DeFi stands for decentralized finance. The basic idea behind this emerging blockchain use case is to take the concept of decentralization that underpins Bitcoin and apply it to all other areas of finance. While Bitcoin has enabled an open, incorruptible monetary system, DeFi apps build on top of that with other use cases like borrowing, lending, exchanging, and more in a similarly permissionless manner. In other words, DeFi is about more than just buying and holding some crypto bought from a BTC ATM.
The concept of DeFi came to prominence in 2020. Especially as the crypto market began to recover from the bear market of 2018-2019. Much of this activity was taking place on Ethereum at the time. However, other chains, such as BNB Chain and Solana, have also seen the development of their own DeFi apps. Contrary to popular belief, these decentralized finance apps are being built on top of Bitcoin as well.
DeFi was a key component of the 2020-2021 bull market in crypto alongside stablecoins and non-fungible tokens. And many experts see this as one area of crypto that will be able to survive over the long term.
The Benefits of DeFi
So, what are the key benefits of DeFi applications over the traditional financial system? One benefit of DeFi is there is no need to create an account at a highly regulated financial institution. Due to the Know Your Customer (KYC) and anti-money laundering (AML) regulations exchanges, BTC ATMs, and other centralized institutions must follow, many users will find it difficult to create an account. That is, if they’re able to create an account at all. In DeFi, you’re able to interact with financial apps directly from your crypto wallet without anyone’s permission. Additionally, DeFi works in a non-custodial manner. This means you’re always in control of your money and you can access it 24 hours a day, 7 days a week.
Due to the lack of KYC and AML compliance at the protocol level, it’s also possible to use DeFi in a pseudonymous manner. That said, you should not participate in DeFi under the assumption that your activities are completely anonymous. Blockchain analytics firms track as much as they can on Ethereum and other blockchains. On top of that, the account-based model used by Ethereum and other chains that use the Ethereum Virtual Machine (EVM) to create DeFi apps tends to lead to worse privacy than the UTXO-based model used in Bitcoin. TMany DeFi users also effectively dox themselves through the use of .eth domain names.
Popular DeFi Apps/ BTC ATMs
The concept of DeFi is only a few years old. However, you can already replace most of the functions of a traditional bank with an app built on top of a blockchain. In most cases, the point of the DeFi app is to allow some users to earn yield on their crypto holdings.
For example, Aave allows users to borrow or lend their crypto assets directly from their crypto wallet. Users are able to place stablecoins, ether, wrapped bitcoin, and a variety of other assets into the Aave protocol, and then other users are able to borrow those coins at an either fixed or adjustable rate of interest. Since there is currently no form of judging credit worthiness on the blockchain, borrowers must be willing to put down collateral to back their loans. If a borrower defaults on their loan obligation, then the collateral can be seized by the protocol and awarded to the lender.
Another popular DeFi app is an exchange known as Uniswap. Users are able to use this app to either trade against a wide variety of ERC-20 tokens. They can also provide liquidity to those who wish to make trades. The most popular trading pairs on this platform and other decentralized exchanges tend to be those that involve ether and a stablecoin.
Popular DeFi Apps/ BTC ATMs Continued
Another popular application of DeFi is derivatives trading. This effectively allows a user to tie the value of a particular crypto asset. For example, as ether or bitcoin, to a real world currency or stock. It’s basically a way to place bets on traditional financial assets in a more decentralized way. A way where there is still a degree of censorship resistance taking place. Synthetix is one of the most well-known projects that operates in this niche.
Another key aspect of DeFi is the ability for projects to reward early users of an app with governance tokens. Those who are providing liquidity to various DeFi apps get a reward of governance tokens for the related app. This tends to increase the yield that users are able to generate in the early days after a DeFi application’s official launch. However, the sustainability of this model is unproven. The direct relationship between a governance token’s value and the popularity of a DeFi app is not an exact science.
The Problems with DeFi Today
DeFi still is very much in the early days of development. One should still view it as a generally risky aspect of the overall crypto ecosystem. There are many areas of centralization that have crept back into DeFi protocols. Whether it be through a higher degree of centralization at the base blockchain layer or an over-reliance on centralized stablecoins. Much of this DeFi activity may need to be moved off chain for these sorts of applications. Especially for them to become more scalable and private. DeFi is much more complex. It is more than buying bitcoin at a BTC ATM, but it’s also an exciting area to watch in crypto.
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