Simply put, DeFi is a term used to describe financial products and applications built on top of blockchain technology. DeFi products are designed to be trustless ( you do not need to trust a third party) and transparent, meaning that they eliminate the need for central authorities or intermediaries.
This makes them ideal for use in peer-to-peer applications and allows for the decentralization of finance. When talking about decentralized finance, there are a few terms you should be familiar with:
Debt vs. Equity
Most financial products fall into one of two categories: debt or equity. Debt products provide money now in exchange for repayment at a later date contingent on an agreed-upon interest rate. Equity products provide money now in exchange for a percentage of the company later, but you can exchange equity for services.
DeFi protocols allow users to exchange debt and equity p2p without a third party reducing trustless transactions to a single point of failure.
This is where you will find applications that allow you to issue debt. Users can borrow money by issuing debt, promising to repay the loan plus interest at a future date.
This is where you will find applications that allow users to exchange an equity percentage of a company for funding and receive money or services in exchange.
These applications function similarly to initial coin offerings (ICOs) that allow users to exchange a percentage of a cryptocurrency for the opportunity to use or develop on top of another blockchain.
Both debt and equity DeFi applications predominantly revolve around decentralized exchanges (DEXs). All DeFi applications are DEXs, but not all DEXs are DeFi applications.
Decentralized Exchanges (DEX)
A DEX does not rely on a third-party service for customer fundholding. This system can be built on top of blockchain technologies and allows for the decentralization of finance.
Popular Use Cases for DeFi
There are several famous use cases for Decentralized Finance products:
This is where users can send IOUs or tokens instead of currency. For example, if A wanted to send B $1,000, they could agree to issue an IOU for $1,000 on top of a DeFi platform. This transaction would occur on the blockchain without requiring a third party.
IOUs are used frequently in the Bitcoin community to allow users to transact without using cryptocurrency directly. Similarly, tokens can be issued on top of DeFi protocols and represent debt, equity, or fungible assets like money or gold.
These networks require trust but reduce risk by using collateralisation to repay their loans.
This is where users can store their funds and earn interest on them. Interest-bearing accounts are similar to traditional savings accounts, but they are often much higher-yielding and allow for the decentralization of finance.
These accounts do not require trust as the funds are stored on the blockchain. However, they require users to lock up their funds for a set period.
This is where users can lend money to others in exchange for interest. Lending platforms allow for the pooling of funds from many lenders to provide loans to a large number of borrowers.
These platforms require trust as the funds are not stored on the blockchain, but they reduce risk by diversifying; if even one borrower fails to repay their loan, the loss is distributed across all lenders.
Margin trading is where users can borrow money to trade on margin and increase their buying power.
This type of trading requires a high degree of risk as the user is borrowing money to trade and can lose more than their initial investment if the trade goes sour.
Decentralized finance is a term used to describe applications that allow users to interact directly without the need for a third party. These applications include decentralized exchanges, interest-bearing accounts, and lending platforms.