Before the introduction of blockchain, centralised finance was the only banking method available to everyone. In this traditional method, money flows through a central authority, such as the government and banks. They monitor your accounts and determine the terms of your loans. Conventional finance is also incredibly costly, as personal loans charge as much as 18%, whereas credit cards typically charge around 25%. Even with these high fees, people continue to use these financial products because they have few other options.
What Is DeFi?
DeFi is short for Decentralised finance and is based on three key pillars: decentralised apps, blockchain, and smart contracts. Banks have been swapped for bits of code serving as money middlemen, making it censorship-resistant and much cheaper than conventional centralised banking. DeFi is accessible to anyone and requires no trust, as it is simply code running programs on the blockchain. If you want, you can review the code yourself to verify its integrity.
Popular Use Cases of DeFi
DeFi is a unique ecosystem that can grow far beyond the reach of mainstream finance. Some of the most popular use cases are listed below.
Decentralised Trading Â
Decentralised exchanges (DEXs) are used for crypto trading, where no central authority is involved and everybody trades independently. By storing everything on the blockchain, DEXs ensure the integrity of transactions. Furthermore, DEXs avoid the manipulation associated with centralised exchanges.
Finally, removing intermediaries such as brokers can lower enterprises’ trading costs. One such DEX is Uniswap, an extremely popular option that allows anyone to exchange crypto directly.
Stablecoins To Solve Financial Pain Points
Stablecoins serve as the intermediary between decentralised and traditional finance. They are digital currencies connected to actual assets like the United States dollar. The DAI, Tether (USDT), and USD Coin (USDC) are some examples. These stablecoins have a constant value, where one USDT will always be equivalent to one US dollar.
Let’s look at an example to see why stablecoins are good. Suppose you buy one Bitcoin Cash for $500, then it goes up to $1,000. If you were going to buy and sell on a centralised exchange, you’d have multiple obstacles. To start with, the exchange would charge a commission. And then you’d owe taxes on your profits, which could take days to appear in your bank account.
Later on, if Bitcoin Cash dropped to $250 and you wanted to purchase again, you’d have to deposit the funds back into the centralised exchange, wait for the transaction to clear, and buy Bitcoin Cash again. For stablecoins, this is much easier. You could trade your Ethereum for 1,000 USDC directly and put the profit into a secure, safe digital currency. If Ethereum falls in price, you can buy more Ethereum almost instantly using your USDC for less than 1% on a decentralised exchange.
Borrowing and Lending in Decentralised Finance (DeFi)
In finance, borrowing and lending are transactions based on trust and collateral. Borrowers, for example, usually provide 20% collateral, and the loan will be terminated if they do not repay it.
In crypto, however, things are different. The first thing about crypto is anonymity, so enforcing loan payments becomes difficult. Someone could deposit 20% of the collateral, take out the rest and walk away. To remedy this, smart contracts allow safe borrowing and lending. These contracts allow users to lend out their money without losing custody of it.
For example, if Person A wants to get interest on their crypto and Person B wants to borrow crypto, they can use a company such as Compound or Aave, which specialises in lending and borrowing crypto. Person A deposits their coins into a smart contract, which awards DeFi tokens representing the deposit amount and the interest.
From the borrower’s perspective, Person B has to oversecure their loan. For example, if they want $1000, they must put in $1200 in crypto. When they default on the loan, the smart contract uses the collateral to pay back the lender, including interest.
But why take out money when you have it? This is a standard feature of crypto, where borrowers might want to hold their funds instead of selling them. For example, if a person has 10 coins worth $1,000 and trusts that the token will grow in the long run, they can pledge these coins and take out $800 in stablecoins like Tether. They can exchange or invest the funds and repay the loan later to recoup their Coin.
If the coin’s price rises during this time frame — say, to $1,500 — they will own the raised collateral after repaying the loan. This enables them to tap into their resources without going through the sales process. But if the market goes against them and they can’t make good on the loan, they will lose their collateral.
Yield Farming Â
Yield farming is a way for investors to generate interest on their coins by depositing them to DEX. Projects usually use these deposits to raise liquidity, but there are some other applications, such as staking and lending. The interest rate or commission generated from these tokens is then shared with the investors. The DEXs lock tokens are loaned for yield farming through smart contracts. In contrast to the monopolistic structure of finance in which companies are given a majority of rewards, DeFi projects have to compete against one another with a smaller percentage of rewards.
DeFi Insurance
DeFi insurance lets individuals insure assets using smart contracts that pool money from different people to protect against a loss. The resulting fund is built up through individual premiums to make claims payable for a covered loss. All of this takes place on a transparent blockchain such as Ethereum.
DeFi insurance is currently used primarily to guard against smart contract bugs, protocol crashes, stablecoin de-pegs, and other risks that might affect the ecosystem’s financial viability.
Funding
Capital funding can be a real challenge for start-ups. DeFi platforms could replace the existing fundraising model by connecting companies directly to funders. This eliminates go-betweens such as venture capitalists, which can decrease fundraising costs.
Smart contracts are a direct and simple way to make the whole fundraising process transparent and secure. Companies such as Harbor, a security token sale platform, use DeFi to open up opportunities for startups and accredited investors. Such contracts also automate steps such as investor onboarding and fund distribution.
The Future of DeFi
DeFi is still in its infancy but has rapidly impacted how we manage our money. As the DeFi industry develops, it becomes more scalable, secure, and regulation-friendly, enabling widespread adoption. New projects and platforms are launched daily, presenting new financial services to users worldwide. If it continues on this growth trajectory, DeFi could one day sit alongside financial architecture and ultimately emerge as the dominant monetary framework for individuals and institutions.
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Lido Staked Ether 
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