Decentralized Finance

Why is DeFi important?

DeFi is important because it represents a paradigm shift in the way we think about financial infrastructure. For the first time, users can access a wide range of financial services without having to trust a centralized institution. This has the potential to upend traditional finance. It also has the potential to provide financial inclusion to billions of people around the world who have been excluded from the traditional financial system.

In traditional finance, financial institutions like banks act as intermediaries between savers and borrowers. This centralized model is inefficient and prone to counterparty risk. In a decentralized system, however, there is no need for a central intermediary. Instead, transactions are carried out directly between users (peer-to-peer) without the need for a third party.

By moving financial services to blockchains (such as Ethereum), DeFi protocols can offer a number of advantages over traditional finance:

• First, reduced counterparty risk: Without a central intermediary, there is no single point of failure.
• Second, increased security: Decentralized applications are often built on top of Ethereum smart contracts, which provide a high degree of security.
• Third, improved transparency: DeFi protocols offer transparency and auditability that is not possible with traditional financial systems.
• Lastly, improved accessibility: DeFi protocols are available to anyone with an Internet connection.

Decentralized Finance Benefits

DeFi benefits are not just theoretical — they are already being realized by users today. For example, MakerDAO is a protocol that allows users to collateralize Ethereum and mint stablecoins. This has enabled users to hedge against the volatility of Ethereum and other cryptocurrencies. It has also provided a way for people to access US dollars without having to go through a traditional bank.

Here are some of the ways people are using DeFi today:

• Lending and Borrowing. Users can lend or borrow funds using protocols such as MakerDAO, Compound, and dYdX. These protocols use smart contracts to automate the process of lending and borrowing, which allows users to do so without having to trust a centralized party.
• Hedging Against Cryptocurrency Volatility. Protocols like MakerDAO and Synthetix allow users to collateralize their cryptocurrencies and mint stablecoins. This can be used to hedge against price fluctuations.
• Accessing Loans and Borrowing. Platforms like Compound and dYdX allow users to use their cryptocurrencies as collateral to take out loans or to borrow against them.
• Trading and Investing. Protocols like Kyber Network and 0x allow users to trade a wide range of assets in a decentralized manner. These protocols can also be used to access liquidity for investments.

How does DeFi work?

DeFi protocols typically make use of smart contracts to automate the process of lending, borrowing, and trading. Smart contracts are self-executing agreements that are written in code and stored on a blockchain. For example, a lending protocol built on Ethereum could use a smart contract to automatically lend out money to borrowers and collect interest payments. This all happens without the need for a centralized authority, such as a bank.

Because DeFi protocols are built on blockchains, they can take advantage of the existing infrastructure. This includes its decentralized network of nodes, its decentralized storage (IPFS), and its decentralized computing (for example: Ethereum Virtual Machine). This infrastructure enables DeFi protocols to offer a wide range of features, including:

• Censorship Resistance. First, DeFi protocols are built on a decentralized network making them resistant to censorship from central authorities.
• Fraud Prevention. Second, because smart contracts execute automatically and cannot be altered, they are resistant to fraud.
• Security. Third, DeFi protocols make use of a blockchain’s decentralized infrastructure and thus benefit from the security that this provides.