Understanding DeFi: The most important terms:
The term “DeFi” stands for “Decentralized Finance” and describes a monetary system that does not require any middlemen: banks or stock exchanges are replaced by software.
For this to work, a booking system that is protected against manipulation is required. This is where the blockchain comes into play: ownership rights to all possible asset classes can be verified via smart contracts in a forgery-proof manner.
A revolutionary technology:
Smart contracts are digital programs that set the conditions for a money transaction. Only when all contractual partners meet the conditions is the smart contract executed, of course automatically.
These simple if-then statements eliminate the need for human intervention and add real value to cryptocurrencies. Because before DeFi, Bitcoin and Ethereum were mainly unproductive digital currencies that investors could buy and sell.
Smart contracts are revolutionizing the sector, allowing the crypto industry to offer the same services as those that exist in the existing financial system. The implementation succeeds using decentralized applications, the so-called dApps. The majority of DeFi applications are based on the Ethereum Blockchain.
Derivatives:
Some of the decentralized trading places sometimes also allow investors to speculate with derivatives such as options or futures. In theory, all asset classes can be packaged and executed within a smart contract as a derivative.
Yield farming:
Anyone who likes to use speculative financial instruments will be able to make friends with the principle of yield farming. Yield farming provides that investors make their tokens available to a liquidity pool and receive interest in return.
So far not very spectacular — the highlight, however, is that investors reinvest the distributed return, for example in other liquidity pools. Sometimes the platforms also allow investors to borrow and reinvest part of the deposited amount themselves.
Lending:
The so-called lending works a little easier. Here, too, users provide capital, this time in the form of loans. A bank usually decides whether someone gets a loan or not, a prerequisite may be a negative score.
In a decentralized network, access to a loan is much less complicated. In theory, a smartphone with internet access is enough to get a loan, and users deposit cryptocurrencies such as Bitcoin as security. The amount deposited exceeds the amount of the loan.
Decentralized Exchanges (Dex):
So do most decentralized exchanges — they work in a similar way to conventional exchanges, with the big difference that a Dex is little or not involved in currency exchange.
Their task is to enable a quick and cheap exchange of different cryptocurrency pairs. They use the blockchain and smart contracts for this. How exactly a Dex enables this service, however, depends on the respective project.
Some use an order book that processes transactions directly on the blockchain. Others outsource the order book, which makes the system faster, but some of the decentralization is lost. Still, others use an automated network that takes advantage of an algorithm. The money for the currency exchange comes from liquidity pools, which in turn are provided by users.
What are the pros and cons of a decentralized exchange?
Advantages:
- Wallet-to-wallet transactions guarantee sole control over the private keys.
- No registration or verification is required to use a Dex.
- There are no country-specific restrictions.
- Many different cryptocurrencies are available.
Disadvantages:
- No customer support or other tools available.
- Trading on a Dex is more complicated than ordinary crypto exchanges, so they are more suitable for advanced users.
- No currency exchange with fiat money such as euros or US dollars is possible.
- No cross-blockchain exchange of cryptocurrencies is feasible.
