It seems that many of us have heard of DeFi, but few fully understand what is hidden behind this term. In this article, we’ll look at what DeFi is, how it works, and why it’s becoming increasingly important in the world of finance.

Decentralized finance (DeFi) is a system of financial services that operate without intermediaries. Users can interact directly with each other using decentralized applications (Dapps), which in turn operate using smart contracts.

DeFi is not a specific product or organization, but a collection of various financial products and services that replace traditional financial institutions (banks, insurance companies, securities markets, etc.). Decentralized financial applications (hereinafter referred to as Dapps) allow users to flexibly combine different services. Because of this ability to assemble DeFi products together, they are often similarly referred to as “Money Lego.”

To use DeFi applications, you usually need to place collateral in smart contracts. The total deposit in such applications is often called “Total Value Locked”. Since 2019, the total value involved has increased from $275 million to a record $1.2 billion in February 2020, according to DeFi Pulse data. This rapid growth demonstrates the rapid development of DeFi.

DEFI ECOSYSTEM

With such rapid expansion, it is impossible to cover everything DeFi has to offer in this article. So we’ve focused on a few key DeFi categories and applications that we think are important for newbies and for those who increase knowledge.

DeFi applications have the potential to revolutionize traditional financial services by cutting out intermediaries. However, it is worth remembering that DeFi is still in its infancy and experimentation stage. Many projects are constantly improving, and DeFi may undergo significant changes over time. But understanding the basic principles can help you get the most out of existing decentralized finance applications and protect yourself from fraudulent activities.

HOW DECENTRALIZED IS DEFI? It is difficult to determine the level of decentralization in DeFi. To simplify, we classify it into three categories: centralized, partially decentralized, and fully decentralized.

1. Centralized
   Features: Frequently operate on centralized pricing data, set interest rates centrally, and provide liquidity for centrally managed margin calls.
   Examples: Celsius, BlockFi, Salt, etc.

2. Partially decentralized (has one or more of the following features)
   Features: Use decentralized price sources, provide free access to margin calls and margin liquidity, and determine interest rates and update the platform in a decentralized manner.
   Examples: MakerDAO, Compound, etc.

3. Fully decentralized
   Features: all components are decentralized
   Examples: there are no such ones yet, alas…

Today, many DeFi applications are considered partially decentralized. After discussing the concept of decentralization, let’s move on to the main categories of DeFi.

KEY DEFI CATEGORIES

In this article we will cover 8 categories. Namely:

Payments

Everything is simple here. Would you like to pay with crypto for ice cream in a small shop or a taxi ride?!

Cryptocurrencies can help with this, they play a key role in facilitating the direct transfer of value from sender to recipient, without the need to trust intermediaries. With the rise of DeFi, we are seeing experiments with innovative payment methods.

With the development of DeFi and the emergence of new innovations in this area, we are seeing changes in the understanding of payment processes that can address the shortcomings of the current financial system.

Exchanges

You can use centralized exchanges such as Coinbase or Binance to exchange cryptocurrencies, but they act as intermediaries and custodians of assets, which limits users’ control and exposes their assets to possible hacker attacks, compliance with sanctions policies or internal problems of the exchange — hello FTX.

Decentralized exchanges solve this problem by allowing users to exchange cryptocurrencies without having to transfer them to a custodian. This reduces the need to trust centralized exchanges and provides greater control over your own funds. But everything that calls itself an exchange is one, be careful and read our this article.

Stablecoins

Cryptocurrency prices are known to be highly volatile, with intraday fluctuations often exceeding 10%. To mitigate this volatility, stablecoins were created — tokens pegged to stable assets such as the US dollar.

Decentralized stablecoins are designed to solve the problem of trust. They are issued in a decentralized manner using over-collateralization and run on decentralized blockchains. They are managed by decentralized autonomous organizations and their reserves can be publicly verified.

While stablecoins are not financial applications in themselves, they are important because having a stable store of value makes DeFi applications more accessible to everyone. We talked more about stablecoins in this article.

Credits and loans

Traditional financial systems require bank accounts, limiting access to their services for the 1.7 billion people (who do not have accounts). Obtaining a loan from a bank also depends on your credit history and the availability of collateral, which is also not available to everyone.

Decentralized lending and borrowing removes these barriers, allowing anyone to use their digital assets as collateral. You can also earn income by participating in the lending market and investing your assets in lending pools. In this case, there is no need for a bank account or credit history check.

Derivatives

Derivatives are agreements whose value depends on an underlying asset, such as stocks, commodities, currencies, indices, bonds or interest rates.

Traders use derivatives to protect their positions and reduce risk in trades. For example, a muffin maker might enter into a futures contract with a supplier for a certain amount of flour at a predetermined price.

Typically derivatives are traded on centralized platforms, but decentralized derivatives markets are starting to emerge in DeFi.

Portfolio management

Portfolio management (or portfolio management) is the process of monitoring and managing your assets to generate income from your investments. There are two main approaches to portfolio management: active and passive. An active approach involves a team of portfolio managers who make investment decisions with the goal of outperforming a specific benchmark, such as the S&P 500. A passive approach, in contrast, does not require active management and the goal is to match returns as closely as possible to a specific benchmark.

There are already projects in DeFi that allow for passive portfolio management on a decentralized basis. The transparency of DeFi allows users to easily control the management of their assets and understand the associated costs. But be careful, there are a lot of not real “portfolio managers” who will not earn you dividends, but will steal what you have. We wrote more in this article.

Lotteries

With the rise of DeFi, new, innovative financial applications are emerging that expand access to financial services and cut out intermediaries. Applying DeFi principles to lotteries makes it possible to manage the prize pool through smart contracts.

By leveraging the flexibility of DeFi, it is possible to connect the decentralized lottery application with other DeFi projects and create a more valuable solution. As an example, one DeFi application allows participants to pool their funds into a pool that is invested in the DeFi lending application. The resulting percentage of the profit is won by a random participant at a certain moment. This ensures a win-win lottery, as the smart contract returns funds to participants after the winner is announced.

Insurance

Insurance is a risk management method in which a person can obtain financial protection or compensation for losses from an insurance company in the event of an accident. Generally, insurance applies to auto, home, health, and life. But is there decentralized insurance for DeFi?

All tokens used in smart contracts are at risk and may attract the attention of hackers looking to cause damage. Despite the fact that most projects are audited, we cannot be sure of the absolute security of their smart contracts. There is always the possibility of hacking, which could lead to loss of funds. In this book we will look at several options for decentralized insurance.

In conclusion, DeFi is an exciting world of disintermediated finance, bringing new opportunities but also risks. This dynamic sector is constantly changing and its potential is just beginning to be realized. The future promises even more innovation and change in the world of finance and investing.

But in this world there are quite a few threats. One of the easy ways to avoid them is to AML check a crypto address for dirty funds or connections with illegal activities. You can do this using our service for checking cryptocurrency addresses Btrace.