What is Decentralized Finance | Cryptotesters
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What is Decentralized Finance (DeFi)?

Emanuel Coen |
Sat May 09 2020
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Decentralized finance is one of the areas in crypto that has received notable traction. At a high level, DeFi aims to re-create the financial system that we use today but in a way that removes the need for intermediaries like banks. Bitcoin, the first decentralized network, laid the foundation for this movement by facilitating trustless peer-to-peer payments. This means you can send bitcoin to anyone in the world without having to know or trust that person AND without using an intermediary like a bank.

Why is building applications on Ethereum different to traditional finance?

Ethereum, which came a bit later extended these trust properties to a broader range of use cases by allowing developers to build “smart-contracts” which are applications that move assets according to pre-specified set of rules. Because these smart contracts exist on the Ethereum Blockchain, they can be accessed by anyone and people can trust that the code specified in the contract will be executed. Moreover, once these contracts are deployed to the Ethereum Blockchain, they are 'immutable' meaning that they can't be artbitrarily taken down or censored because they live on thousands of computers simulatenously.

The promise of the DeFi space is that, using these building blocks a new kind of financial system can emerge. One that will be global, transparent, fair and open for anyone to use and build upon.

Defi_Graphic

To give you an idea of the type of financial applications that are built already today on Ethereum, we’ll cover some of the most interesting projects that exist today.

What is MakerDao?

Naturally, for these applications to be useful they need to work with dollars not just cryptocurrency. The dollar is the most stable currency in the world. Many people in the world wish to get exposure to it but can't because they live outside the geographical boundaries of the United States. That's why stablecoins or 'crypto dollars' emerged very early on in the history of crypto.

Stablecoins like Tether or USDC are tokens that exist on the Blockchain and are pegged 1:1 to the value of the US dollar. They are issued by private companies (often cryptocurrency exchanges) who guarantee that they store the equivalent amount of dollars in bank accounts and allow anyone to redeem their stablecoin token at anytime against fiat dollars. The market cap of stablecoins on Ethereum has exceeded $10 billion dollars and keeps rising.

However, these stablecoins are not decentralized. Although, they can be exchanged freely within the Ethereum ecosystem, to actually redeem them against fiat dollars, individuals must identify themselves with these stablecoin issuers. Furthermore, these token smart contracts have special functions built in, which allow issuers to blacklist certain addresses or freeze assets.

The aim of the MakerDAO protocol is to create a stablecoin without these limitations. One that isn't issued by a company but in a truly trustless fashion happening entirely on the Blockchain.

In short, MakerDao is a financial protocol consisting of a set of smart contracts on the Ethereum Blockchain. The main function of the MakerDAO protocol is to supply DAI, its stablecoin that tries to always be worth $1. However, it is not backed by real dollars and that's why the value of DAI (expressed in dollars) can sometimes fluctuate slightly. Instead, DAI is backed by Ether and generated through a process, in which any person can send Ether into a smart contract (called a 'Vault') where it’s temporarily locked and receive DAI in return. For instance, if a user sends $150 of Ether he receives 100 DAI, i.e ⅔ of the Ether locked in the smart contract as collateral.

How MakerDAO works The process

After, the user can send the DAI to anyone in the world or sell it and buy something with the money. Effectively, the user has borrowed DAI from the smart contract but since the smart contract holds the user’s Ether back as security, there’s no default risk whatsoever. When the user wants to get the Ether back he needs to pay back the principal of the loan as well as the accrued interest over the loan period.

Of course, not everyone needs to go through this process to obtain DAI. Only users who have financing needs or want to take a long position mint DAI. Most users simply buy DAI on an exchange. Now, like any currency that’s traded on free markets, DAI derives its value from demand and supply.

If too many people sell DAI to buy other cryptocurrencies for example, the value of DAI can fall under $1. In that case, there are two forces that bring the market price back to $1. One is that people who have taken out loans will use the opportunity to pay back their debt at a discount, buy DAI for cheap on the market (e.g $0.95) and close their debt position. The 100 DAI that were initially borrowed will only be worth $95 now so there is an arbitrage opportunity to be seized. This increases the market demand for DAI and at the same time, the supply of DAI is stifled because DAI is being paid back to the smart contracts and burnt there.

If the market forces alone don’t bring the price back to $1 the Maker Organization which is governed by thousands of individuals who collectively vote on policies, can additionally raise the interest rate, making it more expensive to borrow and thereby affecting supply.

In other words, these smart contracts work like a decentralized “central bank” that mints currency and makes sure that the currency is backed by a sufficient reserve of Ether to maintain it’s stable value.

What is Compound?

Compound is a decentralized protocol that lets people borrow & lend assets by providing a liquidity pool that anyone can either borrow from or lend to. Users wishing to lend money, can send their assets to the liquidity pool and immediately start earning interest. The interest generated from the entire pool is distributed across all suppliers so even when funds are not being used, suppliers receive interest.

Users wishing to borrow money from the liquidity pool have to provide collateral just as in the MakerDAO system, which guarantees the security of the loan at any point. The interest rates are set algorithmically based on supply and demand which means that they fluctuate. If a lot of DAI is supplied to the pool and there is not enough demand to match it - the interest rate for DAI will be lowered. Low supply and high borrowing demand, on the other hand, will lead to an increase in the interest rate.

Compound works not only with DAI but many other tokens that exist on the Ethereum Network. Each token has its own liquidity pool and own interest rates. At the time of writing, Compound supports lending & borrowing of Ether, WBTC, BAT, USDC, DAI and many other assets.

What is Pool Together?

To show how composable these different DeFisystems are, we'll finish by explaining PoolTogether, a no-loss lottery that uses both DAI and Compound in its product. It allows users to pool together their funds and collectively invest into the DAI pool of the Compound protocol. For every DAI users' contribute to the pool they get a lottery ticket in form of a token. As the money sits in the the Compound pool it generates interest, which is paid out as a weekly prize to a random wallet address.

Effectively, users have a chance to win the weekly prize without the risk of losing any money. They are free to withdraw the sum they invested at any point in time. Two more advantages PoolTogether has over traditional lottery are 1) the code is open fully open-source and auditable so users can be assured that the prize distributions aren't rigged and 2) PoolTogether has contributed more than $300k DAI of its own money to the pool, which generates itnerest but is not eligible to win.

Summary

These are just two examples of decentralized finance applications. There are others and many more applications joining every week developed by young developers. The magic with decentralized finance is that it is global by definition and it can be used by anyone in the world with a smartphone - even by the 1.7B people without a bank account. They are powered by open-source code produced and auditable for anyone. Compare this to the highly centralized, opaque and rent-seeking financial system that we live in and you’ll understand why this vision fascinates the crypto community.

This might all have sounded incredibly complex but for the normal user all this is happening in the background. If you want to use MakerDAO or Compound to take up a loan in DAI or lend your crypto and earn interest on it, we recommend using wallets like Argent or Authereum. Alternatively, you can check out our wallet review page to see for yourself which wallet you like.

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Emanuel Coen

I am passionate about Bitcoin and Ethereum and want to on-board new people to crypto.

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