⚖️What is DeFi?

DeFi is Decentralized Finance in short. This refers to financial products and services powered by decentralized blockchain technologies. Unlike the traditional financial world, banks, brokerages and other financial intermediaries are not needed to facilitate transactions in DeFi ecosystems.

TRADITIONAL FINANCIAL SYSTEM:

DECENTRALIZED FINANCIAL SYSTEM:

DeFi can be considered as the most practical application of blockchain because it adopts the advantages of this technology, including:

Eliminate third parties:

The traditional finance system is run by third party intermediaries that facilitate money movement between parties, and charge fees for their services. For example, when you make a purchase with your credit card, the charge goes from the merchant to an intermediary, which forwards the card details to the credit card network. The network clears the charge and requests a fee from your bank. Your bank then approves the charge and sends the approval to the network, through a financial intermediary , back to the merchant. Each intermediary in the chain receives a fee for its services, which increases the cost between the original parties, and results in a loss in efficiency for the overall system.

Security:

A secure method of eliminating third parties relies on the immutable and trustless nature of the blockchain network, which is triggered via smart contracts, instead of relying on financial intermediaries or third parties. These blockchain facilitated ledgers are accessible to all parties regardless of who they are, opening up access globally for all parties to access this system.

Automation:

Use of Smart Contracts for automation of each process while preserving the terms and accuracy of each contract.

Cost savings:

Cost reduction of intermediaries such as banks, agents, and brokers that charge fees to execute financial transactions, as blockchain technology can achieve the same effect almost instantaneously at a fraction of the cost.

DEFI APPLICATION TYPES

DeFi 2.0

DeFi 2.0 is a movement of projects improving on the problems of DeFi 1.0. DeFi was targeted at opening up access to traditional financial products without financial intermediaries, but has struggled with scalability, security, centralization, liquidity, and accessibility to resources. As mentioned above, liquidity is a common problem for all DeFi protocols, due to the discordance in size of the DeFi market and the TradFi market.

Due to the current market environment with limited liquidity, projects have to incentivize liquidity providers to provide liquidity for their projects over other projects in the space, and to retain such liquidity in these liquidity pools.

This can lead DeFi projects to compete in a ‘race to the bottom’ scenario, where the bottom is defined as the value of the token plummeting. This often occurs due to transaction fees, incurred from providing liquidity to decentralized exchanges, being insufficient to incentivise liquidity providers to lock liquidity. Fluctuations in token prices can lead to providers suffering impermanent loss, and DeFi projects typically have to offer their native tokens as incentives to such providers.

However, as the rewards for liquidity providers increase due to competition between such DeFi projects, the price of such tokens falls due to the increase in the supply of such tokens in the market, leading to a corresponding increase in selling pressure. The DeFi 2.0 solution was that of protocol-owned liquidity, where DeFi projects would own their own liquidity instead of relying on external providers, and this resolved the need to compete with other projects to retain liquidity from external providers.

This process occurs via the bonding mechanism, where the protocol sells its native token (i.e UTD) in exchange for an established cryptocurrency (i.e BTC/ETH/ stablecoins) or a liquidity pool token (i.e UTD/USDC pair). The buyer is incentivised to buy these tokens from the protocol as they are typically priced at a discount to the current market price. However, these bonds are usually vested over a period of time, such as typical TradFi short term bonds. All these inflows from bonding then flow into the DeFi project’s treasury, which will primarily serve the goal of backing tokens, so that these tokens have an intrinsic value and thus a level of support for the price of the token on the market.