DeFi Hype: What is Decentralized Finance and How Does it Work?

Cryptocurrencies have become a trillion-dollar industry globally, disrupting finance extensively owing to the DeFi hype.

Dating back to the 1980s, the history of cryptocurrencies showcases the evolution of cryptography. Notably, Bitcoin emerged in 2009 as the pioneer digital currency, becoming widely recognized.

Despite its scalability, Bitcoin’s volatility makes it an unfavorable choice for mainstream financial transactions and investments.

Decentralized finance, or DeFi, is a hot topic in the crypto space, offering unique opportunities for exploration and understanding.

What is DeFi?

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DeFi is a young financial technology based on secure, distributed ledgers—the same kind used by digital currencies like Bitcoin.

It’s decentralized, meaning it bypasses the centralized monetary system in the U.S., along with its oversight from the Federal Reserve and SEC.

That means DeFi, at its heart, will refer to financial applications built on blockchain technologies that typically use smart contracts.

These contracts represent automated, self-executing agreements that anyone with an Internet connection can access.

In decentralized blockchain networks, DeFi applications, and peer-to-peer protocols, development does not require any access rights.

DeFi applications are used to provide ease of lending, borrowing, and trading of financial tools and instruments.

Most DeFi applications are built on top of the Ethereum network; soon, other public networks will give stiff competition in terms of speed, scalability, security, and lower cost.

What is DeFi Hype?

The DeFi, or Decentralized Finance, hype is significant in the financial world. Traditional finance will never be the same again because of blockchain.

DeFi removes most of the conventional financial middlemen involved—banks—and replaces them with peer-to-peer transactions combined with smart contracts.

Such innovation allows access to financial services such as lending, borrowing, and trading more transparently, safely, and openly.

This gives DeFi all the hype: it democratizes finance, puts users in control of assets, and creates the ability to gain high yields.

Because the number of both investors and developers involved in the DeFi ecosystem was increasing, its area of application was expanding further and further; hence, its impact has also continued increasing, which keeps the excitement and adoption going on within the cryptocurrency community.

Like other blockchain- and cryptocurrency-related projects and businesses, actions of decentralized finance are also subject to a great deal of DeFi hype and misinformation that hopes to attract users and their money.

Extreme price volatility surrounds cryptocurrency, blockchain, and all associated technologies.

History of DeFi

DeFi, which emerged in 2009, aims to give a decentralized system of finance that is open to everyone and requires minimal trust and reliance upon some central authority.

The launch of Bitcoin in 2009, the very first peer-to-peer digital asset built on top of the blockchain network, cleared the route for DeFi’s transformation.

The Ethereum network, a second-generation blockchain, facilitated further development. This created a DeFi ecosystem of businesses and enterprises that would build and eventually deploy projects.

DeFi has opened several doors for transparent and robust financial systems; these projects reached a turning point in 2017, extending beyond peer-to-peer money transfers.

How Does DeFi or Decentralized Finance Work?

DeFi ousts safety protocols, connectivity, and betterment of hardware by peer-to-peer financial networks.

Thus, it avoids banks and other financial companies that take their fee from businesses and customers to perform their services.

The only way of making the present system work is through this. DeFi fills up these intermediaries with blockchain technology.

1. Blockchain

A blockchain is a highly secured, decentralized database or ledger that keeps transactions recorded in blocks and checks them through automated processes.

Every block is “chained” to the others; thus, information in older blocks cannot be changed without changing the following ones.

In combination with other security protocols, this concept gives a blockchain its secure nature. Ownership of a digital cryptocurrency or token is based on whoever possesses a private key to it.

This is much like a password that grants access to the holder of a virtual token representing value.

The change in ownership is affected by transferring an amount to another entity that then goes on to generate another private key for them.

This entails token ownership; therefore, the blockchain design ensures that the transfer cannot be rolled back.

2. Applications

DeFi applications are software programs installed on devices such as personal computers, tablet computers, or smartphones that allow users to use their money for purchases, loans, gifts, and trading, among others without a third party.

These applications provide an interface that automates transactions between users by offering financial options such as one making a loan and charging interest.

Users can look for lenders, be they banks or individuals, who can lend out their digital currency after agreeing on conditions.

Some applications allow users to enter service parameters and then the blockchain matches them with another user.

Since the blockchain is a global network, a user can give or receive financial services from anywhere in the world.

These applications are not necessary for DeFi to exist independently; users would just have to know the command line or terminal of their respective operating systems.

Example, Protocol, and Use Cases of DeFi Hype

DeFi stands for decentralized finance. These are applications that utilize blockchain and cryptocurrency technologies in rendering financial services, including savings accounts and liquidity providers, to businesses and investors alike.

Aave is the notable DeFi provider; anyone can join it at his own will on either the liquidity provision side or as a borrower.

Decentralized finance, intended for banking and lending, has expanded into a diverse industry with multiple sectors.

1. Asset Management

DeFi provides asset management services for investment in an increased, inexpensive, and more democratized form. This includes the transparency, composability, and truthfulness of the services.

Ampleforth was founded in 2020 by Evan Kuo as a non-collateralized digital asset to aid traders in having diversified crypto portfolios.

Using real-time data from Bitfinex Exchange and KuCoin Exchange, supply adjustments of the tokens are achieved every day through intelligent contracts at Ampleforth.

If the price of tokens is below $0.96, then the supply decreases; otherwise, if it is above $1.06, the supply increases.

2. Blockchain Oracle

For decentralized applications, such as prediction markets, real-world data must be connected to the blockchain. An oracle system bridges the connection from a blockchain to the external world.

Oracles can write data from the blockchain into the real world; conversely, consensus oracles aggregate data from multiple sources onto a single data point.

3. Borrowing  and Lending

The decentralized lending concept ensures that people can borrow cryptocurrency at determined interest rates, decentralized and trustless to allow peer-to-peer lending.

Automated codes of smart contracts give out loans without credit checks so that everyone can loan funds without restrictions on location.

Some platforms allow for rate switching to protect against the volatility of loans. However, DeFi lending runs risks of locking funds into a liquidity pool and the potential of flash loans to manipulate token prices.

Compound Finance is the most popular and influential DeFi lending application on the Ethereum blockchain and was created in 2018.

4. Decentralized Exchanges

DeFi has decentralized exchanges that enable users to swap tokens without the presence of an intermediary.

Uniswap was established in 2018 and is the largest automated token exchange on the Ethereum blockchain.

Three major functionalities include token swap, add liquidity, and remove liquidity.

5. DeFi Insurance

Blockchain-based insurance policies integrate real-world scenarios—like farming and disasters—through the use of parametric models, which are then combined with innovative contract technology.

Such decentralized policies have exhibited benefits of the system over centralized policies, in which money is disbursed automatically using smart contracts.

DeFi insurance protects activities occurring on blockchain about exchange hacks, price crashes, etc., targeting a vast crypto asset on exchanges.

These policies keep stablecoin investors safe, along with lessening claim processes.

6. Derivatives

Derivatives allow investors to participate in market assets without directly buying them, as in some options, buying the underlying asset.

DeFi derivatives, however, are then pegged to cryptocurrency tokens.

They can track traditional asset value and provide marketplaces that allow users to create synthetic assets pegged to real-world assets.

They increase potential return but naturally increase risk. DeFi derivatives can lead to regulatory issues for unregistered exchanges.

7. MakerDAO

MakerDao is a decentralized autonomous organization on the Ethereum blockchain, created by Rune Christensen in 2015 to save, borrow, and lend with stable cryptocurrency.

It runs on a Collateralized Debt Position system where users are allowed to deposit or deposit $ETH into it to create a stablecoin; in case of a drop, the CDP closes to ensure capital is locked against the borrowed tokens.

8. Non-Fungible Tokens / NFT

NFTs are simply tokenized assets, for example, a work of art, digital content, or even the simplest ones like videos. Tokens are unique identification codes one gets out of metadata via an encryption function.

The token is stored on a blockchain, but somehow, the actual assets are kept elsewhere. Despite cooling off, non-fungible tokens remain popular among niche investors and collectors.

9. Prediction Markets / Gambling

Prediction markets, much like sports betting, politics, and stock prices, imply a decentralized marketplace that allows individuals to make predictions about future events.

Augur is one of the leading prediction markets using Ethereum to generate real-time predictive data. On this platform, users could create markets by spending Ethereum while setting the fees between takers and makers.

It also facilitates trading in the event shares wherein users can buy or exchange shares, which denote the market’s odds.

The $REP token was utilized for market creation, participation tokens, and dispute resolutions in the platform.

10. Stablecoins

Pegged to some stable assets like gold or the US dollar, stablecoins create a way to solve this volatility of cryptocurrencies.

In such perilous moments in the cryptocurrency space, they offer an excellent solution with the presence of a trustworthy collateral asset.

Apart from this, they are also instrumental in liquidity pools, hence forming a crucial part of the DeFi ecosystem.

11. Yield Farming

Yield farming is a method that cryptocurrency traders use to generate passive income on their tokens.

It involves the lockup of users’ tokens through smart contracts, after which interest rates are paid on the locked assets.

Also, based on transaction costs and loan interest for DeFi loans, this has helped users earn interest. The rewards are paid to offset potential risks such as impermanent loss, token volatility, and rug pull.

The annual percentage rate can be both manually determined by the creator of the pool or adjusted using smart contracts.

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Final Thoughts

DeFi is revolutionizing the financial system—now anyone can be part of governance and create an actively global economic system.

Despite all the challenges, DeFi’s road to prosperity was visible since it disrupted the traditional financial setting with no fees and encouraged peer-to-peer transactions.

Wrapped in its swaddle, DeFi is picking up impetus, and it’s high time those financial service companies and banks rushed to be a part of the transition to a blockchain-based financial system.

The world of DeFi stands at the threshold of turning into a fast, secure, and egalitarian system. Additionally, Liquid tokens will also grow immensely.

A Liquid Token is a smart contract that runs an automated market maker controlling the purchase and sale price of a token along some predetermined price curve, all collateralized by a single pool.

You are essentially adding collateral when buying liquid tokens or liquid cryptos and removing it when selling liquid tokens.

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