If you weren’t living under a rock for the past few months, you probably have heard of something called decentralized finance, or “DeFi”. So what is DeFi, what’s the buzz about it, and what’s the difference between it and traditional finance? In this piece, let’s find out.
Difference between Traditional Finance and DeFi
In contrast to traditional finance, when you use financial services such as trading, lending, or borrowing in the DeFi space, there is no middleman involved. Instead, you’re interacting with protocols on a public blockchain with transparent, public algorithms. You can always verify the status of your funds, observe whether assets are being inflated, monitor protocols to ensure funds are being used as advertised, and numerous other aspects not open to users of traditional finance.
For example, a DeFi lending platform can never lend out more assets than users have placed into the platform, assuring that hidden inflation is not occuring.
Another aspect of this transparency is pricing. For instance, when trading on Uniswap v2, a decentralized exchange (DEX), the price of an asset is determined by a constant formula of x*y=k where x is the amount of one asset in a trading pair and y is the amount of the other asset in the same trading pair. Since the k in the formula stays constant, if a user wants to swap z amount of the asset for another asset, he will receive y-k/(x+z) in return. Predictable and transparent.
However, you might wonder - what if there is a price discrepancy between the price on Uniswap and the outside world? Good question. That’s where arbitrageurs come into play. Since a blockchain is open and everyone can read every piece of information on it, whenever there is a wide enough price discrepancy, arbitrageurs will step in and trade to correct the market price on Uniswap v2.
- Self-custody of funds
DeFi services do not hold or control any of their users’ funds. All funds are under the user’s control at all times, and can only be transferred or manipulated using the user’s keys contained in their own wallet. Funds cannot be frozen or seized by any third party. This is a radical departure from traditional finance, where all funds are held by service providers and can be subject to seizure by third parties at any time.
- Open Access + Composability
What’s more, given that these protocols live on a blockchain, anyone with the internet can access the services - no matter who you are, where you live, or how rich you are, these protocols treat you the same. This accessibility also means that developers can create services on top of an existing protocol or integrate with services created by others without permission.
For example, there are multiple money markets on Ethereum where you can deposit one asset and use it as collateral to borrow another asset. A permissionless pawn shop, if you will. The interest rates on such protocols are determined by an algorithm - as more people supply one asset, the interest rate paid to lenders drops; as more people borrow one asset, the interest rate paid by borrowers increases. Supply and demand, economics 101.
By utilizing the interest rate from Compound Finance, one of these money markets, developers of Pool Together built a loss-less lottery where users can deposit their money on their protocol, and once per week, the protocol picks a winner to get all of the interest generated from the deposited funds on Compound Finance. Since the “lottery rewards” come from the interest, participants can withdraw 100% of their deposited funds, whether they won or not.
The example above is just the tip of the iceberg. Besides Pool Together, there are a lot of applications that don’t exist in traditional finance, such as loans that repay themselves over time, easy automation of financial services, community-governed ETFs, and more.
To this point, we hope you now understand why people are into DeFi and what makes it special.
If you want to know more about leveraged products in DeFi, you can check this article.