https://nasacademy.com/blog/article/what-is-defi-and-its-top-use-cases-2
On the internet, information can be freely transferred from one person to the other. In the same way, DeFi, also known as Decentralized Finance, aims to facilitate free, open, transparent, and verifiable financial transactions between two people without any third-party involvement i.e., permitting Peer-to-Peer transactions.
Before it became popularly known as Decentralized Finance, DeFi was known as ‘Open Finance.’
DeFi is an Umbrella term for progressive financial applications based on Blockchain technology, thus gearing it with the characteristics of Decentralization, Distributed Ledger System, and Security.
DeFi is not limited to simple value transfers, its application is extended to crypto lending and borrowing, investing, buying insurance, managing your portfolio, and much more. Owing to the decentralized nature of DeFi these services don’t involve a bank or any intermediary resulting in faster transactions without the need for any paperwork.
Let’s dig deeper into What is DeFi, its characteristics, and its use cases.
Bitcoin was introduced to the World as a digital currency which is an alternate store of value operating on its own Blockchain, it allowed simple transfers and enabled Peer-to-Peer transactions, thus becoming the first DeFi Application.
But the idea of DeFi is to provide a variety of financial services, it’s not just limited to simple transfers. DeFi can be built on Public Blockchains like Ethereum or Bitcoin. It comprises activities of lending, earning interest, trading derivatives, and much more.
Most of the DeFi platforms are built on the Ethereum Blockchain, the world’s second-largest cryptocurrency, a Blockchain platform that allows developers to build Decentralized Apps. Adding on the features of Bitcoin Blockchain like Decentralization, Distributed Ledger System, and Immutability, Ethereum also has Smart Contracts i.e., an agreement that is fulfilled only when all conditions are met.
Smart contracts on the Blockchain aid in facilitating services apart from just storing and sending value.
Smart contracts assist in making digital money programmable. You must wonder ‘how can money be programmable? It’s not a software…’ but logic can be programmed into payments thus allowing not just the control of your digital money but also services that are only provided through Financial institutions like lending and borrowing a loan or trading in derivatives.
DeFi eliminates the role of third parties in any financial transaction over the Blockchain thus saving a lot in fees, commissions and brokerages.
Let’s take an example of the traditional finance system and how DeFi is different.
For example, if you wanted to borrow a loan, you would have to:
In DeFi, you will not have to wait for any approval, the transaction will be done within minutes nor will you have to disclose your identity. Anyone can borrow money on DeFi all you need is internet access, digital assets, and a digital wallet.
The biggest advantage and most important trait of DeFi is complete control over your Digital Assets. In traditional financial institutions, the bank is custodial of all your finances and is free to do whatever it decides with your funds.
DeFi eliminates the involvement of intermediaries thus being cost-effective. There are also no geographical barriers or monetary limitations for entering the DeFi realm.
Anyone can enter the world of DeFi, unlike traditional financial institutions no prior approval or permission is required for access. Instead, DeFi follows a free, open, and permissionless model thus providing the people unable to do financial activities through traditional mediums the freedom of accessing those financial services through DeFi.
Anyone with internet access and a crypto wallet has access to DeFi. The DeFi platform has no cross-border barriers thus allowing anyone from any place with any amount of money to be a part of DeFi.
The distributed ledger system will make all the transactions on the DeFi platform transparent as everyone on the network will have a copy of the transaction. All the members of the Ethereum Blockchain network will also have to verify these transactions. Ethereum addresses are encrypted keys thus making the identity of the members anonymous.
Opportunities on DeFi are interoperable, deeper you dive into the DeFi world the more services you’d want to access. New DeFi applications and interfaces are developed to work interoperably with different blockchains and different applications for specific use cases.
Third-party applications can also be integrated with the existing protocols and applications.
As everyone can be a part of the DeFi realm, it is of utmost importance that financial transactions are not tampered with. Since the risk of fraud is always high with regards to financial activities, the immutability characteristic of the Blockchain provides security and maintains the data integrity of DeFi activities.
As most of the DeFi applications are based on the Ethereum Blockchain, smart contracts can be programmed and used in the automatic execution of financial activities which will also pathways for creating new financial service use cases and financial instruments. Thus making the DeFi realm as equipped as any traditional financial system.
Now that we’ve covered the basics of DeFi, let’s take a look at the use cases of DeFi…
It must be surprising to see gaming on the list of use cases of DeFi, but nowadays games have a lot of in-game purchases, for eg. buying new skins or weapons for your characters, and for making such in-game purchases real-life currency is required.
Banking on that developers are creating Ethereum based games that provide an incentive or bonus points in DeFi coins.
P2P borrowing and lending is the most vital use case of DeFi, as traditional banks are eliminated in the DeFi ecosystem it makes it easier and faster to make transfers from one person to another thus enabling Peer-to-Peer lending and borrowing.
As there is no need for paperwork and it’s pseudonymous it enables people not being able to access financial services provided by traditional financial systems.
Compound and Pool together are the most popular DeFi platforms for borrowing and lending.
The most beneficial impact of DeFi is the complete control and ownership of one’s assets. Several DeFi projects are allowing users to manage their assets i.e., buying, selling, lending, or even earning interest.
There is no need for sharing any personal data or sensitive information on the DeFi platform as one would with their bank or credit card company.
Through DeFi projects like MetaMask users can store such private and sensitive data and information on their personal devices that can only be accessed by the user. This ensures that only the user alone can manage and control their digital assets.
On prediction-based platforms, users trade value based on predicting the outcome of future events. DeFi platforms automate such transactions. These projects are decentralized and peer-to-peer but also provide access globally.
DeFi projects like Augur allow users to place bets on events like gaming, sports, etc.
Stablecoins are backed by assets like gold, fiat currency, or many other cryptocurrencies they help in reducing the volatility in the cryptocurrency market.
The applications of stablecoins in the DeFi ecosystem are lending, borrowing, payment transfers, etc.
Exchanges that are decentralized and no central party is involved and enable peer-to-peer transactions are Decentralized exchanges. These exchanges are not limited to just cryptocurrency trading; its application is extended from asset trading to derivatives trading.
Since the assets are not owned and controlled by the decentralized exchange, the risk of hacking is low. The fees charged by Decentralized exchanges are comparatively very less.
DeFi is still in its initial phase of development, there can be smart contract bugs and breach of contract. DeFi platforms like Nexus assist in buying coverage and provide smart contract cover for DeFi users.
Decentralized Autonomous Organizations (DAOs) serve administrative goals like implementing governance, managing assets, etc. They are a counterpart of centralized financial organizations but since they are decentralized they are not bound to follow any government regulations.
Due to its decentralized nature and distributed ledger system, an unprecedented amount of data can be discovered and analyzed. Analysis of these data can help in coming up with better ways to mitigate risk, aid in making well-informed financial decisions.
In legacy systems, the focus is heavily relied on KYC (Know Your Customer) which prevents Money Laundering and Financing of terrorist activities. But on the DeFi platform, great emphasis is given to maintaining anonymity.
To provide a solution for detecting Money Laundering and Financing terrorist activities while keeping the identity anonymous, the DeFi ecosystem has the KYT (Know Your Transaction) mechanism meaning the focus would rely on the transaction details and the user’s digital address instead of on the user’s identity.
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By Team Nas Academy