The DeFi Deep Dive
So far in our Ethereum series we’ve talked about the origins of the Ethereum network, as well as its purpose and overall value in the crypto ecosystem. This platform allows for decentralized applications to be built on top of the blockchain — extending the possibilities of ownership, creativity and finance in the digital world further than ever before.
We’ve also discussed smart contracts, promises forged in immutable code that allow for agreements to be made outside the influence of humans (often on Ethereum). These concepts will all form a bridge to the next topic at hand: how DeFi operates and what that means for society.
What Makes DeFi Different from Traditional Finance?
Decentralized Finance, in its simplest form, refers to financial behaviors and structures that are situated outside of centralized institutions (like banks, governments and people in general). In the systems most people are currently used to, banks are not just a place to put your money; they’re the custodians of it, which means they can technically limit your abilities, place costs on certain fiscal actions and even manipulate monetary behavior. Yet most of us have grown so used to these traditional methods that we couldn’t picture it operating any differently.
In tech and crypto spheres, there’s a phrase often tossed around that goes something like, “code is law.” The impact and responsibility of software is now so profound that it can shape human capability and restraint, and this verbiage serves as a reminder that decentralized technology uses protocols to stand in for the institutions themselves.
So those smart contracts we spoke about earlier — they’re part of the package that can allow financial transactions and decisions to operate outside of banks and the Fed. Together, blockchain technology, cryptography and smart contracts form the foundation for DeFi.
Arguments for DeFi versus traditional, centralized finance? It has levels of censorship resistance. It’s cheaper and often faster. DeFi can also be made more accessible to the general public, and no one bank or business sets the rules (note: this one’s a slippery slope, since dApps are often built by people — and Proof of Stake could shape a less-than-equal playing field).
DeFi Put Into Practice
So what are some examples of financial practices and behaviors that may operate differently in a decentralized setting?
TRADING + EXCHANGES
We’ve heard of centralized exchanges like Gemini, Coinbase and Kraken. But there are also decentralized ones, where individuals can pool money without the need for a bank or institution. The use of immutable code is more prominent on DeFi platforms, and that code is therefore accessible to everyone. These exchanges — like Uniswap and SushiSwap — also offer a larger selection of tokens than centralized platforms do.STABLECOINS
Stablecoins are a type of cryptocurrency tied to an external reference (like fiat, crypto or an exchanged commodity). The value is then backed by the asset to which it’s matched. As demand increases, new stablecoins can be minted to stabilize the price.
An example of this would be Tether, a coin pegged to the US dollar (each worth 1.00 USD). Stablecoins are supposed to provide a reliable way to trade outside of a centralized exchange. However, having many unregulated stablecoins in circulation could make it difficult to discern whether they’re truly backed when they say they are.LENDING + BORROWING
When we lend and borrow money, institutions and legal systems are all part of the process. Banks and investors can be as selective as they want with their decisions. With smart contracts, these processes can be automated.Aave and Compound are two examples of open source and non-custodial protocols that run on Ethereum. They allow users to earn interest on deposits and borrowed funds, with no human intermediary.
A person can borrow against their assets to pay back a loan, and if they’re lucky, they might accrue money if the crypto backing it has risen throughout this time. These loans can be collateralized against stablecoins or other cryptocurrencies whose prices fluctuate.
FINANCIAL PRODUCTS
With DeFi, traditional financial products can be remixed to the tune of a smart contract, removing large institutions and operating on fixed protocols instead. One example here would be insurance. Smart contracts could be used to substitute code for the insurance company itself, allowing all parties to insure their assets with fewer people involved, and potentially save some time. Funds are allocated exactly as specified in the contract. As discussed in an earlier newsletter, there are lots of factors that can be considered (like Oracles) to ensure accuracy.
The Wrap-Up
From flash loans to margin trading, this list only skims the surface of DeFi possibilities…but we’ll pause here for now.
The takeaway is clear: DeFi continues to make waves in both crypto and traditional sectors. As blockchain technology and decentralized innovation create unique financial opportunities, digitalization will continue to change how we all do business. With the help of smart contracts and the Ethereum network, DeFi is well on its way.
Still, it’s important to consider the steps society will need to take in order to bridge current habits and customs with this fast-paced tapestry of tech — and the choices we each can make on a personal level to bring us closer to financial freedom.