What is DeFi? (Decentralized Finance Complete Guide)

What is DEFI? Well, it stands for decentralized finance.

In the past, we have always used centralized finance which is where there’s a central authority that controls the flow of money. The government and the banks control it.

They don’t really say they do, but they do. They can print more of it if they want to. They can stop you from borrowing it if they don’t want you to.

They can even stop you from having a bank account if they wanted to. At any time they could have your money. They have your money so they could change it and you really couldn’t argue against it.

I mean you could, but how would you prove it? You gave your money to them it was based on trust. Also if you’re running a business they limit what you can do.

For example, right now if you have a little magical tree business that may be for medicinal purposes, they can tell you not to bring in any of that money from the business to the bank which seriously limits you.

It means you can’t deposit it or invest it or even use them to keep it safe. 

One more thing traditional finance is quite expensive. Payday loans go up to 500%, credit cards can average 25% and even personal loans can cost you 18% of your value.

These are really high rates but you pay them if you need to because that’s what you got.

The alternative is decentralized finance.

Table of content

What is DEFI?

In DEFI, there are no banks. Instead, there are pieces of code that run and act as a bank. They’re open to anyone, they don’t require you to trust them because they’re literally a piece of code running a program.

If you wanted to, you could read through it and verify that it’s not going to scam you. They are also censorship-resistant and lastly, they are much much cheaper than traditional centralized finance.

Decentralized finance is built on three main things:

If you don’t know what these are, I highly recommend that you check out our other posts on these topics where we break these topics down so simply using stories, examples, and analogies that even your grandfather could understand them.

Now, Assuming you understand cryptography, the blockchain, and how smart contracts work, let’s dive into the five pillars of decentralized finance:

  1. Stablecoins

First off we need to understand the bridge of decentralized finance to centralize finance and that is a cryptocurrency that is matched to a real-world asset.

For example, Dai, Tether, and USDC are all that we call stablecoins. This is because their price is tied to the united states dollar.

Think about it like this, when you buy one for one dollar, a new USDC coin is minted, and when you withdraw one, a USDC coin is burned.

The coin is always worth one united states dollar. Now, the purpose of this is to have a reliable way to buy and sell certain coins without buying and selling them. Instead, we can just trade them.

Here’s an example of why this might be beneficial. Let’s say you bought one Ethereum at $500. Well, now it’s one thousand dollars, and you want to sell because you think it’s high, you want to take your profits.

Without stablecoins, you have to sell your Ethereum at a centralized exchange like Coinbase or Binance, and in return, they will give you some united states dollars for it.

Of course, they’re going to take a cut of that transaction because they want a fee, and they’re going to take it. Also, the IRS makes you pay tax on any gains that you make from trading or selling.

Coinbase and Gemini will be snitching that you made it, so you can’t really get around it.

The next step would be to wait for Coinbase or Binance to give them to your bank and then withdraw them from your bank because you don’t really want the bank controlling your money.

Well, a month later, Ethereum drops to $250, and you want to buy more, so you deposit your $1,000 back into Binance, wait a few days for the transaction to clear because you have to wait and then buy four Ethereum and hold them.

Well, Ethereum rises again to $500, and you decide to sell. You sell them at your centralized exchange.

You bite the fee, and then you wait a few more days for it to hit your bank account.

You see, in this example, there’s a lot of fees, there are taxes, and there’s waiting.

Now, let’s say we utilized a stablecoin like USDC. You bought one Ethereum at five hundred dollars, and it raises to one thousand dollars. Instead of going through all that headache, you trade your one Ethereum for 1000 USDC, and you just hold it.

A month later, similar to the previous example, it drops to $250, and you trade your 1000 USDC for four Ethereum, then it raises to $500. And here’s the valuable part, within five minutes, you sell your four Ethereum for two thousand dollars.

The fees were less than one percent because you used a decentralized exchange to trade, which I’ll explain later.

But because of it, you could trade almost instantly, plus the USDC was secure, and you trusted it because it’s just code. It doesn’t change.

That’s the purpose of Stablecoin. You can be in the cryptosphere without actually using your government-owned bank.

We take banks for granted in many places, like in the US, but some countries are really limiting and how much money you can move around or what currency you can buy them from.

In fact, every transaction over ten thousand dollars has to be vetted and approved by a bank in the united states. Meanwhile, using a stablecoin like USDC, you can move 10 million dollars from one address to another without anyone blinking an eye for like a five-dollar fee.

You could never do that with united states dollars.

  1. Borrowing and Lending 

Another critical pillar of decentralized finance is lending and borrowing. In fact, a considerable part of our current financial situation in the world is based on lending and borrowing money.

So it would make sense that the blockchain could do it better.

One of the reasons we can reliably lend and borrow with banks is because we usually put something down like 20% collateral so that if we never pay back the entire loan, our government can come after us and throw us in jail or make us pay that money. In short, there are legal consequences for not paying a loan back.

With crypto, this is a problem because one of the pros of crypto is anonymity. You could put 20% down and run away with the rest of the loan, never to be seen again.

So we have to find a way to solve this. In fact, with the use of smart contracts, we can actually allow others to use our funds while still keeping custody of them.

Let me go through a little example. Person A wants to earn interest on his coins, while person B wants to borrow some coins. So person A goes to compound or AAVE, which are two platforms that allow crypto borrowing and lending.

And person A deposits his coins into a smart contract. If you don’t know already, smart contracts are just code that runs a particular function. In turn, what he gets are called C tokens or A tokens that represent his original coin plus interest whenever he wants to.

He can just turn his A tokens or C tokens into that smart contract that compounder AAVE created, and they spit out his original deposit plus interest.

Now, the smart contract is created this way so that no human being has to do the calculation or have to do the transaction. It’s all automatic by code.

That solves person A wanting to earn interest by lending traditionally.

Person B must do something called over-collateralizing his loan in the borrowing portion. This means if he wants to borrow $100, he must put up $120 so that way if he runs away and never pays back his loan.

The smart contract is written in a way that it can pay back person A their coins plus interest.

Now, at this point in time, you might be asking what’s the point of taking a loan if you already have the money?

Well, you’re probably thinking in united states dollars. Say you have 10 Ethereum worth $1,000 because they’re each worth $100, but you don’t want to sell them because you greatly believe in the Ethereum project.

So you put them up as collateral and borrow 800 worth of tether, which is a stable coin pegged to the united states dollar.

You trade that eight hundred dollar around, you make some money, you lose some money, you make some more money, and now it’s time to pay back your loan.

So you have eight hundred and fifty dollars in Tether, and you pay back the original eight hundred dollar loan to get back your 10 Ethereum.

Well, in this little example, you made fifty dollars from the little trades that you did, and you got lucky. But it has also been a few months, and Ethereum like it has done in the past few months,

Exploded.

Now they’re worth 150 each. Now you have 10 Ethereum at 150 dollars each. You control 1,500 plus the 50 dollars you made trading.

If you believe in Ethereum and you have it but don’t want to sell it, and you want to use the value of it, you can take a loan out on it, hoping that it will be worth more whenever you cash it out.

However, if you traded, you lost some money, you gained some money, and then you lost some money, and maybe you ended up with 750 dollars Tether.

You would have two options:

  • Option A is to front the extra $50 to pay back the full loan, the 800 to get back all of your collateral
  • and option B is just to keep your $750 and lose your 10 Ethereum, which could be worth a lot.

Now, this might be information overload, but real quick, there is a second type of loan in crypto called a flash loan which is a loan that lasts for like 10 seconds.

If you could buy Ethereum for $10 on Binance and then sell it for $11 on Gemini, theoretically, you can make a dollar every time you do that. 

You can use what is called a flash loan to borrow millions of dollars literally. You don’t have to put any money down. You just write a flash loan to borrow 10 million dollars, you tell it to go buy Ethereum for ten dollars and then immediately sell it for 11, and then you pay back the original loan 10 million dollars and all one small minor smart contract that gets run in 10 seconds.

Essentially, you made a million dollars minus the fees that you had to pay for borrowing, but these fees are small because the lender knew that you would have to pay them back and that it was for a concise period of time.

This is a more advanced technique, but you could never perform this type of arbitrage in traditional finance.

  1. Decentralized Exchanges

I have a friend who traveled to London a few years ago from the united states. In London, the standard currency is euros, while it’s dollars over here in the US.

Naturally, he had to visit a foreign exchange booth and trade out his dollars for euros. Unfortunately for him, the fee was about 15%. So he immediately lost 15 percent of his money because that’s what foreign exchange traders do.

Tourists don’t know any better, and they need local money, so what they do is they take advantage of these people.

When it comes to decentralized finance, instead of a foreign exchange trader, we have a decentralized exchange where you can exchange your coins and tokens for other coins and tokens.

The fees are usually minimal, like less than half of a percent which is an excellent benefit for anyone who regularly wants to trade their crypto assets.

Most popular decentralized exchanges or DEXs work in a manner where investors pool their money together, and then traders can trade that money. The fee of every trade that I mentioned earlier goes back to those investors, and it’s all written in code, so it doesn’t change.

A government can’t step in and say you can’t buy bitcoin anymore.

The fees and the percentages that you change are locked too; they’re written in code, so they don’t change, and they can’t raise to crazy prices like 15%.

Decentralized exchanges open the world up to a whole new variety of tokens and coins.

For example, Coinbase, the first centralized exchange to go public, only allows you to buy and sell 32 cryptocurrencies at the moment since they are regulated by the government and have to abide by certain regulations.

They very closely analyze each coin before adding it.

The most popular decentralized exchange, which is called Uniswap literally has hundreds, maybe even thousands of tokens that you can trade, and no one regulates them. That’s the decentralized part.

There are billions of dollars locked up in these liquidity pools so traders can trade, but nobody can control these billions of dollars; they’re just following a program that someone wrote.

In fact, only investors can be the ones to pull out their money out of the pool, but if they did that, the lending rates would rise, and so new investors would come along and put their money in.

As I said earlier, the code can’t be changed either; it’s what we call immutable. So in the crypto space, we like to say that the code is the law, the government doesn’t control it, the code does, and everyone has access to the code, and it doesn’t change.

Uniswap is one of the major exchanges on the Ethereum network, and it has billions of dollars in its pools.

Pancakeswap is another exchange on the Binance smart chain network with a few billion dollars of liquidity.

  1. Insurance

Insurance is straightforward to explain. For example, you pay 100 a month to protect your new tesla with car insurance. However, one day while using the autopilot feature, another car causes the autopilot to glitch, and you drive into a ditch unharmed, though, but you totally wrecked the vehicle.

Well, since you paid insurance, the insurance company pays you what the tesla was worth to go buy a new one.

They use statistics to predict how many of their drivers will crash their cars and then use this data to predict how much they would have to pay each year to determine the monthly price of the insurance, which is also called the premium.

With decentralized finance, the insurance company can be coded. Let’s go over an example:

Let’s say a farmer wants to buy crop insurance. If his crops die, he still has income for planting them and taking that risk; we could write a piece of code on the Ethereum network that says if there are any days this summer that is 90 degrees Fahrenheit or hotter, four days in a row, payout farmer joe one hundred thousand dollars.

However, to start this contract, he has to pay two thousand dollars so farmer joe can buy his crop insurance through what is called a smart contract which is just a code that sees if the conditions are met to pay him.

At this point in time, you might have two questions: how does the code know if it’s 95 degrees Fahrenheit and where do a hundred thousand dollars come from?

To connect the real world to the blockchain, we have to use something called oracles which are trusted sources that become a bridge between the real world and the crypto world.

We can create an oracle in our city that reads the temperature and is verified by a few people to make sure that it can’t be frauded, then the smart contract can reliably use it as a data source to decide if insurance requirements are met or not.

Secondly, the one hundred thousand dollars comes from other people buying insurance that bought the premiums, but maybe they didn’t get paid out because the requirements were not met.

Just like an insurance company makes profit.

People who provide liquidity to any decentralized finance platform may be incentivized to earn on their deposits within an interest rate.

In other words, some of the hundred thousand dollars may come from investors who earn money by lending their money.

  1. Margin trading

Margin trading is a whole new beast. Let me explain margin trading in the traditional world real quick, and then I’ll explain it in the decentralized world.

So you want to buy the Apple stock, and right now, it is one hundred dollars. Essentially, what margin is is a loan that will automatically sell your stock if the stock goes below your down payment.

To buy a hundred dollar stock, you need a hundred dollar loan, and the bank agrees to give you that hundred dollar loan if you can give them a twenty-dollar down payment and a small fee of five percent a year.

Here are two scenarios that could happen: the stock goes from one hundred dollars to one hundred fifty dollars. You have paper hands, so you decide to sell the stock and get one 150 dollars.

You pay back 80 of your loan because the bank already had your original 20 as a down payment, and you keep the rest which is a profit of 70 dollars.

Essentially, you made 70 dollars by only spending 20. This means that you more than tripled your money even though the stock only went up 50 percent. This is the power of margin.

You use it when you think something will increase in value to multiply your own money.

Now, let’s take a look at another situation.

This is the second scenario, and it’s if the stock drops to $50.

Well, with margin, you actually have to sell as soon as the value of what you bought can’t pay back your loan.

The stock starts out at $100; then it starts dropping $90, $85, and then as soon as it hits $80, the bank forces you to sell your one stock of apple at eighty dollars so that you can pay them back those eighty dollars that you borrowed.

The eighty dollars you made from selling the stock plus the twenty dollars that you gave them as a down payment equalizes the loan, and now the bank has the original $100 they originally gave you.

You’re free and clear you’ve paid your loan back, but you didn’t profit anything. In fact, you lost your original $20 that you put up as a down payment.

In centralized finance, to trade on margin, you usually need to be able to prove who you are, along with having a minimum of a few thousand dollars to even have access to margin trading.

The fees are also much higher than five percent, and decentralized finance margin trading can be a lot quicker, open to anyone in the world with money, and a lot safer as well.

Wrapping this article up, we have covered five big pillars:

  1. decentralized finance
  2. stablecoins 
  3. lending and borrowing
  4. decentralized exchanges
  5. insurance 
  6. and margin 

Hopefully, now you can see the value add of decentralized finance and why so many investors are piling billions of dollars into this new technology.

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