What Are DeFi Tokens? Know About Blockchain-based Decentralized Finance

With the advent of anonymity, the blockchain-based coins known as the cryptocurrencies or crypto coins have gained immense importance. The initial cryptocurrency was Bitcoin (BTC). However other crypto coins or digital assets like Monero (XMR) and Litecoin (LTE) followed the path. Currently, there are numerous options to choose from. The DeFi tokens are digital currencies but differ from the usual cryptocurrencies. 

In This article, we will learn about DeFi and its tokens in detail. We will try to explain everything is a lucid language that is easily understandable by both the beginners and the intermediates. 

What Is DeFi? How Does It Work?

DeFi is the abbreviated term for Decentralized Finance. DeFi can be termed as a digital financial system operating independently and is autonomous. Meaning, that it does not include the centralized financial intermediaries. 

Now, what are centralized financial intermediaries? The centralized financial intermediaries are credit unions, banks or the insurance funds. The centralized platforms can be managed by a group of people or an individual usually within the jurisdiction of a Fintech company or financial technology. 

Decentralized finance utilizes a set of smart contracts and algorithms for executing its functions. Smart contracts are automated agreements that do not require any centralized financial intermediaries such as banks or related institutions. They utilize blockchain technology and run on the Ethereum network. Ethereum is a DIY platform for the decentralized programs or Dapps whose own currency is Ether (ETH). The Ethereum accounts can hold funds and additionally can send or refund them based on specific conditions. When smart contracts are live, it is impossible for anyone to alter that and thus, it will always run as it had been programmed.

Take for example, there are two accounts – Account “X” and Account “Y”. On a particular day every week, a certain sum of money is transferred from Account X to Account Y. This will continue to happen as long as Account X has sufficient funds to transfer to Account Y. It is impossible for one to change the smart contract and add another Account “Z” as a recipient for stealing funds.

The smart contracts are also made public for anyone who can inspect and audit. This implies that the bad contracts will mostly come under the community scrutiny very easily. This indicates that presently there is a need to rely on the Ethereum community capable of reading codes. The open source based communities aid in keeping the developers in check. But, over time this need will diminish as the smart contracts become much easier to read and alternate ways of proving trustworthiness of codes are developed.

What Are The Key Benefits of DeFi?

There are basically five major benefits of DeFi:

  • Security: On splitting up everything, the system tends to lose many of its weak points receiving several redundancies.
  • Cost-Effectiveness: As the Dapps is capable of offering services autonomously, they offer them at a much cheaper rate than their central equivalents.
  • Programmability: The highly programmable smart contracts automate the execution enabling curation of digital assets and new financial instruments.
  • Immutability: Security and auditability gets increased using tamper-proof data coordination across a decentralized architecture of a blockchain.
  • Transparency: Every transaction on the public Ethereum blockchain is broadcasted to and verified by the other users on the same network. This transparency level involving the transaction data permits rich data analysis and ensures that the network activity is available to all users.
  • Interoperability: The composable software stack of Ethereum ensures that DeFi applications and protocols are built to complement and integrate one another. DeFi offers the product and developing teams to enjoy the flexibility for building on top of existing protocols, integrate the third-party applications and customize the interfaces. 
  • Permission-less: Anyone can access the DeFi applications built on the Ethereum if they possess a crypto wallet and an active internet connection. Often they do not require any minimum funds or a specific geographical location to start with. This is impossible with traditional finance. DeFi is open and permissionless.
  • Self-Custody: The permissionless financial protocols and applications require Web3 wallets to interact. The participants of the DeFi market always keep custody of their stored assets and even control their personal information.

Why Is Ethereum The Perfect Foundation For DeFi?

Quite a few number of reasons support the fact that Ethereum is the apt foundation for DeFi. Below are the best reasons:

  • Ethereum is autonomous, meaning that it is not owned by any group, organization or individual. This states that no one has the rights and scope to alter the rules on you.
  • The DeFi products are all based on Ethereum. This ensures that all the products work simultaneously and seamlessly. It enables you to lend tokens from one platform and exchange the tokens with interest in a different platform or market on a completely different application. This is equal to cashing out loyalty points at your bank.
  • The cryptocurrency and tokens are built into Ethereum, which is a shared ledger that keeps track of the transactions and the ownership.
  • Ethereum permits the complete financial liberty which means that most of the products will never take over the custody of your funds and thus leaves you in control.

DeFi can be assumed in various layers such as – 

  • Blockchain: Ethereum bears the transaction history along with the state of accounts.
  • Assets: Ether (ETH) and other currencies or tokens.
  • Protocols: The smart contracts that furnishes the functionality such as a service that permits decentralized lending of assets.
  • Applications: Products we utilize for managing and accessing the protocols. 

What Activities Can You Perform With DeFi?

DeFi is a decentralized alternative for most financial services. However, Ethereum also curates opportunities for constructing brand new financial products and the list is ever-growing:

  • Access Stablecoins: Volatility of cryptocurrencies is problematic for many of the financial products and general spending. The DeFi community has completely solved this with the help of stable currencies or stablecoins. Their value remains pegged to another asset, commonly with a popular fiat currency such as dollars. Stablecoins such as Dai or USDC possess a great value that remains within a few cents of a dollar. This makes these coins perfect for retail or earning. Many Latin American people had used the stablecoins as a means of protecting their savings when there is uncertainty with their government-issued fiat currencies.
  • Borrow Funds With Collateral: Borrowing currencies from the decentralized providers mainly comes in two varieties –
      1. Peer-to-Peer which means that a borrower will directly borrow from a specific lender.
      2. Pool-based enabling the lenders to provide liquidity or funds to a pool from where the borrowers can borrow.

In today’s scenario, borrowing and lending money revolved around the individuals who are involved. The banks require you to know if you are willing to repay a loan before you lend. The decentralized lending performs without both of the parties having to identify themselves. Instead of this, the borrower needs to put up collateral for the lender to receive automatically if they fail to repay their loans. Some of the lenders do accept NFTs as collateral. NFTs are usually a deed to a unique asset. This permits one to borrow money without the need for credit checks or handing over the private data.

  • Borrow Funds Without Collateral: These are basically flash loans that are more experimental for the decentralized lending that permits you to borrow without the collateral or offering any personal information. These are not broadly available to the non-technical people at the moment. But they give an insight that it might be available to everyone. It works on the simple logic that the loan is taken out and repaid within the same transaction. If the repayment could not be completed, the transaction reverts back and poses as nothing has happened. 

The funds that are mostly used are held in the liquidity pools, which are big pools of funds utilized for borrowing. If these funds are not used at a given period, it creates an opportunity for someone to borrow these funds and conduct businesses with the funds. They repay them in full literally at the same time they are borrowed. This indicates that a lot of logic is included in  bespoke transactions. 

A simple instance to this might be that someone uses a flash loan to borrow the required asset at one price so that they can sell it on a different exchange where the price is relatively higher. 

Thus, in a single transaction, the following thing occurs:

  1. You borrow ABC amount of $asset at $1 from exchange “X”
  2. You sell the ABC $asset on exchange “Y” for $1.10
  3. You repay a loan to exchange “X”
  4. You hold the amount (profit minus the transaction fee).

In case, the exchange Y’s supply drops surprisingly, the user would not be able to purchase enough to cover up the actual loan and that the transaction will fail.

In the traditional finance system, to conduct such a transaction one would require an enormous amount of money. However, these money-making strategies are solely accessible to those having existing wealth. The flash loans are a better example of a future where possessing money is not a necessary prerequisite for making money. 

  • Commence Crypto Savings: Two segments combined form the crypto savings viz., lending and no-loss lotteries.
    1. Lending – You can have an opportunity to earn interest on your cryptocurrencies by lending it and experiencing your funds to grow in real-time.The interest rates are much higher than that of your local banks.
    2. No-Loss Lotteries – PoolTogether, a no-loss lottery is an innovative and fun way to save your money. The prize pool gets generated by all of the interests generated via lending the ticket deposits.
  • Expand Your Portfolio: The fund management products on Ethereum try to grow your portfolio depending on your chosen strategy. This is open-source, automatic and does not require a human manager to take a cut from your profits. One of the best examples is the DeFi Pulse Index Fund (DPI). This fund rebalances automatically ensuring that your portfolio includes the top tokens from DeFi by the market capitalization. Thus, you never have to manage the details and you may go ahead to withdraw the funds whenever you feel like.

Disclaimer: Read the complete disclaimer here.

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