What is DeFi? A Beginner’s Guide to Decentralized Finance

What is DeFi? Can I use it to earn interest
on my cryptocurrency holdings? Is it risky? And will it really change
the future of finance as we know it? Well, stick around. Here on Crypto Whiteboard Tuesday, we’ll tackle these questions and more. Hi, I’m Nate Martin
from 99Bitcoins.com and welcome
to Crypto Whiteboard Tuesday where we take complex
cryptocurrency topics, break them down and translate them
into plain English. Before we begin,
don't forget to subscribe to the channel and click the bell
so you’ll immediately get notified when a new video comes out. Today’s topic is decentralized finance,
or DeFi for short. If you’ve watched our previous videos you already know that Bitcoin
is a form of money that isn’t controlled
by any central bank or government. It can be transferred to anyone
from anyone around the world, without the need of a bank
or a financial institution. Bitcoin is decentralized money, and if you’re just starting out you may want to catch
our “What is Bitcoin” video before moving forward.

However, transferring money
is only the first of many building blocks in a financial system. Aside from sending money
to one another, there are a variety of services
we use today. For example, loans, saving plans,
insurance and stock markets are all services
that are built around money and together create
our financial system. Today, our financial system
and all its services are completely centralized. Banks, stock markets,
insurance companies and other financial institutions
all have someone in charge, whether it be a company or a person, that controls and offers these services. This centralized financial system,
or CeFi for short, has its risks – mismanagement, fraud
and corruption to name a few. But what if we could decentralize
the financial system as a whole in the same way
Bitcoin decentralized money? That’s exactly what DeFi is all about. DeFi is a term
given to financial services that have no central authority
or someone in charge.

Using decentralized money,
like certain cryptocurrencies, that can also be programmed
for automated activities, we can build exchanges,
lending services, insurance companies and other organizations
that don’t have any owner and aren’t controlled by anyone. Confused? Don’t worry,
we’ll break it down for you… In order to create
a decentralized financial system, the first thing we need
is an infrastructure for programming and running
decentralized services. Luckily for us, Ethereum does just that. Ethereum is a Do It Yourself platform
for writing decentralized programs also known as decentralized apps
or Dapps. Our “What is Ethereum” video
explains Ethereum in great detail, but for now we’ll just say
that through the use of Ethereum we can write automated code,
also known as smart contracts, that manage any financial service
we’d like to create in a decentralized manner. This means that we determine the rules
as to how a certain service will work, and once we deploy those rules
on the Ethereum network we no longer have control over them –
they are immutable.

Once we have a system in place like Ethereum
for creating decentralized apps we can start building
our decentralized financial system. Now let’s take a look at some of
the building blocks that comprise it. The first thing any financial system
needs is of course money. You may be thinking: “why not use Bitcoin or Ether,
which is Ethereum’s currency?” Well, as for Bitcoin,
while it is indeed decentralized, it has only very basic
programmable functionality and is not compatible
with the Ethereum platform. Ether, on the other hand,
is compatible and programmable, however it is also highly volatile.

If we’re looking to build
reliable financial services that people will want to use we’ll need a more stable currency
to operate within this system. This is where stablecoins come in. Stablecoins are cryptocurrencies that are pegged to the value
of a real world asset, usually some major currency
like the US dollar. Our video “What are stablecoins”
explains in more detail how stablecoins are created and what the different types
of stablecoin pegs are.

Make sure to check it out if you want
some additional information. For the purpose of DeFi we’ll want to use a stablecoin
that doesn’t use fiat money reserves for maintaining a peg, since this will require
some sort of central authority. This is where DAI comes into play. DAI is a decentralized cryptocurrency pegged against the value
of the US dollar, meaning one DAI equals one US dollar. Unlike other popular stablecoins whose value is backed directly
by US Dollar reserves, DAI is backed by crypto collaterals that can be viewed publicly
on the Ethereum blockchain. DAI is over collateralized, meaning if you lock up in a deposit
$1 worth of Ether, you can borrow 66 cents worth of DAI. As soon as you want your Ether back, just pay back the DAI you borrowed
and the Ether will be released. If you don’t have any Ether
to lock up as collateral you can just buy DAI on an exchange.

Because DAI is over collateralized, even if Ether’s price
becomes extremely volatile, the value of the locked Ether
backing the DAI in circulation will most likely still remain
at 100% or more. In essence, the DAI stablecoin
is actually also a smart contract that resides on the Ethereum platform. This makes DAI a truly trustless
and decentralized stablecoin which cannot be shut down
nor censored, hence it’s a perfect form of money
for other DeFi services. Now that our decentralized
financial system has stable decentralized money, it’s time to create
some additional services. The first use case that we’ll discuss
is the decentralized exchange, or DEX for short. DEXes operate
according to a set of rules, or smart contracts, that allow users to buy, sell,
or trade cryptocurrencies. Just like DAI they also reside
on the Ethereum platform which means they operate
without a central authority.

When you trade on a DEX,
there is no exchange operator, no sign-ups, no identity verification,
and no withdrawal fees. Instead, the smart contracts
enforce the rules, execute trades, and securely handle funds
when necessary. Also, unlike a centralized exchange, there’s often no need to deposit funds
into an exchange account before conducting a trade. This eliminates the major risk
of exchange hacking which exists for all centralized
exchanges. But the range of decentralized
financial services doesn’t stop there. Let’s move on to decentralized
money markets – services that connect borrowers
with lenders.

Compound is an Ethereum based
borrowing and lending dapp, meaning you can lend your crypto out
and earn interest on it. Alternatively, maybe you need some money
to pay the rent or buy groceries, but the only funds you have
are cryptocurrencies. If that’s the case you can deposit
your crypto as collateral, and borrow against it. The Compound platform automatically
connects the lenders with borrowers, enforces the terms of the loans,
and distributes the interest. The process of earning interest
on cryptocurrencies has become extremely popular lately,
giving rise to “yield farming” – A term given to the effort
of putting crypto assets to work while seeking to generate
the most returns possible. You can take a look
at the description below this video for some of the more exciting
DeFi projects that you can start using today.

So we have decentralized stablecoins,
decentralized exchanges and decentralized money markets. How about decentralized insurance? All of these new financial products
definitely entail some risks which we will cover shortly, so why not create a service
that insures my funds in case something goes wrong? Well, how about
a decentralized platform that connects people
who are willing to pay for insurance with people who are willing
to insure them for a premium, while everything happens autonomously
without any insurance company or agent in the middle. DeFi services work in conjunction
with one another, making it possible to mix
and match different services to create new
and exciting opportunities. This kind of resembles how you can
use different LEGO blocks and get creative with whatever it is
you want to build.

Hence the term ‘money legos’
has been coined to refer to DeFi services. For example, you can build
the following service from different money legos – You start out by using
a decentralized exchange aggregator to find the exchange
with the best rate for swapping Ether for DAI. You then select the DEX you want
and conduct the trade. Then you lend the DAI you received
to borrowers to earn interest. Finally, you can add insurance
to this process to make sure you’re covered
in case anything goes wrong. That’s just one example out of
the many opportunities DeFi offers. By now you can probably imagine
what advantages DeFi presents. Transparency, interoperability,
decentralization, free for all services
and flexible user experience, to name just a few. However there are also some risks
you should be aware of.

The most important risk is that DeFi
is still in its infancy and this means
that things can go wrong. Smart contracts have had issues
in the past where people didn’t define the rules
for certain services correctly and hackers found creative ways
to exploit existing loopholes in order to steal money. If you decide to test out
any of the existing DeFi services, make sure to do it
with an amount of money you can afford to lose
in case anything goes wrong.

Additionally, you should remember
that a system is decentralized only as its most central component. This means that some services
may be only partially decentralized while still keeping
some centralized aspects that can act as an achilles heel. It’s important to understand
exactly how a product or service works before investing in it so you can be aware of any issues
that may come up. To sum it up, it seems that the DeFi revolution
has reached its early adopter stage and the coming years will tell if it manages to cross the chasm
into mainstream adoption. There’s no doubt
that a decentralized financial system can benefit a huge portion
of the population that currently suffers
from financial discrimination, high fees and inefficiencies
in managing their funds. That’s it for today’s episode
of Crypto Whiteboard Tuesday.

Hopefully by now you understand
what DeFi is – a term given for a variety
of decentralized financial services that aim to replace our current
centralized financial system. You may still have some questions. If so, just leave them
in the comment section below. And if you want to take a look at some of the more popular
DeFi services in the works today just check out the list
in the description below. Finally, if you’re watching this video
on YouTube, and enjoy what you’ve seen, don’t forget to hit the like button,
subscribe to the channel and click that bell
so that you’ll be notified as soon as we post new episodes. It really helps us out a lot. Thanks for joining me
here at the Whiteboard. For 99bitcoins.com,
I’m Nate Martin, and I’ll see you…in a bit..

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