While I intend to cover DeFi in depth in this post, I want to spare some lines to my favorite hobby i.e. bashing centralized banking system. In the past we have always used centralized finance which is where there’s a central authority that controls the flow of money. It is usually the government and the banks who are at the heart of this system. They can print as much of it as they want to. (A) They can stop you from borrowing it. (B) If they don’t want you to they can even stop you from having a bank account. (C) Since it is a purely trust based system, they could literally do anything with your money because you gave it to them. While these scenarios may look like unlikely, but history shows that governments have screwed up time and again.
Not only that. (D) Imagine that you’re running a business, these banks can limit what you can do. For example if you are into growing of some “special” plants, for medicinal purpose of course, they can tell you not to bring in any of that money from the business. (E) Some banks also charge if you drop your balance from a preset threshold. On the other end, some may also put limits to the maximum you could hold. (F) One more thing traditional finance is quite expensive. Starting from home loans we have plethora of products in CeFi which can go up to a price of 30% per annum (Credit Cards).
Now you may think what alternative do we have right? Well, thanks to smart contracts and blockchain, now you do. Enter Decentralized Finance or DeFi. The hottest domain of cryptocurrency is here to rescue you.
What is Decentralized Finance a.k.a DeFi?
What if I told you that there could be a world where there would be no banks. Only pieces of codes that can exactly do what banks can, but in a much more efficient way? How? These pieces of code or banks would be open 24×7. Open to anyone. There is no trust required because one could literally see the open source code to validate that everything’s fine. This alternative is much cheaper and censorship resistant.
There are three main pillars on which DeFi is based on.
C. Smart Contracts
Top Use Cases of DeFi:
A. Stable Coin:
Well, for making it a success, one first needs to bridge the gap between Centralized and Decentralized finance. For doing that, we have something called Stable Coins. Stable coins are cryptocurrencies that are pegged to fiat in 1:1 ratio. In other words, these coins mimic the price of a fiat currency like USD. Examples of such stable coins are USDT (Tether), USDC, BUSD, TUSD etc. Stable coins can also mimic other assets like Gold, Silver etc.
But why Stable Coins?
Say you own Ethereum worth Rs. 2000 from an exchange. Your analysis says that Ethereum is going to dip. If you plan to sell your holdings in return of USD/INR, it may be subject to taxes and a lot of fees (exchange, banks etc.). Not to forget that it may take some time for your money to reflect in your account. as there are multiple parties involved here.
Now instead of USD/INR, you could convert your holdings into USDT. This entire process will be subject to minimum cost and can be completed within in 5 minutes. Next time when the price has sunk and you want to enter back into the trade, simply exchange your USDT with ETH.
While a lot of us may take banking services for granted, but if you have to transfer an amount greater than X, then bank has to be informed about that transaction. Don’t forget the exorbitant fees that would follow.
On the other side, crypto like USDT can enable a transaction of millions of dollars within a few seconds for as low as $5 in fees.
B. Lending and Borrowing:
Lending and borrowing in fact a huge part of our current financial system. Why this works seamlessly is because banks usually ask you to put something like collateral on the line. If you default on your loan, banks liquidate that collateral to recoup the money. There could be other legal consequences involved too if you fail to pay back. All this is possible because there is a whole set of documents and KYC involved before disbursing the loan.
How do you deal with the problem of defaulters in cryptoverse? There is no KYC. Anyone could make a small down payment and run away with the loaned amount.
The answer lies in overcollateralization and smart contracts. For borrowing fiat money worth Rs. 1000 you may have to put Rs. 1200 worth of cryptocurrency as collateral. One may ask why would I borrow if I already have the money? Well, say you hold BTC worth Rs. 1000 and you strongly believe that it is going to jump higher in the coming days. In such a case, you would not sell your holdings and instead borrow money using that crypto. You can use that money to trade elsewhere and make some money, only to come back and repay your loan.
Well, once again, smart contracts are to the rescue. Say you have additional crypto lying around and you want to earn interest on it. So you go to a crypto lending platform like AAVE or Compound and deposit your crypto worth Rs. 10,000 in a smart contract. In return you get a different token (Lets call it X token) which is a representation of your crypto along with some pre decided interest.
Comes along another person who needs a loan of 10,000. He can put another crypto as a collateral (>10,000 worth) into that smart contract and now if he tries to run away with that money, smart contract will automatically liquidate his holdings and pay you back.
Flash loan is another interesting use case of crypto borrow and lending. It is a loan worth of millions of dollars given to you for about 10 odd seconds.
If you could buy Ethereum for $10 on CoinDCX and then sell it for $11 on Binance, theoretically you can make a dollar every time you did that and so you can use what we call is a flash loan to literally borrow millions of dollars. You don’t have to put any money down you just write a flash loan to borrow 10 million dollars and tell it to go buy Ethereum for ten dollars and then immediately sell it for 11. Ten seconds later you pay back the original loan. This way, you made a million dollars minus the fees that you had to pay for borrowing. These fees are small because the lender knew that you would have to pay them back and that it was for a very short period of time. Performing such an arbitrage is impossible in traditional finance.
C. Decentralized Exchanges:
If you have travelled abroad, you would know the pain of converting INR into USD or Euro. The rates of conversion are as high as 10% in some areas and you end up losing a lot of value of your money because of that. These exchanges are centralized and are managed by governments.
However, decentralized exchanges like Uniswap or Pancakeswap are running with zero intervention from the governments. One could swap multiple types of coins and tokens on these exchanges. People who want to earn interest on their crypto come and lock up their funds in these exchanges, thus creating liquidity pools. This enables seamless barter of coins with the help of code. (More on liquidity pools in upcoming blogs). The price is also less than 0.5% in most cases.
Let’s zoom out and think. What is insurance at a fundamental level? Nothing but a series of ifs and buts right? If X event occurs, pay Y amount to the beneficiary. Insurance companies use algorithms and ML models to evaluate the past history of a driver and come up with a fixed cost of insurance called premium.
Why can’t we just automate this thing using smart contracts? Say a farmer wants to purchase crop insurance. We could code a smart contract that would say if the rainfall for the entire year was less than an average of 90mm, the farmer will be paid a sum of 1L. Farmer could be charged Rs. 5000 for this insurance.
But how does a smart contract measure rainfall? Well, its using something called oracles which connect real world to the cryptoverse. This definitely deserves another blogpost. For now, let’s assume it is absolutely possible.
E. Margin Trading:
Before diving into how DeFi turbocharges the margin trading, for the uninitiated, let’s cover what are we talking about.
Say you want to buy a stock of Reliance which is trading at Rs. 1000 right now. For buying this stock, you need a loan of Rs. 1000. You put a down payment of Rs. 200 and borrow this money to buy a stock.
Say Reliance jumps to Rs. 1500. You book your profits, and pay back the remainder of loan of Rs. 800. Your total profit becomes 1500-800=Rs. 700. In other words, you almost tripled your money even though the stock only moved up by 50%.
This time around say the stock starts falling. From a Rs. 1000, price starts falling to a level of 900, 850 and 800. At this point, bank asks you to sell the stock and pay back your entire debt. You finally end up losing your down payment of Rs. 200 and the loan fee.
One thing is established here for sure. Margin is a really powerful tool to jumpstart.
And just like every other domain, Defi margin is much better than traditional systems. Let’s find out how:
- For margin in CeFi, the fees is usually quite high (>5%). On the other hand, it is less than 0.5% in DeFi.
- Margin isn’t accessible to everyone in traditional finance. There are constraints like trader’s profile, background etc. As you might’ve guessed, everyone’s welcomed in DeFi
- KYC is another factor hindering the mass adoption of margin in CeFi.
Each one of these five use cases of Decentralized finance or DeFi deserve a blogpost of their own. This field is so vast and revolutionary that it is all set to overtake CeFi with a storm. I am super excited to see the developments here.
What about you?
Until Next Time. . .
For our beloved “non readers”, I also do quick carousels on these topics over Instagram. Come join the fun. Hit me up here.