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What is DeFi and how does it work?

What is DeFi and how does it work?
31/05/2024
#Earning Strategy #ArbitrageScanner #Research and Analysis

WHAT IS DEFI

DeFi – decentralized finance built on smart contracts, where unlike traditional finance, the role of intermediaries is minimized thanks to blockchain technology. 

Where is DeFi Used?

  • Lending and Borrowing Protocols

Special platforms that allow users to borrow and lend their cryptocurrencies.

Prominent examples of such platforms include Compound, Aave, MKR, and others. Through smart contracts, which algorithmically define repayment methods, interest rates, and collateral liquidation, users have full control over the process without the need for a third party.

  • DEX Exchanges

Platforms for cryptocurrency trading where users swap one asset for another. Trading is done using non-custodial wallets. (Read more about non-custodial wallets).

An important feature of such trading platforms is the absence of the need for KYC, thus preserving user privacy. Examples include 1INCH, Uniswap, PancakeSwap.

  • Oracles

These are services that provide smart contracts with access to external data. Their role is crucial as they provide timely and reliable information to fulfill smart contract conditions. Prominent examples of oracles include Link, PYTH, TRB, and others.

  • Stablecoins

Cryptocurrencies that maintain a stable value, usually pegged to fiat currencies 1:1. For example, to the dollar, euro, and so on. Besides centralized stablecoins like USDT or USDC, there are also decentralized ones.

An example is DAI, which is created and managed by the MakerDAO protocol. Unlike its counterparts, it is backed not by fiat but by locked Ethereum within the protocol.

  • Prediction Markets (Betting Protocols)

Platforms that allow betting on event outcomes, match results, etc.

Examples of such platforms include Polymarket, Augur, Gnosis, among others.

!!! NOTE: Gambling carries significant risks of deposit loss. Please, use reason and practice proper money management.

  • Asset Management

Protocols that allow earning income from assets through automated investment strategies.

An example is Yearn Finance, CVX.

  • Staking

By providing their assets to secure the network, users can receive rewards in the form of interest.

  • Derivatives Trading

Analogous to the securities market. Tokenized assets are pegged to underlying assets (indexes, exchange commodities, currencies, stocks), allowing trading with them.

An example is Synthetix.

  • Crowdfunding and ICO/IDO

DeFi is used for conducting initial coin offerings (ICO) and initial DEX offerings (IDO), where startups can raise capital from investors.

  • Remittances

International fund transfers with high processing speed and low commission costs.

What are the Strengths and Weaknesses of DeFi?

Like any technology or product, DeFi has a range of advantages and disadvantages. Below is a table of pros and cons.

Pros and Cons of DeFi

Pros

  • Decentralization: absence of central intermediaries.
  • Accessibility: open to everyone with internet access.
  • Transparency: all transactions are public and blockchain-verified.
  • Automation: smart contracts automate processes.
  • Control: users can participate in decision-making.

Cons

  • Liquidity: Some DeFi projects may have low liquidity, making large operations difficult and contributing to price slippage
  • Security: Smart contract vulnerabilities can lead to financial losses.
  • Volatility: Asset prices can fluctuate significantly.
  • Scams and fraud: There is a risk of falling victim to fraudsters.
  • Centralized oracles: Most protocols rely on these data sources, and if they're in the wrong hands, it can disrupt their entire operation.
  • Complexity: Technical expertise is required.

Table №1 – "Pros and Cons of DeFi"

Thus, DeFi is decentralized finance that minimizes the role of intermediaries through blockchain and smart contracts. It is used in lending, DEX exchanges, oracles, stablecoins, prediction markets, asset management, staking, derivatives trading, crowdfunding, and international transfers. Advantages include decentralization, accessibility, and transparency, but there are also drawbacks: low liquidity, vulnerability, volatility, fraud risk, and usability complexity.

!!! NOTE: When using any DeFi service, remember to manage risks and practice proper money management.

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