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Decentralised finance explained
This will be the first of a regular, weekly column in The Inside Investor that seeks to both educate and highlight the fast-evolving world of cryptocurrency and digital assets.
A new movement taking the crypto world by storm is DeFi, or decentralised finance.
Unlike traditional banking platforms that allow customers to deposit and lend money, there are no major banks involved in the Decentralised Finance (DeFi) space. According to Etherem.org, DeFi “is an open and global financial system built for the internet age – an alternative to a system that’s opaque, tightly controlled, and held together by decades-old infrastructure and processes. It gives you control and visibility over your money. It gives you exposure to global markets and alternatives to your local currency or banking options.”
It basically is an umbrella term used to describe financial products and services accessible to anyone who can use Ethereum. So in other words, there is a market where people can lend, borrow, go long or short, earn interest and trade cryptocurrency like they can in the physical markets. DeFi aims to recreate financial systems on which banks and exchanges operate. The main difference is that DeFi operates without a central service exercising control over the entire system. The main argument is that a centralised system is prone to human error, fraud and corruption.
The aim of DeFi is to restructure the traditional banking system in a “permissionless” way.
DeFi lending – Users can lend out cryptocurrency and operate like a bank, earning interest as a lender would normally do. Loans are formed in real-time between mostly anonymous parties, with automatically calculated collateral and an ability to enter and exit the loan at any time. Ethereum was chosen as the cryptocurrency that has a decentralised infrastructure capable of writing smart contracts that manage any financial service. To build a reliable financial service, “stable coins” were selected because they are pegged to a real-world asset, such as the USD.
Dai is the most widely used DeFi application: it is a decentralised cryptocurrency built on Ethereum and pegged to the USD. This reduces volatility that prevents most cryptocurrencies like Bitcoin from being practical everyday currencies. According to Forbes, “Compound is a crypto version of a money market fund, letting users earn interest. Dharma lets you issue and underwrite debt to gain investment returns.”
How is interest charged?
The lines of code that make up Dai set up the rules for how new Dai are minted and how the system is maintained. To create $100 worth of new Dai, users must pledge $150 of Ether, as an example. They must also pay an interest rate or “stability fee,”. This is done because the user is borrowing Dai when they create it. Dai has a sister currency called MKR, and people who hold MKR vote to determine Dai’s interest rate.
