What is DeFi and What is the Logic Behind It? (Part 1)

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To read the first part of this Blockchain Series, click here to learn more about blockchain, how does it work, how are things deployed on the blocks and connected to each other.  

Defining DeFi

Decentralized finance (DeFi) is a relatively new phenomenon created by smart contracts, which live on the blockchain. DeFi is used to perform financial functions by using smart contracts.    

It is really just about how currencies work, how people can swap between currencies, lock their stocks, or put their money in savings account and dividends in exchange every year. DeFi is more like services that banks provide, but not a bank itself. It is built on multiple smart contracts like farming, liquidity pools, staking, and many more interesting concepts this article will get into.   

Blockchain is a type of ledger that records and tracks events. Anyone creating an event, such as transferring money, minting tokens, burning tokens, or interacting with a contract, will be recorded, and users can track every event made on the blockchain.    

Minting tokens is when a token is being created. Burning tokens, is when a token is being used and disappears due to spending the token. That is how coins are created and exchanged in two different networks.  

Decentralized finance (DeFi) and blockchain

DeFi is based on many smart contracts, each performing a specific independent task that creates a circle between them – and makes one depend on the result of the other.  

 

One smart contract is for swapping and another is for creating pools. All those contracts working together are what makes DeFi. 

After deploying the smart contracts on the blockchain, DeFi will be enabled and automatically execute transactions between participants. If it is legitimate and all the conditions for a secure smart contract are met, they are then approved. The smart contract will work by itself without the need to be managed or controlled by anyone. DeFi enables faster and less expensive transactions when compared to traditional bank services.  

DeFi has many features that attract people to use it. The user has full control over their finances, and can freely trade or do whatever they want with them.  

And although there are gas fees involved in moving assets (learn more about gas and fees here), just like with standardized bank fees, the process itself is still faster. Furthermore, users can open an account without providing personal information and seamlessly trade or store their assets. Users can also easily access trading, loans, and staking without going through a complex approval or even being physically present at an office.    

With all of these features available for individuals, you may ask, what is in it for investors? Well, investors are the ones who will lend their money by using peer-to-peer (P2P). In this process, two individuals interact directly with each other, without intermediation by a third party, and exchange assets such as cryptocurrency for goods or services. The investors earn higher yields than others, and they can access their funds via digital wallets without paying traditional banking fees.   

Crypto Staking

Staking happens when users lock up their assets for a period of time to earn a specific percentage from previously agreed-upon assets. Technically, by doing this, users are helping the security and operations of that network to perform well, which is called proof-of-stake.   

Proof-of-stake (PoS) is a verification method for blockchain. It is a protocol used to keep the blockchain safe from hacking or modification. In simple terms, PoS is a secure way to create a new block in a blockchain.  

As a user, all you need to do is lock your assets in a staking wallet for some time to receive rewards. There are three different ways of staking:    

DeFi staking —albeit risky, it can be explained as lending your coins to act on your behalf in various DeFi protocols. 

Locked staking —locking your coins for a specific amount of time to get benefits at the end of the period. 

Flexible staking —earning a small daily amount, while being able to withdraw your coins at any time. 

Liquidity pools are pairs of tokens locked in a smart contract.   

To further explain how smart contracts work, let’s imagine it like a pool with 10 tokens: 5 Ethereum and 5 Uniswap. If someone buys Ethereum for the first time, the cost will be $2000. However, when bought for the second time, it will be $2003, and it will keep adding up whenever it is bought from the pool. Whenever you buy more, it will charge you more. In contrast, the other token will get cheaper because the pool now has more of it.  

A smart contract is written in a certain way to hold a specific number of coins, and then allow users to trade based on the math the contract did.  

Pools are an important tool, and in most cases, it is the connection between two tools to finish a certain request. 

A liquidity pool is essentially a pool with two kinds of tokens in equal amounts. When you have two tokens on each side, you actually are allowing people to swap between those tokens. You are putting an equal amount on each side of the tokens, which creates a balance for you to swap between them.   

This creates arbitrage possibilities for users to purchase and sell the same asset/token in different markets to profit from small differences in the asset’s listed price. Doing this also automatically helps the liquidity pool to stabilize the price between the pair.  

Arbitrage is a way of using liquidity pools, and it stands for exchanging assets in different pools.  

If the demand for a coin is high in one pool, then it is worth more than its regular price, and less demanded by users in other pools. In that case, people will buy the coin from the second pool, trade it in the first pool, and earn more assets using the methodology of how liquidity pools work. 

Why are people locking their money in a pool?  

Because they are earning money from locking their assets. Users earn money when others swap and pay the fee to swap. And whomever (investors) locked their assets in the pool will get a percent of the fee.    

Investors lock their money for a certain amount of time. After that, they collect their profits from the fee, it is not different from savings accounts that people have in the bank. When you create a savings account in your bank, and you don’t take money out of it, banks will give you a 3% dividend every year by just having your money in this account, this differs from one bank to another. Banks mostly use it to loan out money to other people, and after they collect the benefits from them, they will give you your promised percentage.    

The difference between bank savings accounts and liquidity pools is that liquidity pools are open to everyone, and everyone can invest at any time. It’s not centralized to a third party like a bank, and everyone can invest and earn interest. In addition, it is also more flexible and easier to use and invest in.

Conclusion

DeFi is increasingly becoming a more important aspect of blockchain. It has already been adopted into many things in our lives, and it will keep growing over time. DeFi is comparable to the Internet; when we were first introduced to it, it started small and was used for specific topics and things. But over time, it has become the main part of our daily lives, and now, no one can go through a day without the Internet. DeFi is growing to be at the same level of importance as the Internet.

Stay tuned for Part 2 of this article where we continue our journey into decentralized finance, and explore the similarities between the DeFi world and the real world.

The views and thoughts expressed herein are those of the authors taking part in the ARYZE Ambassador Program. They do not necessarily reflect the views of ARYZE or its employees.

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