What is DeFi? DeFi for Beginners

Take out a loan without a complicated credit history check and without revealing your identity?

Earning on a crypto deposit while the money is in your wallet and you can access it at any time?

Does that sound a bit crazy or like science fiction?

Now it is possible! With DeFi!

What is DeFi?

Decentralised finance, or DeFi for short, describes how blockchain works to enable users to use financial services without having to rely on centralised entities such as banks. These financial services are provided through decentralised applications and processed on the blockchain. Consumers effectively act as a kind of personal bank. Furthermore, blockchains are considered very secure and address the need for trust.

Traditional financial sector

The evolution of finance leading to the era of Decentralized Finance (DeFi) isn’t just a mere chance. A few years back, it was quite clear that the future seemed bleak for traditional financial systems. To facilitate a money transfer, one had to undergo the painstaking process of filling a transfer form, hand it over to the bank and then, after about three days, revisit the bank to print a statement as proof that the transfer occurred. This procedure may appear archaic to many, but even today, a significant number of people are still engaged in this process, and not everyone has adopted online banking.

Additionally, we cannot overlook the astounding 1.7 billion people in the world devoid of any bank account. While some enjoy the luxury of securing a consumer loan with just a mouse click, others face a lengthy and cumbersome credit check process to apply for a much-needed loan at traditional banks. The conventional financial system, involving commercial and central banks, is largely characterised by inefficiencies, delays, and high costs. Excessive manual processes dominate, with smart software solutions conspicuously missing. The operations conducted by banks with our deposits, behind a veil of secrecy, remain largely unknown.

FinTech

The first FinTech companies emerged almost two decades ago. In the beginning, they set themselves the goal of reducing staff and using software to speed up financial processes and make them more efficient. Many companies have succeeded in this. PayPal makes it possible to transfer money without the need for a bank account.

Monese, on the other hand, offers a modern bank account via a ‘mobile app’.

Mintos, on the other hand, allows peer-to-peer lending and credit with controlled risk. However, FinTech companies, like conventional lenders and financial service providers, have one thing in common: they are centrally controlled institutions to be trusted. As a rule, they can deny or restrict user access to their services at any time. And security is not guaranteed. What can happen when the power of big capital is in a few hands was demonstrated by the 2009 financial crisis – keyword: Lehman Brothers.

Blockchain – a new era

When it comes to security and trust, blockchain enters the scene with its own rules. In the simplest terms: blockchain is a digital, decentralised, encrypted network that cannot be hacked and can be accessed by anyone in the world, regardless of background, age or religion – 24 hours a day. In the case of the financial sector, this could mean: financial services that anyone can participate in without asking permission and without the need for interference from a central authority. Sounds too good to be true? Thanks to Bitcoin, this is no longer a dream!

Bitcoin – the first blockchain

In 2009, the Bitcoin blockchain network was the first of its kind. The Bitcoin Blockchain is a digital, decentralised and transparent ledger and Bitcoin (BTC) is the base currency. The basis of this online payment system is cryptography and a planned maximum circulation of 21 million units. The concept of this mechanism uses various elements of game theory, cryptography and computer science and is known as a proof-of-work consensus mechanism. This decentralised mechanism ensures that past transactions cannot be altered by anyone with timestamps. This excludes ‘double spending’ on the cash register. In the bitcoin blockchain, transactions are recorded as data records in a ‘block’ and then confirmed by all other participants in the network. Once this happens, the data sets remain unchanged forever. This decentralised security makes a neutral intermediary superfluous.

Digital gold

A long book could be written about exactly how the Bitcoin network works and the role that so-called miners play in it. A simple analogy with gold largely simplifies the picture. Just like gold is mined, bitcoin can only be generated with considerable energy and computing power. Like gold, bitcoin is a scarce commodity. The mining effort increases over time and the allocation is halved every four years. For this reason, bitcoin is often referred to as digital gold. Bitcoin is the first digital, global and proprietary cryptocurrency that is not controlled by any government and is not subject to any access restrictions. The basis is programmable mathematics! Transactions in Bitcoin can be made at any time, anywhere in the world and have significantly lower fees than any financial system known to date.

Dive deeper into our detailed comparison – Bitcoin vs Gold.

Ethereum – the second generation blockchain

After Bitcoin, the revolutionary principle of the blockchain inspired other developers to apply this decentralised approach to applications beyond the payment system. In addition to the usual transaction data, other interaction data should also be stored securely and unchanged on the blockchain. With this in mind, the Ethereum blockchain was created in 2014: a global, decentralised and open-source platform for decentralised applications, so-called DApps, that work with smart contracts. Since then, Ethereum has been the first public blockchain on which various applications can be programmed and used without restrictions. A kind of global computer that can never be switched off.

Smart contracts

Decentralised applications (DApps) are interfaces that interact with the Ethereum blockchain via smart contracts. A smart contract is a programmable contract that is based on simple ‘if this, then that’ logic. In this type of contract, two parties can determine the terms of the transaction without having to delegate execution to a central third party. Ether(ETH) is the cryptocurrency underlying the Ethereum blockchain. ETH is needed for transfers and smart contracts, such as DApps and smart contracts, Ethereum also offers the possibility of digitally creating so-called DAOs and other cryptocurrencies.

More on smart contracts find in this article.

DAO

DAO stands for Decentralised Autonomous Organisation. It is an independent organisation without human beings behind it, but with a programmable structure. Regulation takes place through code and smart contracts. Direct human intervention is therefore not possible. Execution within the DAO takes place through a special voting mechanism and is completely transparent.

Tokens as activities

The creation of additional cryptocurrencies in the Ethereum blockchain is possible in the form of programmable tokens. There are two commonly used token standards: ERC-20 and ERC-721. ERC stands for ‘Ethereum Request for Comment’, literally translated. While ERC-20 tokens are equivalent, exchangeable assets, ERC-721 tokens represent unique, non-exchangeable assets. Who has heard of the famous ERC-721 cryptocurrency? This new, unlimited ability to create digital money at will led to an unprecedented hype around ICOs (ICO = Initial Coin Offering) in 2017, which is hard to imagine a second time around in this form. Of course, Ethereum is much more complex. At this point, one cannot help but mention the Ethereum Virtual Machine (EVM) on which all smart contracts run, and the planned change of the consensus mechanism from Proof-of-Work to Proof-of-Stake.

Centralised providers dominate the cryptocurrency market

Bitcoin and Ethereum are by no means the only cryptocurrencies. There are currently several thousand of them. With bitcoin as the driving force, not only has a huge market for cryptocurrencies been created, but also a unique ecosystem around them that is constantly evolving and growing. However, this ecosystem is characterised by strong centralisation. Many decentralised cryptocurrencies are surrounded by a number of centralised providers and trading platforms (exchanges).

Exchanges

Initially, exchanges only dealt in trading, but now offer additional services.

Binance, Bybit or Bitget depending on the provider- can use a whole range of services. From trading through betting, to margin trading and CFD trading. Meanwhile, providers offering initial services such as lending and borrowing cryptocurrencies under the DeFi banner have also emerged on the market. For many users, cryptocurrencies are still considered a pure object of speculation. However, with the growing trend towards financial services in the cryptocurrency market, such as loans, the question is increasingly being asked whether it makes sense to sell one’s cryptocurrencies when their value has already increased.

Why sell when cryptocurrencies can work for you? Check our list of “best crypto exchanges“.

Access and verification

However, all central providers are required to provide secure storage. Moreover, they usually only allow access if KYC (know-your-customer) and AML (anti-money laundering) requirements are met. And for service providers without KYC and AML, the account must be registered with an e-mail address. The user remains anonymous, but this anonymity usually comes at the expense of security. All providers in the cryptocurrency market undoubtedly have the right to exist. Without their contribution, the blockchain ecosystem would not be where it is now. What is even more likely is that the system will grow stronger and cryptocurrency storage will become more secure over time. However, it is still possible to approach the ideal of a fully decentralised financial economy. It is very likely that decentralised blockchain applications will play a key role in achieving this goal.

DeFi DApps via Ethereum

The unique nature of the Ethereum Blockchain as a smart contract platform offers all the necessary conditions to make DeFi applications quick and easy to use for everyone. Unlimited access to the secure and decentralised blockchain on the one hand, and unlimited programming possibilities of the open source platform on the other. In addition, Ethereum makes it possible to create different financial applications based on smart contracts and link them together like LEGO bricks. Currently – as of May 2020 – Ethereum is the largest ecosystem for DeFi DApps.

One reason for this dominance could be the large network effect of the ‘first mover’. Furthermore, Ethereum, whose programming language is Solidity, is believed to have access to the largest number of developers.

How much decentralization does Ethereum’s DeFi truly offer?

While it’s true that teams of developers are instrumental in creating DeFi DApps, achieving total decentralization can be challenging. However, the automated execution of smart contracts and unrestricted accessibility suggest a state of at least partial decentralization. There’s no requirement for transferring cryptocurrencies into a central depository. With DeFi DApps, financial services can be accessed globally, eliminating the need for a bank account or any permission. All that’s needed is internet connectivity and a crypto wallet with an adequate amount of ETH.

Can Ethereum’s DeFi maintain its dominance in the future?

DeFi on Ethereum is relatively nascent, with the development of DeFi Projects commencing just around three years ago. Despite this, numerous applications are already in existence, and more are being added consistently. It’s predicted that the current DeFi ecosystem will undergo significant transformation within the next couple of years. The cryptocurrency market is renowned for its dynamic and rapid changes. This is exactly why it’s beneficial to acquire foundational knowledge now. Armed with this knowledge, tracking the evolution of DeFi use cases becomes much more manageable. In the subsequent section, we’ll delve into the primary application areas of Ethereum-based DeFi DApps.