6 Key Categories of DeFI 📖
This is a new series called Blockchain Academy, where I will discuss and explain on a weekly basis one key concept in the blockchain and crypto space. There are so many interesting use cases that I am learning on a daily basis, some of them are more difficult to grasp like zk-SNARK but I will do my best to explain the concepts in the easiest way possible.
Hope you enjoy it.
In today’s blog post, we will talk about the DeFi ecosystem. Defi has seen huge growth since 2019, and it only excelled from there. The current TLV (Total locked value in smart contracts) sits at around 60B $ at the time of writing and topped this year somewhere close to 100B $. DeFi is not a project or entity, it is an umbrella term for decentralized protocols that are set to disrupt the traditional financial services.
Let’s move on to the key categories of the DeFi space.
Stable coins are cryptocurrencies, which are pegged to a stable asset such as the US dollar. As you know, cryptocurrencies are generally known as being highly volatile. The first stable coin was USDT Tether that is supposedly backed by $1 in the issuer’s bank account. One downside is that the user will need to trust the company that the USD reserves are fully collateralized and actually exists, which was one of the critiques in the past month. Decentralized stable coins are using an over-collateralized method, and they operate fully decentralized. Stable coins are not really financial applications themselves, but they are essential to make DeFi more accessible to everyone.
Lending and borrowing is another large use case of DeFi. You might have heard of Aave, as an example. In the traditional financial system, if you apply for a loan, you will need to provide a lot of information regarding your salary, your life situation, your family situation, etc. Then the financial institution will do credit scoring and evaluate whether you are a risk to default on the loan. In the decentralized lending and borrowing approach, this barrier is lifted. You will provide cryptocurrency as collateral to borrow e.g. US dollar stable coin.
Exchanges are used to exchange one cryptocurrency for another one. You can use, for example, Coinbase or Binance. But it is highly recommended to remove your coins from exchanges because they are having custody over your coins and when they go bust your coins go with it. There are countless stories, hacks, and scams where people lost money in centralized exchanges. What you want to do is use a decentralized exchange. Examples are Uniswap, Sushiswap, Pancakeswap and many more. These platforms use automated market-maker mechanisms to buy and sell cryptocurrency.
A derivative is a contract whose value is derived from other assets such as stocks, commodities, currencies, etc. Traders can use derivatives to hedge their position and decrease the risk in any particular trade. For example, if you are a global manufacturer of rubber gloves want to hedge yourself from an increase in the rubber price you can buy a futures contract from your supplier to deliver a specific amount of good at a specific future delivery date at an agreed price today. These contracts are mainly traded on centralized platforms and DeFi platforms are starting to tap into this huge market.
Insurance is another large area in DeFi. The definition of insurance is that a financial institution covers you for any future loss against an e.g. monthly premium that you pay. Common insurances are in health, car, home and life. In the DeFi space, a huge amount of money is locked in DeFi protocols. DeFi insurance protocols would allow you to hedge against the risk of an exploit of protocols where you have money locked.
Governance of crypto projects is also becoming more decentralized. A trending term, which will grow in the future is a decentralized autonomous organization or in short DAO. These are smart contracts that handle each decision of the company. For example, if the founders of a project want to use the fund to build a specific product in a DAO they would need to get the votes of the community before progressing. This takes the centralized power of founders away and puts it to the community.
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