What is DeFi? Will it replace traditional finance?

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12 Jan 2024

The emergence of blockchain means that we no longer need to rely on centralized institutions such as "traditional banks" for asset transfers. Instead, we can realize the ideal of "finance without borders" through the blockchain-driven DeFi decentralized financial system. What exactly is DeFi? What is decentralized finance? What are the common DeFi applications? Let's keep looking.

What is DeFi?

The full name of DeFi is Decentralized Finance. Unlike traditional finance that relies on the operation of centralized institutions, Defi can automatically perform financial services such as transfers, transactions, and loans to achieve a decentralized financial system.

In the transaction process of users using DeFi, there is no intervention by centralized institutions (such as banks, governments, securities firms) or manual review. It is an open, transparent and borderless financial service that anyone can participate in.

How does DeFi work?

≣ What is a smart contract?

Smart Contract is a program code on the blockchain. When specific conditions on the program code are met, the corresponding action will be automatically executed, which is very similar to the operation of a vending machine.

Imagine that when you go to the vending machine, you see some delicious snacks or drinks, and then you put in coins and select the product, it is like "specific conditions are met" of the smart contract, and you pay the fee , letting the machine know you want to buy something.

Next, the vending machine starts working. It checks whether the amount you invest is enough, and then distributes the corresponding products based on your selection. This is like a smart contract that "automatically executes corresponding actions." The machine automatically performs the results you want based on your operations.

In general, smart contracts and vending machines operate in similar ways. The former runs on the blockchain, with specific conditions set in advance. When these conditions are met, corresponding actions will be automatically performed; the latter automatically sells goods based on consumers' coin input and selection. This automated mechanism gives smart contracts the ability to implement various interesting functions on the blockchain.

≣ How DeFi works

Now that we understand what a smart contract is, let’s take “lending” financial services as an example to explain how DeFi operates.

Suppose there is a DeFi lending platform that allows users to freely borrow or lend cryptocurrencies without relying on traditional banks or financial institutions as middlemen. The platform uses smart contracts - which clearly define the rules and conditions for both borrowers and lenders, such as interest rates, terms, etc. - to automate the lending function.

A wants to borrow 10 Ether coins.
B is willing to lend 10 Ether coins.
Both A and B have established accounts on the platform and deposited their guaranteed funds (margin, collateral) into the smart contract.

The execution process of the smart contract is as follows:

A initiates a loan request on the platform, borrows 10 ETH, and agrees to repay the principal with interest within a certain period of time according to a certain lending rate.
The smart contract automatically checks whether there is enough margin in A's account to borrow 10 ETH. If the conditions are met, the contract will be executed.
The contract transfers 10 ether from B's account to A's account, while locking the collateral provided by A in the contract.
During the term of the loan, A must pay interest and repay the principal to B. Once the repayment is overdue, the smart contract will automatically implement corresponding punitive measures, such as confiscation of the deposit.

In this case, the smart contract acts as an intermediary in the lending process, automatically executing the lending transaction without the involvement of a third party. This makes the lending process more efficient and transparent, and there are no potential trust issues during transactions.

The difference between DeFi and CeFi

The concept opposite to DeFi is called CeFi (Centralized Finance). The biggest difference between the two is that "the objects of trust are different."

CeFi operates based on people's trust in centralized institutions. For example, in traditional finance, we need to rely on centralized institutions such as banks and governments as third parties to use various financial services.
DeFi operates based on blockchain smart contract technology. The basis of trust comes from code (code is law) and does not require a centralized organization to use financial services.

Let us also use "lending" to compare the differences between DeFi and CeFi:

≣ CeFi Advantages and Disadvantages

Centralization ❌ The lending services of traditional banks require the participation of middlemen (such as the Joint Credit Information Center), which results in higher transaction costs.
Cumbersome application process ❌ Traditional bank loans may require filling in a large number of forms and documents, which increases the processing time and procedures.
Geographic limitations ❌ In some areas, especially developing countries, it may be difficult for people to access the services of traditional banks.
Security ⭕️ Traditional banks are regulated and have a long-term and stable operating history, providing higher security.
Credit Rating ⭕️ Traditional banks usually have a complete credit rating system and provide more suitable lending conditions based on the customer’s credit status.
Customer Service Support⭕️ Traditional banks provide dedicated customer service support departments to help customers solve various difficult problems.

≣ DeFi Advantages and Disadvantages

Decentralization ⭕️ Through pre-defined rules and conditions, smart contracts can automatically execute all transactions without the intervention of intermediaries, which brings greater autonomy and transparency; it also saves the fees charged by middlemen during transactions.
Low participation threshold ⭕️ Compared with traditional banks, using DeFi services does not require cumbersome form documents, identity verification and other requirements, and users can participate easily.
Openness (no borders) ⭕️ Anyone can join and use the DeFi platform freely and equally.
High Liquidity ⭕️ Due to the borderless nature of DeFi, users around the world can trade on the DeFi platform 24/7, which provides higher liquidity.
Technical Risk ❌ Smart contracts may have loopholes, leading to potential loss of funds. In addition, due to the lack of supervision by a central agency in DeFi, once something goes wrong, users usually have no recourse, further increasing risks.
Regulatory Compliance ❌ Currently, the DeFi field faces regulatory challenges, and a lack of compliance may lead to legal risks, thereby limiting the widespread adoption of DeFi.
The operation is not easy ❌ For newbies in the currency circle, using the DeFi platform is a relatively advanced operation, including hot wallet management, smart contract signing, etc., which is difficult, let alone users who have never been exposed to cryptocurrency.

≣ DeFi value one: decentralization

DeFi does not rely on the operation of centralized institutions, but automatically executes transactions and services through smart contracts, which eliminates trust issues and effectively reduces the costs and risks caused by centralized operations. More importantly, since the intermediate costs of centralized institutions are eliminated, the profits generated by all financial services can be returned to the users who provide value, allowing users to enjoy the benefits they deserve.

≣ DeFi value two: global (open, transparent)

Regardless of nationality, race, gender, age, class, wealth or political stance, everyone has equal rights to use DeFi, and no one is excluded; in addition, all transactions and contracts are public and anyone can view and Verify transaction data on the chain, which increases the transparency and security of the system.

≣ DeFi value three: low cost, high efficiency

DeFi removes the costs and fees incurred by many centralized institutions and provides lower-cost transactions and financial services. And the Defi system operates through smart contracts, so users can conduct transactions at any time, which improves the liquidity of assets and greatly improves market efficiency.

≣ DeFi value four: financial innovation

The development of DeFi has also spawned a wave of new financial products, such as Liquidity Collateral Derivatives (LSD) and the Real World Assets (RWA) track. These innovations allow more value to enter the DeFi ecosystem.

In terms of the value of RWA, the biggest benefit is to increase the market liquidity, usage efficiency and transparency of assets.

Whether it is gold, real estate, debt, art or ownership, these tangible or intangible values can be represented in the form of tokens on the blockchain. For example, in July 2023, a holder of the luxury brand "Patek Philippe" mortgaged his watch and turned it into a tokenized debt certificate. In this way, he successfully borrowed a loan of US$35,000 from a stranger, similar to the blockchain of pawnshop transactions.

This initiative not only provides creditors with more diverse ways to recover funds, but also demonstrates the practical application potential of "asset tokenization" to everyone.

The four major tracks of DeFi applications

≣ DeFi Track 1: Decentralized Exchange (DEX)

【Decentralized Exchange】

Decentralized exchanges are an important member of the DeFi ecosystem. These exchanges are built on the blockchain and use smart contract technology to allow users to conduct transactions without the need for third-party intermediaries.

In DEX, there are multiple trading pools, and the liquidity of these pools is provided by users. We use the term “swap” to describe the act of exchanging cryptocurrency to these pools, which is different from traditional pending order transactions:

Users can directly exchange coins in the trading pool to complete the transaction "instantly" without waiting for confirmation from the exchange.
Moreover, the handling fees when exchanging coins will also be "allocated" to users who provide liquidity to the pool.

💡 Provide liquidity

Adding cryptocurrency to the trading pool of a centralized/decentralized exchange so that other users can exchange coins on the platform is called "providing liquidity" or "adding liquidity".

[Uniswap, the leading decentralized exchange]

Uniswap is built on the Ethereum blockchain and is the largest decentralized exchange (DEX) in the entire cryptocurrency industry.

This DEX faucet was created by Hayden Adams, a former Siemens mechanical engineer, in November 2018.

On Uniswap, there is a group of liquidity providers who put cryptocurrencies into Uniswap, thus establishing one trading pool after another, allowing buyers to trade easily because they do not need to find matching buyers in the spot market. home or seller.

Unlike traditional markets that require "order books" to wait for transaction matching, Uniswap uses a technology called "Automated Market Maker (AMM)", which is a smart contract that can adjust the price of tokens according to specific rules, allowing users to Can be freely exchanged between different currencies.

Uniswap is very decentralized. Anyone with sufficient liquidity can list their own tokens on Uniswap without paying any listing fees.

≣ DeFi Track 2: Liquid Staking

【Liquidity Staking】

Staking is a mechanism for participating in the operation of cryptocurrency. Users lock the tokens they hold to the blockchain validator (Validator). On the one hand, they contribute to "maintaining the security and efficiency of the blockchain" and at the same time, they can also earn money. Get rewards, usually in the form of the blockchain’s native cryptocurrency.

≣ DeFi track three: Lending Protocol

【Loan Agreement】

Protocol refers to a market or tool that uses smart contracts to provide decentralized transactions.

The DeFi lending protocol uses smart contracts to replace banks as the intermediary between borrowers and lenders, allowing users with idle funds to lend funds and earn interest. Users who need funds can successfully lend funds at the cost of a certain interest.

Users who want to participate in the lending agreement first deposit cryptocurrency into the DeFi platform as a guarantee. The smart contract automatically matches the borrowers and lenders based on the previously defined rules and conditions, and directly issues loans to borrowers who meet the transaction conditions, without the need for banks or other parties. Involvement of intermediaries.

Common lending protocols are Aave and Compound.

[Leading Lending Agreement: Aave]

The Aave protocol is the largest DeFi lending protocol on Ethereum.

Aave was founded by Finnish Stani Kulechov in 2017 (then named ETHLend) and was officially launched on the Ethereum blockchain in January 2020; in the traditional financial system at that time, lending services were often stuck with many thresholds and The middle steps include high interest rates, expensive handling fees, and cumbersome documentation requirements. These restrictions make it difficult for many people to easily obtain fair and reasonable lending services.

The emergence of Aave is to solve these problems. Borrowers can be automatically matched directly with fund providers (lenders) without going through banks or other intermediaries. This makes the lending process faster and more convenient, and can obtain more Competitive interest rates and low fees - Aave's purpose is to establish a fairer, transparent and open Defi lending protocol structure. This spirit is also reflected in its logo, which is a "ghost" pattern.
Aave is famous mainly because it pioneered the "flash loan" service, which allows users to borrow money without providing collateral. They only need to complete the repayment of the loan principal and interest in the "same block". You can conduct transactions smoothly.

💡 Flash loan
Flash loan is a new type of unsecured loan
in the world of decentralized finance . It was launched by Marble in 2018 and later popularized by Aave and dYdX. Its features are:

1. No collateral : The borrower does not need to provide collateral.
2. Loans are fast and instant : Borrowing and repayment are both in the same transaction and must be completed within one block time, otherwise the transaction will be revoked.
3. Completed through smart contracts : The specific terms of the flash loan are set by the program code and the loan is carried out.

In a typical lending relationship, collateral exists to ensure that the borrower can repay the loan. In most DeFi lending projects, there is no KYC and borrower risk assessment by traditional banks, and there is no joint credit agency to investigate the borrower's credit. Therefore, the way to ensure that the borrower can repay is to require it to provide a loan that is greater than the value of the loan. Collateral, commonly known as "over-collateralization".

There is no collateral in flash loan services, so is there a way to ensure that borrowers can repay smoothly? Blockchain technology makes this possible: because blockchain transactions must be confirmed after miners include the transaction in the block, put the block on the chain, and most nodes accept the block.

This means that everything can be revoked before the transaction is successfully uploaded to the chain; flash loans use this mechanism to require that borrowing and repayment must be uploaded in the same block in the smart contract, solving the problem of repayment The problem.

≣ DeFi Track 4: Derivatives Protocol

【Derivatives Agreement】

A derivative is a contract that relies on changes in the value of an "underlying asset".
The value of a derivative adjusts as the price of something (e.g. a stock, Bitcoin) changes. Although you do not need to actually own these things, you can participate in them by signing derivatives contracts and share the risks and opportunities brought about by price changes in these things.

Similar to the lending agreement, the derivatives agreement is also designed to expand the functions of the DeFi ecosystem and provide more contracts such as futures, options, leveraged tokens (Leveraged Tokens), synthetic assets (Synthetic Assets), etc., so that participating users can have more Trading strategy selection.

How do I make money in DeFi?

≣ Method 1 of making money in DeFi: Participate directly on the “Decentralized Trading Platform”

The most intuitive way to earn DeFi returns is to directly participate in DeFi projects on decentralized trading platforms. First, you must set up your own cryptocurrency hot wallet and choose the corresponding type of platform based on your preferred investment strategy and return type (spot buying and selling, staking, lending, derivatives trading…).

When using DeFi services, be sure to choose the platform you use carefully. Pay special attention to what items are authorized by the smart contract. Remove risky authorizations. It is safer to choose a well-known platform. Never use an unknown platform that you have never heard of.

≣ Method 2 of making money in DeFi: Invest in DeFi platform-related tokens

Just like "buying stocks" in the real world, we can also consider directly purchasing related tokens of well-known DeFi platforms. You can check these DeFi sectors on currency price tracking websites such as CoinMarketCap or CoinGecko .

≣ Method 3 of making money in DeFi: Participate indirectly in the “Centralized Trading Platform”

Another way to earn DeFi returns is to participate indirectly through centralized trading platforms (Binance, Coinbase...). These platforms provide DeFi-related businesses, such as staking, lending, yield farming, etc.

Although this method is relatively easy to get started, you must also bear the risk of "lack of asset management autonomy" because you are indirectly participating in DeFi projects through a "centralized exchange".

DeFi major risks

DeFi, as a blockchain track that has suddenly emerged since mid-2020, although it provides many attractive advantages, the maturity of this industry has yet to be tested by time. Before using or participating in DeFi, we must know its three existing risk:

≣ DeFi fraud risk

DeFi scams often appear in e-mails, Twitter posts, or social media using phishing techniques, inducing the victim to click on malicious hyperlinks, thereby "authorizing" the fraudster's smart contract to operate the cryptocurrency in your wallet, and the assets will be compromised.

When a cryptocurrency wallet wants to interact with any smart contract on the blockchain, we need to open the wallet permissions so that the smart contract has the right to use the funds in the wallet. This action is called "authorization." "Authorization" is like when we want to deposit money in a bank, we must agree to the bank's terms of service and directly authorize the use of funds to the bank.

Perpetrators often tag or send private messages to users, claiming that users have won prizes or received free cryptocurrency, such as "Congratulations on becoming the lucky winner of 10 Bitcoins", "You have received an OO token airdrop", "Limited time limit to get blue chip NFT for free" "wait.

≣ DeFi hacking risk

The operation of DeFi is based on smart contracts, so there is a risk that hackers and malicious users can steal DeFi protocol funds through smart contract vulnerabilities. If a hack occurs, in addition to the loss of funds, it will also affect users' interest in DeFi. Platform, and even confidence in the entire DeFi ecosystem.

Summing up:

Although DeFi provides many advantages, it also faces some challenges, such as the security of smart contracts and regulatory compliance. These problems need to be continuously improved and solved.

Whether DeFi will replace CeFi is still an open question. CeFi plays an important role in the traditional financial field and has a mature regulatory system and risk management mechanism.