack of a Defi

The present Defi technology stack is made up of several verticals. The most popular is loan and borrowing, with examples being Compound, Aave, and MakerDAO. In these systems, customers deposit one digital asset like Ethereum and borrow others such as DAI or USDC. For the time being, these loans are typically overcollateralized.

Decentralized exchanges, such as Uniswap, Curve, and Balancer, are yet another vertical with significant growth. These enable permissionless trading on market creation as well as trading itself. Anyone on Uniswap can launch a marketplace for any Ethereum token, begin supplying liquidity to it, and any consumer can deal on this market using their funds.

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Lastly, investment managers of Defi, with examples like Yearn and the PowerPool Index, have acquired significant interest and attention. They proactively implement methods to find the best yields and actively distribute resources, while the PowerPool Index is more akin to a financial derivative, ETF-like product. A consumer can deposit an asset into the index and gain exposure to all of the index’s assets which instantly get recalibrated.

Oracle Solutions is a frequently incorporated vertical in the Defi tech stack, utilized to migrate off-chain data onto the blockchain. Chainlink is the most visible example of an Oracle Solution. While Oracles are an essential aspect of Defi for their wide usage, we consider them a more significant infrastructure than a finance system. Since all of these systems are developed on the same technology stack, they are also interchangeable.

As a result, one can easily make individuals interact with one another. Developing a whole new financial procedure resembles stacking lego pieces on top of one another. For example, a consumer can create a stable coin on MakerDAO, put it in the compound’s liquidity pool, and then use the awarded COMP management token in a Uniswap liquidity pool to receive trading fees on the COMP-ETH pair. The fees can then be employed in another system, and so on. This technique has the significant advantage of stacking varied product yields. This method, known as Yield Farming, can provide customers with annual returns of up to 100%.

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Pavan Vadapalli

Blog Author
Director of Engineering @ upGrad. Motivated to leverage technology to solve problems. Seasoned leader for startups and fast moving orgs. Working on solving problems of scale and long term technology strategy.
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Frequently Asked Questions (FAQs)

1What makes Defi important?

The purpose of Defi is to build a trustless and anonymous financial market. Significant work and investment have gone into the advancement of Defi, and it is essential for financial advisors to recognize this field.

2 Why should a person invest in Defi?

Savings account interest rates on Defi products are more than ten times higher than traditional banks, and using stable coins eliminates the need to be exposed to fluctuating crypto markets.

3Why is Defi on Ethereum?

Ethereum enables consumers to write decentralized applications in a way that Bitcoin did not, pushing Ethereum to its present role as the top blockchain for Defi.

4Why isn't Bitcoin Defi?

Bitcoin is a financial asset that functions on its own blockchain. Defi, on the other hand, allows a consumer to give loans, borrow, and exchange cryptocurrencies like Bitcoin, much like traditional financial institutions such as banks.

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