Limitless Potential – Is DeFi Coming Of Age?
(7 min read)
Decentralised finance (DeFi) is a catch-all term for protocols and applications (dapps) in the cryptocurrency space. Where Initial Coin Offerings (ICOs) looked more generally at decentralised versions of traditional applications (e.g. social networks, food delivery and more), DeFi focuses on specific areas of finance.
Interest in DeFi has peaked in recent months. The total value exchanged via decentralised exchanges reached $1.6bn in July. In this article, we look at what DeFi is, its benefits and the associated risks.
‘Permissionless’ and Disintermediated Finance
Bitcoin (and cryptocurrencies more generally) appeals partly because transactions can avoid going through a centralized entity. For example, when buying a product at Macro Hive in a digital hard currency (i.e. a credit card), a financial institution intermediates the transaction. In the crypto space, no such middleman exists. Transactions are decentralised and noncustodial. That is, buyers and sellers trade directly and hold their own private information via keys.
This permissionless and dis-intermediated way of doing business has existed for several years now. More recently, however, it has extended to include almost every financial service we use today: savings, loans, insurance, exchanges (for trading assets), betting markets and so on.
Instead of relying on traditional banks or financial institutions, ‘smart contracts’ make trades on applications offering these services possible. Simply, these are just contracts under which transactions between two counterparties occur according to transparent and predetermined mathematical conditions. In other words, a dapp (an app in the decentralised financial space) is designed based on a protocol that has specific constraints and requirements. Once certain conditions are met, an application will execute functions according to the rules of the contract.
Take MakerDAO as an example (credit Nathaniel Whittemore). It is a protocol that allows people to mint stable coins. In this system people can mint their own coin, or ‘dai’, by taking out a collateralised debt position. For instance, if a user deposits $150 of Ether, and the contract requires a minimum collateralisation ratio of 150%, he/she can withdraw up to 100 dai. In essence, they have minted their own stable coin by using another crypto as a deposit.
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