What is DeFi and What is the Logic Behind It? (Part 2)

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First part summary

Decentralized finance (DeFi) is all about how currencies work, and it is similar to the services that banks provide. DeFi is built on multiple smart contracts like farming, liquidity pools, staking, and much more. All of them are interconnected in a way that makes them work perfectly with each other.  

In part one of this article, we talked about how DeFi works, its features, smart contracts, crypto staking, and why people are locking their money in pools. Now, let us continue discovering this journey of DeFi. 

Farms 

It’s like you are farming your coins to grow. An example could mean if you take $1000 and lock it up in the DeFi farm. You can get 3% daily returns if you put it on a farm and lock it. Every day after that, you should get 3% on your farm; if you take the 3% and also throw them on the farm, it will grow too.   

Farming is when you lock your assets to earn more money.

To further explain what is really happening in farming, it is essentially giving your money to someone who can use it for something else.  

If you have no use for your money for a good amount of time, you lock (farm) your money in a program, which will then take it and give it to whoever signs a request for the money. By locking your money, you allow them to work with it on your behalf — until you request it back. Of course, they should give it back with interest, which you will earn daily. 

In real life, it is similar to when your friend needs to buy something, but doesn’t have the money for it and cannot wait until their next salary. If you offer to lend them the money with an expected 3% interest and they agree to it, this would be just like locking your money for a month away for someone else who will return it together with interests.  

Crypto Loans and Borrowing 

It is the process of locking money so that others can loan it, and after some time – they will pay it back with interest. Loaning is similar to a securities-based or mortgage loan, since you use your crypto assets to obtain the loan and pay it off over time.  

How does it work in crypto terms? The lender will put some money, and you are allowed to loan more of it in a different format for the same amount. After a certain amount of time has passed, you are forced to pay it back because it is connected to your wallet, and the money will be taken from it automatically. Of course, you will be paying more of that loan than they loaned you (interest).   

Before you started to borrow money, someone put it there for you to borrow through staking or farming. From people loaning money to the lender using this money and paying it back with interest. And then the loner stalking/farming their money again for other people to borrow it.

It is a never-ending circle in which everything works separately and does independent things, but somehow is also connected to each other.

Liquidity pools allow you to swap currencies, but it is not possible to do so without creating a pool first. Furthermore, staking allows for flexible ways of moving money around and allowing people to get returns. And lastly, we have farming. These processes seem similar to each other, but they are contractually different.  

To clarify more, farming allows you to earn passive income by depositing crypto into a liquidity pool. Staking refers to pledging your crypto assets as collateral for blockchain networks that use the PoS (Proof of Stake) consensus algorithm. Liquidity mining focuses on providing liquidity to the DeFi protocol. You can read more about the difference between them here  

Although there is a fundamental difference between them, almost all lead to the same benefit when it comes to running the processes. You cannot swap without pools, and if you cannot swap, you cannot lend or stake.  

The difference between a liquidity pool and a centralized bank is that a bank is responsible for everything, and it is the main resource for every asset in all the things the bank does. In DeFi, however, everyone can be an investor and earn assets, and everyone helps to ensure there is enough money in liquidity pools to allow people to swap, earn and do other things. 

Cross Chain Router 

It is what connects two smart contracts to each other. Although contracts are individual, how can a router connect them to each other? 

In essence, most contracts utilize the Ethereum network and use ERC20, which is the same protocol for every contract. To further illustrate, for creating a contract on the Ethereum network, you will preferably use the ERC-20 protocol since it is widely used. Here we put an emphasis on “preferably”, because other networks such as Binance or Polygon have its own contracts, and contracts exist on them but with different protocols. 

Using the ERC-20 protocol means that every contract created in the Ethereum network using the same protocol will be connected through the router.  

It is similar to using the internet, where two people want to connect with each other, so they make a program to chat and interact together.   

Cross Chain Router works, by scanning the network to discover all the liquidity pools and direct you to the best way to swap between them.

Stablecoins  

Stablecoins are a type of cryptocurrency that match real-world money, and their price is tied to real assets. For example, a USTD coin, which is one of many stablecoins, should be tied to a real $1 bill. This means that 1 stablecoin always equals $1 bill.   

This concept is not new, as stores, today sell gift cards representing real money tied to the store. People can buy gift cards with a fixed amount of money that represents real value, with the only limitation being that the gift card is bound to be used at a store or mall.   

Stablecoins are interesting in every way! check out this article about stablecoins written by our amazing writer Adina Andersen.

Decentralize exchanging to trade 

Decentralize means it is not centered on something, it’s not reliable on one investor. It is decentralized and there are too many investors, there is no Decentralized means that it is not centered on something, or reliant on a single investor. It is decentralized, and there are investors with no senator in this exchange. All investors are equal, and the market – which is what dictates the prices – is not a centralized actor. 

Today, everyone is familiar with trading and swapping money. Doing this in a decentralized way means that a pile of money/tokens you want to trade must exist, and you have to put it on each side. Trading stablecoins or any token between each other must come from somewhere. And if it is decentralized, there needs to be a liquidity pool that holds a large amount of crypto ready to be traded to people. These liquidity pools often have two different currencies linked against each other, and must have an equal amount of worth on each side.  

For example, if one United States Dollar is worth 3.75 Saudi Riyal and there is $10 in a liquidity pool, then there must be 37.51SR to equal the value between the two of them.  

Only then will the liquidity pool be created, allowing people to swap between these two currencies. Other people will lock (invest) their money to enhance liquidity in these pools and keep it running. They will also earn from the fee other people pay when they swap in this pool.  

To put it plainly, with decentralize earning, everyone can earn and invest since it is not centered around specific people or organizations.

Conclusion

DeFi is not a new concept for us, but it is a new word that happens to be an umbrella term for many interesting things like staking, farming, liquidity pools, and more. DeFi tends to be mentioned every time crypto is being discussed, and how it functions and drivers. If we look closely, it is the same way we use it in banking services. They are basically the same things in different ways and in different terminologies. 

A new perspective 

The younger generations, specifically those aged 18 and under, are taught to value digital objects on their electronic devices. They are consistently exposed to digital value on a daily basis. 

When they play games, they have been trained to recognize rare objects with specific values, and they have even learned to understand that there is a marketplace with these visual digital representations. For example, buying a new weapon skin in the CSGO game means that players can make their weapon look different to what others have. With time, they may even trade it with others or sell it. All in visual representation, as there are no physical assets. 

Younger generations have been taught to use cryptocurrencies, which have already been implemented within games. And now, it crawls into the real world and gets put into practice.  

GameFi is a merge between the gaming world and the finance world. When you play a game, you will get profits from it whenever you complete a task or a level. When you earn something in the game, here is where the finance world will come. You can transfer the assets you earn inside the game to use them outside the game and trade on crypto exchanges. 

Farming, staking, and liquidity pools’ foundational underlying functionality is fundamentally the same as banking services, but they are just a new and smarter way to automate them. After identifying and knowing all these features on DeFi, in our next article, we will see how each of these features is used in a user interface.

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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