An emerging star in the vast universe of cryptocurrency, Decentralized Finance or DeFi, as it is widely called, stands to create a big revolution in the ever-growing crypto industry.
DeFi – The Whats and Whys?
Based on the Ethereum platform, Decentralized Finance (DeFi) is defined as a newer subset of financial products comprised of independent automatic products built on blockchain and governed by a smart contract in place.
Smart contracts comprise the code containing the terms of the agreement that are executed automatically. Their digital form usually includes encoded contacts, with the help of which parties anonymously execute traceable but irreversible transactions.
The main aim of DeFi is to turn the entire financial industry into a decentralized form; where the control doesn’t lay in the hands of a select few, for example as in the case of traditional banks. It discourages custody of currencies, which means that individuals investing in them have complete control over their financial assets.
Putting in simple words, DeFi is to bank credit as Crypto is to paper currency. DeFi provides an outlet for accessing seamless credit in a decentralized manner for those who cannot access credit in a traditional form otherwise due to any reason. While it comes with its own set of risks, it looks promising as an equitable, transparent, and flexible form of finance.
Let’s glance at an example of how significant the growth of Ethereum had been in the past few years:-
How does DeFi work?
On the Ethereum platform, DeFi allows users to trade, obtain loans, earn interest on credit lent, and much more using existing blockchain technology in place. Users can purchase DeFi coins/tokens as a store of value, and they can also transfer funds within a matter of minutes. Any middleman charges or fees are eliminated that are otherwise charged by financial entities for the services they provide in a centralized finance organizational setup.
DeFi uses a host of arrangements such as security protocols, connectivity, software & hardware utilities through using peer-to-peer financial networks. A common database is distributed for access across various locations by collection and accumulation of data from all users and uses a consensus mechanism to verify the same.
Through the use of existing blockchain technology, transactions are recorded in blocks and then simultaneously verified by other users. If the verifiers agree on a certain transaction, the block is encrypted by closing it and another block is created that has information about the previous block in it.
Some DeFi coins grant the holder certain managerial rights. Some others could be staked to earn an income by trading them within a short timeframe. Lastly, some tokens can also be burned i.e. destroyed at regular intervals, which reduces the overall supply and functions similar to a share buyback in the stock market.
Benefits of using DeFi
DeFi comprises a major component which is - Peer-to-peer (P2P) financial transactions. A P2P DeFi transaction is one wherein two parties agree to exchange cryptocurrency for goods or services without the interference of a third party.
In the case of DeFi, the very nature of P2P lending can meet an individual's loan needs. The algorithm matches the peers that are convinced to agree on the lending terms mutually decided, after which a loan is issued. Payments made from P2P transactions are carried out via a decentralized app and the same process is followed for subsequent transactions in the P2P network.
Some benefits of using DeFi for lending are enlisted below:-
- DeFi platforms don't rely on a centralized financial institution network and hence are not subject to any adversities. The decentralized nature of DeFi mitigates much of the risk of bankruptcy.
- DeFi enables the parties to directly negotiate interest rates amongst themselves and lend money via DeFi networks at terms mutually agreeable to both parties involved.
- Smart contracts published on a DeFi network and records of completed transactions are available for review but do not reveal the person’s identity. Such transactions are immutable, meaning they cannot be changed upon completion.
- Anyone with a stable internet connection has access to a DeFi platform and transactions can occur seamlessly with no geographic restrictions.
Total Value Locked (TVL) – Explained
Total Value Locked (TVL) is the total sum of all cryptocurrencies mortgaged, loaned, deposited in a pool, or used for other financial actions across all of the DeFi network. It can also represent the total sum of specific cryptocurrencies (e.g.:- ether, bitcoin, etc.) used for financial activities.
In simpler language, TVL is the numerical indicator of how much value people are willing to lock up in DeFi contracts. The higher the TVL, the more confidence people have in DeFi and vice versa. The more money gets frozen in DeFi, the more potential exists for the stable growth of the DeFi network.
An example of the TVL trends can be observed as follows:-
It is also a measure of the total funds locked up in smart contracts; and is inclusive of all the coins deposited in all the functions that DeFi protocols have to offer - including staking, lending, and pooling of liquidity. TVL figures are closely watched by market analysts as a barometer of investor confidence in the overall DeFi ecosystem. Hence, one also needs to keep in mind the TVL of a DeFi before investing.
How to invest in DeFi coins?
- Select a virtual wallet: - The user first has to choose a crypto wallet. A wallet is a medium through which DeFi coins can be stored, sent, and received. Wallets are available in all formats nowadays, with a few of them also integrated with exchanges where you can purchase DeFi coins.
- Purchase of DeFi coins: - The user needs to add DeFi coins to his portfolio by making a payment for the same and it gets added to this wallet.
- Participation in a DeFi Protocol: - The users are enabled to both borrow and lend assets without losing custody of the coins in their wallet already purchased earlier.
- Invest in DeFi indexes: - Similar to how ETFs in traditional finance function, DeFi indices invest in different virtual assets according to pre-set conditions.
- Staking and Farming: - Staking is the process of locking DeFi assets in a smart contract and getting returns on it with the same tokens. DeFi yield farming involves taking action for an existing DeFi protocol, get another token for that action, and then stake that token instead of staking a single asset.
An example of staking in a DeFi-enabled software can be seen for reference: -
The user also needs to pay transaction fees in the native cryptocurrency of the blockchain involved.
The Bottom Line
As a part of a well-diversified portfolio - DeFi coins shall become an integral part of an investor’s portfolio sooner than one can imagine.
DeFi hence has become an emerging financial technology that challenges the current status quo of the prevalence of a centralized banking system. It eliminates the fees that banks and other financial companies otherwise charge for their services and enhances the use of P2P transactions for debt financing in a much more futuristic way.