Understanding DEFI

Our current financial system has people that control and offer services related to it, either through banking, insurance, the stock market, and other forms of financial institutions.

This system, which is mostly guided by rules and regulations, is also vulnerable to poor management, corruption, fraud, etc.

Decentralized finance is all about decentralizing the crypto financial system the same way Etherium or Bitcoin is decentralized. It is basically building the same services or even innovating new kinds of services that are automated through coding decentralized apps (Dapps) on platforms like Etherium or Hive.

Etherium and Hive, as opposed to Bitcoin, are highly programmable platforms that can allow this kind of a project. For example, in Etherium, we have a hardware layer (where nodes are hosted and mining is done), and the software layer hosting programming language resources like Viper, Solidity, and others.

The Dapps are thus programs created on top of the software layer, which runs sophisticated code (smart contracts) that dictate the terms of a contract and guide the execution of the contract. These smart contracts transactions are traceable, transparent, and exist for 'eternity'.

The DeFi framework consists of five components:

Stable coins

Crypto that pegs its price to something with stable pricing, like fiat currency, for example. Their function is to have a middle ground between fiat and crypto, giving investors a sense of stability. DAI is an important example because it has transparent records.

Exchanges (DEX)

Decentralized exchanges allow users to swap one type of crypto to another without an intermediary. These offer lower fees and more control to users with more apparent security.

Money Markets

Money markets are spaces where money can be lent and borrowed, a space that banks occupy in the centralized arena. In DeFi, you have to deposit some amount of a crypto asset to be able to borrow another. If the collateral value of the amount borrowed goes below the loan value, the loan position will go into liquidation. A penalty may also have to be paid to the liquidators and the collateral will be lost to the lenders.

Synthetics

Some assets are designed to behave like other assets, only that they don't have the exact same characteristics; basically, derivatives that get their value from another asset and depend on it to offer investors customizable options, providing opportunities for risk exposure and cash flow sequences. Examples of synthetic financial products are options, swaps, and futures contracts.

Insurance

The new and barely tested financial protocols make decentralized insurance necessary. It safeguards investors of DeFi from hacks, glitches, or bugs contained in these new programs.

There is a lot more that goes into the makeup of DeFi, more so the building blocks that represent the above categories of its financial stack.

One example is the Maker Dao CDP tool, a combination of a collateralized depth position tool and the DAI stable coin. This tool allows users to borrow DAI using Ether as collateral. This same tool is open for other developers to use as a building block or lego piece to develop other projects or tools.

Source/more: