[Op-Ed] DeFi 101: Basic components of a DeFi Ecosystem
Decentralized Finance (aka DeFi) is the new emerging technology that is operated by blockchains and smart contracts. DeFi is disrupting financials sectors one by one at alarming rates because it solves some major issues of the existing centralized entities such as: dependency on third parties, lack of transparency etc.
Key components of DeFi
- Decentralized Exchange
- Liquidity Pool
- Lending & Borrowing
- Wrapped coin
- Prediction market
Just like any centralized financial systems, DeFi also gets life when all of its components get together, making an efficient financial system. Each of these components can work fine independently and most of the DeFi based companies actually specialize one specific element of DeFi to build their services. But there are a few projects like “Maker”, which brings all of these elements together and provides a true DeFi ecosystem experience. So for starters, let’s take a look to the absolute basics of DeFi Ecosystems and how they work independently.
The most used form of DeFi that almost all crypto enthusiast might know of, is “Stablecoin”. Stablecoins peg cryptocurrencies to non-cryptocurrency commodities, such as the U.S. dollar/gold, in order to keep the price under control. The most used stablecoin by market volume is Tether (USDT). So according to what we mentioned, 1 Tether (USDT) will always be equal to 1 dollar, since it is pegged by the US Dollar.
Decentralized exchanges (DEXs)
Decentralized exchanges(DEXs) help users exchange currencies for other currencies if there is an available liquidity pool. Although centralized exchanges (CEXs) are currently the market leaders, DEXs are rapidly growing in popularity at the moment. DEX facilitates peer-to-peer trading by relying on automated smart contracts (AMM)to execute trades without an intermediary, unlike CEX which uses orderbooks.
Liquidity pools are pools of tokens locked into a smart contract, that facilitate efficient asset trading & liquidity providers earn a return on their contribution. A liquidity pool is basically an automated market maker (AMM) that provides liquidity to avoid large price swings for an asset. Each liquidity pool contains 2 tokens, and each pool creates a new market for that particular pair of tokens.
Lending & Borrowing
Lending platforms use smart contracts to replace intermediaries such as banks that manage lending in the middle. Higher demand leads to higher interest rates for that pair. DeFi lending is collateral-based, meaning in order to take out a loan, a user needs to put up collateral. That means users don’t give out their identity or associated credit score to take out a loan.
A wrapped token is a cryptocurrency token pegged to the value of another crypto. The reason it is called a wrapped token because the original coin or token is put in a digital vault that allows the wrapped version to be minted on another blockchain.
For example, “Wrapped” bitcoins (WBTC) A way of sending bitcoin to the Ethereum network so the bitcoin can be used directly in Ethereum’s DeFi system. WBTCs allow users to also earn interest on the bitcoin they lend out via the decentralized lending platforms described above.
Prediction markets are basically markets for betting on the outcome of future events. “Prediction market” is where users bet on the outcome of some event, such as “Will Donald Trump win the 2020 presidential election?”. The goal of the participants is to make money, so prediction markets can sometimes better predict outcomes than conventional methods, like polling, since the choice is more objective than subjective.
However, Defi is not just goods, nothing is actually. It is very risky if you don’t do proper research. But it’s difficult for beginners to separate the good projects from the bad even though they do research since there are no central regulators to filter scams out.
As DeFi has increased in activity and popularity through 2020, many DeFi applications, such as meme coin YAM, have crashed and burned, sending the market capitalization from $60 million to $0 in 35 minutes. Other DeFi projects, including Hotdog and Pizza, faced the same fate, and many investors lost a lot of money.
In addition, DeFi bugs are unfortunately still very common. Smart contracts are powerful, but they can’t be changed once the rules are baked into the protocol, which often makes bugs permanent and thus increasing risk. Therefore, only time will tell what the future holds for DeFi. But for the time being, it seems like we will see some radical changes in the financial industries which will allow a more decentralized environment to participate and get incentives out of it.
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