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DeFi Summer 2021: Where To Start?

DeFi, which stands for decentralized finance, is one of the most prominent trends in the blockchain community right now. If you’re not following the cryptoworld closely, then you might have missed that this revolution is currently taking place. All types of financial institutions and products are being recreated in a decentralized world of blockchains. Let’s explore the DeFi phenomena and how you can take a loan in cryptocurrencies or use a savings account to accrue interest over time.

What is a smart contract?

Before discussing smart contracts, let’s briefly review blockchain technology more generally. A blockchain is a digital ledger in which all transactions are written explicitly and confirmed by the network’s participants. Many separate blockchains exist, with the most popular being Bitcoin, Ethereum, Cardano and Binance Smart Chain. Bitcoin was the first cryptocurrency and the first successful implementation of the idea of a blockchain, but the concept crucial for DeFi started later, with Ethereum.

Vitalik Buterin, the creator of Ethereum, introduced the concept of a smart contract. In simple terms, a smart contract is a computer program that automatically executes certain transactions once prompted or triggered by an event. You can think of a vending machine as the easiest real-world analogue of a smart contract. You put in a coin, and because of that event, you can expect a soda or a snack to fall out.

Smart contracts in the crypto world work similarly. You put your money in a certain account and once certain event happens (e.g. a day passes), an action is triggered (e.g. you earn interest). This can be both centralized or decentralized. Centralization means there’s an exchange or a private company taking care of the account you’ve deposited your money to. Decentralization means that the account is governed by the smart contract itself and there are measure to ensure that you’re the only one who can take that money back.

Let’s now get into examples.

Overcollaterized loans and saving accounts

Savings accounts are one of the easiest ways to understand smart contracts, and they exist also in the crypto world. Let’s take Aave as an example, which is one of the largest platforms for borrowing and loaning money.

Aave means Ghost in Finnish

Depositing money into some other account that is decentralized is one smart contract. But why would you earn interest on that? Banks earn money on loans and other services, so that’s why they can incentivize their clients to deposit money. They pay you interest on your deposit and then use that money to conduct other activities to earn their own proceeds. At the same time, they can also lend money from the reserves they build.

This system works exactly the same on the blockchain. You can both deposit money and borrow it as well in many cryptocurrencies. So, each time someone borrows crypto on Aave, his interest accumulates in a pool and is distributed to accounts providing liquidity by depositing their crypto, thus generating interest. So, it’s actually exactly the same as the traditional banking system but without any middlemen.

But how do you borrow money in crypto? And what about defaults, credit applications and all the other problems that emerge when lending? The answer is overcollaterized loans. In order to take a loan, you have to deposit more than you want to borrow. Your loan amount can’t exceed 80 percent of your total deposit. This way, if your interest goes over the limit determined by the smart contract, your loan is automatically repaid and borrowers don’t lose their money. Credit applications are therefore unnecessary for risk assessment pre-loan.

At this stage, you might wonder why anyone would ever take a loan if you need to deposit more to do so. It’s a way to gain leverage as you can take a loan in a different cryptocurrency. Let’s look at an example to get a clearer picture.

Imagine that you have 10 ETH in your wallet, currently valued at about $2,500 per ETH. You put that into Aave, and you then take a loan of 10,000 Dai, which is a stable coin valued approximately one dollar per one Dai. So, you’re $10,000 in Dai debt.

You now change that Dai into ETH, getting 4 ETH, and then put that ETH back into Aave. You have now 14 ETH as your collateral. If ETH goes up to $5,000 per one coin, you would only have to sell 2 ETH to repay your original Dai debt, plus interest. So, you’ve just earned 2 ETH for your efforts. Similarly, if you believe a certain cryptocurrency will go down in value, you could make a deposit in Dai or another stable coin and take a loan in that cryptocurrency.

One final note: Dai savings accounts return interest of about 6 percent yearly, which is way more than if you were to keep your dollar in a bank account. So, even if you don’t want to buy any of the more volatile cryptocurrencies, you can still participate in a crypto market by buying stable coins and depositing them into a platforms like Aave. Aside from Aave, some of the most popular are also platforms for crypto investing are BancorAnchorBlockFicrypto.comBinance. Some are centralized like Binance, some are decentralized like Aave. The difference is that centralized apps like Binance tend to have more customer support but lower interest at the same time.

Staking and liquidity pools

Loans and deposits are only the tip of the iceberg when it comes to decentralized finances. Another important concept in this space is staking and liquidity pools. Following Coinbase’s explanation, “Staking is the process of actively participating in transaction validation (similar to mining) on a proof-of-stake (PoS) blockchain. On these blockchains, anyone with a minimum-required balance of a specific cryptocurrency can validate transactions and earn Staking rewards.” Staking is usually carried out by depositing money to a certain app, often provided by the creators of a given cryptocurrency.

Providing liquidity is very similar to staking, but instead of validating transactions your money supplies users with a certain currency. For example, you need to have both ETH and Dai, and then you can provide liquidity by supplying 1 ETH and 2500 Dai (so that they have the same value) to one of the decentralized exchanges like Uniswap or SushiSwap. Now, you earn a small amount of interest each time someone swaps ETH for Dai or vice versa.

So, for staking you need one cryptocurrency, and for liquidity providing you need two. In the end, though, the principle is the same as with the depositing process I’ve described above. To stake or provide liquidity, you also deposit your money into a wallet, and a smart contract ensures security of your money and makes sure that you’re the only one that can take it back.

Where to start with DeFis in 2021?

This is it — a short guide into DeFis. It’s really just the tip of an iceberg. I truly believe that we’re currently in the building phase of a decentralized world where anyone has access to the best financial tools no matter where he or she is located.

We’ll be digging into some DeFi projects next week, so stay tuned!

 
 
 

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