Decentralized Finance (DeFi)
DeFi are financial services and applications built on blockchain technology. Mostly on smart contract platforms like Ethereum. But it is broader than Ethereum only. DeFi aims to recreate traditional financial systems such as banking, lending, trading, and asset management in a decentralized manner. This removes the need for intermediaries like banks and brokers (and its power and fees). DeFi offers a wide range of decentralized platforms such as decentralized exchanges (DEXs), lending and borrowing platforms, yield farming protocols, and synthetic asset platforms.
Why DeFi fits WEB3
DeFi aligns with the principles of WEB3 by promoting openness, transparency, and accessibility, allowing anyone with an internet connection to access financial services without relying on centralized authorities. It enables greater financial inclusion. It empowers us to have full control over their assets and supports innovation in the global financial ecosystem.
Everything DeFi:
Learn about every aspect before you interact with DeFi. DeFi is nice, but also dangerous! Do not interact with things you don’t know!! Not to make you scared, but to make you aware what is possible, we will list the risks here which will make sense after having read the entire page:
Risks of DeFi:
- Security Risks: DeFi protocols are built on smart contracts, which are susceptible to vulnerabilities and exploits. You should thoroughly research and audit the security of protocols before interacting with them.
- Impermanent Loss: Liquidity providers in decentralized exchanges may incur impermanent loss, where the value of their assets changes compared to holding them. Understanding the risks of impermanent loss is crucial before providing liquidity.
- Smart Contract Risk: DeFi platforms rely on smart contracts to execute transactions automatically. Mistakes in smart contract code or vulnerabilities could result in financial losses. You should exercise caution and review smart contracts before using DeFi services.
- Market Volatility: DeFi assets are often subject to significant price fluctuations due to market speculation and volatility. Be prepared for price swings and potential losses when trading or investing in DeFi assets.
- Regulatory Uncertainty: DeFi operates in a rapidly evolving regulatory landscape. You should stay informed about regulatory developments in your own jurisdictions and be prepared for potential changes in regulations affecting DeFi activities.
- Lack of Insurance: Unlike traditional financial institutions, many DeFi protocols do not offer insurance coverage for our invested funds. In the event of a hack or exploit, you don’t have a back-up solution to recover lost funds.
- Gas Fees: Interacting with DeFi protocols on Ethereum often incurs high gas fees, especially during periods of network congestion. Always consider the cost of gas fees when executing transactions on DeFi platforms, or simply use layer 2 solutions.
- Experimental Nature: Many DeFi projects are experimental and may lack a proven track record of security and reliability. Be careful when using new or untested DeFi protocols and only invest what you can afford to lose.
It is time to dive deeper into what you can do with DeFi and why one would want this!
Automated Market Makers (AMMs)
Decentralized exchanges use algorithmic pricing mechanisms to determine token prices, eliminating the need for traditional order books. Liquidity pools, funded by liquidity providers, enable us to trade directly without relying on centralized intermediaries. AMMs offer more efficient and decentralized trading, allowing to participate in liquidity provision and earn fees in return.
Decentralized Autonomous Organizations (DAOs)
DAOs have evolved to become more sophisticated. They enable decentralized governance, decision-making, and resource allocation within decentralized ecosystems. They empower community members to participate in protocol governance. The benefit of this is a better transparency, more fairness, and more inclusivity in decision-making processes. DAOs utilize blockchain technology and smart contracts to automate governance mechanisms. With that token holders can vote on proposals, allocate funds, and govern protocol parameters. DAOs stimulate community collaboration supporting innovation and collective action in the DeFi space.
Below, you can find some example DAOs with links to their respective pages if you wish to explore some of the bigger and more well-known DAOs.
Examples of DAOs (for the sake of example, no recommendation)
Flash Loans
Flash loans in DeFi by enable us to access capital instantly and without collateral. Borrowers must repay these loans within the same transaction, ensuring that the borrowed funds are used for specific strategies or purposes within a short time-frame. Flash loans serve complex DeFi strategies such as arbitrage, collateral swapping, and liquidation prevention. Flash loans help to execute these strategies with minimal capital requirements and without the need for traditional lending protocols.
Cross-Chain Bridges
Cross-chain bridges are platforms for interoperability between different blockchain networks. They are used to move assets seamlessly across various platforms. Cross-chain bridges enable us to transfer tokens between blockchains without relying on centralized exchanges or custodians. They enhance DeFi’s scalability by connecting various ecosystems and expanding the range of available assets to interact with. Cross-chain bridges enable developers to build decentralized applications that leverage multiple blockchain networks, unlocking new use cases and opportunities for innovation.
With Cross-Chain bridges, fees need to be paid. So compare various cross-chain bridges on your exact transfer to compare rates. Sometimes it is cheap, sometimes it is criminally expensive, therefore really find your cross-chain bridge you are satisfied with.
Below are some examples of cross-chain bridges and cross-chain protocols. As explained with Polkadot it operates on layer 0, and links entire blockchains together. Hence the capability for cross-chain bridges between all connected protocols. Chainlink also provides infrastructure. Orbiter Finance is an example of a cross-chain bridge in which you connect your EVM wallet and even other wallets such as Starknet, and then you are able to swap your crypto on a lot of chains. To name a few, there are many, many more: Ethereum, Linea, Polygon, Optimism, and Starknet.
Some examples of Cross-Chain bridges (for the sake of example, no recommendation)
Decentralized Identity
DeFi projects are exploring decentralized identity solutions to provide self-sovereign identity management. These protocols enable us to control and manage our digital identities without relying on centralized authorities. This stimulates privacy and security in financial transactions. Decentralized identity solutions leverage blockchain technology to create immutable and tamper-proof identity records, ensuring trust and authenticity in digital interactions. We can access decentralized financial services and applications while maintaining ownership and control over our personal data and identity information. Quite smart! These identity platforms are also used by other projects to prevent botting on their platform by requiring a decentralized identity.
Some examples of providers of a decentralized ID are listed below. Usually some transactions are required and depending on the blockchain some costs can be steep. For example using Gitcoin passport on Ethereum is relatively expensive as it is happening on the layer 1, and not layer 2.
Some examples of Decentralized Identity providers (for the sake of example, no recommendation)
Options and Derivatives
Some DeFi platforms offer decentralized options and derivatives markets. By using this type of platform you get access to financial tools to hedge risks or to speculate on price movements. You can also access options trading, futures contracts, and synthetic asset creation without the need of centralized exchanges or financial intermediaries. Because of the transparency, you can customize your risk exposure and investment strategies accordingly.
Insurance Protocols
DeFi insurance protocols provide coverage against various risks such as smart contract vulnerabilities, hacks, and protocol failures. Insurance policies can be purchased for the assets held in DeFi protocols which is an additional safeguard against potential losses due to unforeseen events. Insurance protocols use blockchain technology to create transparent and verifiable policies. These insurance pools allow us to collectively share risks and pool resources to mitigate losses across the DeFi ecosystem.
