Decentralised finance is a means to reduce the control and influence of centralised institutes and politics over money and financial products. It is a peer-to-peer global financial system that operates on smart contracts and computer codes rather than relying on middlemen or third parties.
It is unlike our traditional banking system, where banks control the customers’ funds and they may, if they want to, prohibit people from using their own money.
In recent times, the decentralised financial system has exhibited rapid growth. DeFi products like Compound and Aave have gained enormous popularity. Combined with other DeFi protocols, they have taken the net value locked in DeFi across $6.5 billion as of the time of writing.
While still of an “insignificant” size compared to our massive banking system, DeFi holds huge potential. Today, many DeFi projects offer high-value financial products that strongly challenge similar products in the traditional industry.
- Lending and borrowing
Lending and borrowing are the most widely implemented use-case of DeFi. Contrary to the lengthy process of obtaining loans from banks, DeFi protocols make lending and borrowing a simple, fast, and peer-to-peer process.
Anyone on the network can become a lender and start lending cryptocurrencies for a specified interest rate. People willing to take loans can then opt for cryptocurrency loans by collateralising an amount as proof that they are capable of paying back the amount.
Compared to most U.S. banks that today offer an interest rate close to 0.1%, most DeFi protocols can offer rates above two percent, making them more profitable.
- Yield farming and flash loans
Yield farming is a subset of DeFi lending and borrowing where users deposit funds into the most profitable crypto pools from time to time to make the most profits off of it.
Another part of the DeFi lending and borrowing are flash loans. They allow users to take instant loans for a single transaction. However, they must be able to pay back the principal amount before the transaction ends otherwise the smart contract will reverse the transaction as if the loan never happened.
- Decentralised exchange (DEX)
Decentralised exchanges are an extremely useful part of the DeFi system. They facilitate the trading of crypto assets without the need of brokers. Dubbed DEX, they remove any major transaction costs and brokerage fees, thus making crypto trading a lot cheaper compared to centralised exchanges.
- Cryptocurrency derivatives
In the traditional sense, derivatives are financial products that derive their value from underlying assets such as stocks, bonds, cryptocurrencies, et cetera and help traders reduce or mitigate their risks.
Recently, crypto derivatives such as futures, forwards, swaps and options have made it big in the market. They alone account for almost $968 million of the total value locked in DeFi.
Crypto derivatives make the volatile crypto markets more lucrative for traders looking for reduced risks. At present, the most famous crypto derivative platforms are Synthetix and dYdX.
Although DeFi offers eminent use cases, we cannot fully trust the DeFi ecosystem as it is in its experimental phase. It is still liable to major hacks and thefts and people must be wary of the risks of putting any amount into DeFi protocols. However, with the current progress rate, we are likely to see things improve for the DeFi industry in the near future.