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What is DeFi (decentralized finance)?

If you've been in the crypto industry for a while, chances are you've already heard of DeFi. What is it?


DeFi stands for decentralized finance.

It represents an ecosystem in which transactions are not validated by a "central authority," but by a decentralized peer-to-peer Network.


You can think of it as an on-chain Wall Street.

In Traditional Finance, on the other hand, centralization plays a key role in the institutional structure. In fact, transactions follow a traditional pattern that bases the entire validity of the structure on the trust placed in a central authority.


Although it is still classical financial institutions, such as banks, that offer the majority of investment products to the public, decentralized finance is increasingly gaining a foothold in the landscape of financial instruments.


DeFi offers exactly the same traditionally known products but in a decentralized way. The difference?


First of all, the custody of funds. In CeFi (Centralized Finance) the user is out of custody of the funds as the bank will physically own your financial instruments. In DeFi You have full authority over the custody of your funds. Also, since most of the protocols are open source, anyone can contribute or create their own version. This is in promotion of constant innovation that results in a much faster rate of growth in technological progress. The process of developing centralized systems is constrained by an endless series of regulations that in themselves serve precisely to control the activities of the central authority.


The main advantage of DeFi comes from the composability that allows developers to create products that would simply be impossible in TradFi (traditional finance).


An example of such a product is Alchemix, a project covered extensively in the past.


Alchemix enables you to reimagine DeFi's potential by providing highly flexible instant loans that pay back over time.

TradFi is governed by humans while DeFi is governed by codes.


Infrastructure


DeFi applications need a digital place to thrive. A place where users can interact with it.


Just as iPhone applications are "printed" on the iOS operating system, so-called dApps (decentralized applications) need a blockchain that supports smart contracts.


There are many blockchains that offer dwellings to DeFi:

Ethereum has the largest market share and has been around the longest.

Solana is seeing exponential growth, offering many innovative and established DeFi products.

Binance Smart Chain has many dApps but they are highly centralized, which is a nonsense.


Today we call it decentralized finance, tomorrow it will be just Finance. There are more areas and various types of applications within finance and we will now analyze them:


1) Exchanges

Decentralized exchanges (DEX) are the decentralized versions of exchanges such as FTX, Binance, and Coinbase where users can exchange one token for another by going through the exchange itself. There are two evolving types of DEX:

Chain-specific: allows exchange between tokens that live on a single blockchain (Uniswap on Ethereum).


Chain- agnostic: allows trading between assets on different blockchains (THORChain).


2) Lending Markets.


Lending & Borrowing are one of the most popular financial products on the planet, think of taking a bank loan or using a savings account. This principle is a crucial part of the financial system; a decentralized example is Aave.




3) Derivatives Markets.


Products that derive their price from the spot are called derivatives. The two most popular products are:

futures

options.

In traditional finance, Derivatives Markets are said to be around quadrillions, but this includes leverage. In fact, the actual value was $12 trillion in 2019.


For comparison, the landing market was around $7 trillion in size in the same year.


There is a clear discrepancy within DeFi between loan and derivatives markets as the latter is 10 times smaller than the former in terms of LTV, thus exactly the opposite to TradFi (traditional finance).


Examples of derivative markets are dYdX, Perpetual Protocol, and Synthetix (once futures were introduced).


4) Fixed income.

When you lend (land) your funds in DeFi you earn variable interest, what may start with a 200% APR in one day may become 5% after 24 hours.


With fixed income, users can earn a predetermined stable return.


There are several ways to structure such a product in DeFi, the two most popular being:

Fixed rate loan: this is the simplest product within the fixed income markets. Yield Protocol is one of the protocols that offers it.

Interest Rate Swap (IRS): although this product is a derivative, it is in line with fixed income because it helps users achieve the same result: fixed-rate loans.

It is difficult to explain IRS in a few sentences, but we will give you a simplified preview: the basic premise is to swap a floating interest rate for a fixed one, a type of hedge that locks in a fixed interest rate.


A working DeFi protocol on such a product is: Horizon Finance.


5) Insurance.

We all hear too often about protocol hacks and attacks. This is a big hurdle for DeFi and one of the reasons why many people still prefer to interact with TradFi institutions. Imagine having your funds on a particular protocol while providing liquidity only to see your assets drained due to a bug or smart contract vulnerability. This is where the insurance industry enters DeFi.


The most popular protocols offering DeFi insurance products are Nexus Mutual and InsurAce.


6) Resource management

Last but not least, asset management. The world of funds is a very complex world that includes a high barrier to entry.


Hedge funds can be extremely expensive to set up and manage, which makes it unlikely that one will encounter great success or longevity.


DeFi takes care of this by reducing setup and management costs-they are built into the code rather than completed by humans. There are some DeFi protocols that offer this, such as dHedge, Enzyme Finance (formerly known as Melonport) and Set Protocol.



CONCLUSION


The only two principles that have captured significant traction are exchanges (chain-specific exchanges) and lending markets.


The remaining sectors remain in their very early infancy within DeFi, which means they offer potentially high returns (not financial advice), but this also means they may not see any traction for a few years.


According to cryptohubble analysts, the next two biggest use cases in the coming years will be the fixed income market and derivatives as they would greatly enhance the world of DeFi (non-financial advice).


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