For decades, the Centralized Finance system, also known as CeFi, has been used all around the world. However, with the evolution of the internet and the rise of web3, a new financial system flourished: DeFi, short for decentralized finance.
Only time will tell. The long-term future of DeFi is uncertain. It is possible that DeFi will have a major impact on our daily lives, but it is also possible that it will not live up to its potential. Only time will tell.
What Is DeFi?
It’s important to understand the basics of DeFi before diving into practical things. DeFi is different from traditional finance in a few ways.
Different transactions we make in our lifetime are facilitated by financial corporations, such as banks. These corporations are controlled and owned by a select group of shareholders.
The financial system in which third parties control all our transactions while charging a fee for their services is known as centralized finance (CeFi) or traditional finance (TradFi).
DeFi offers the same financial opportunities as traditional finance, but without any intermediaries like banks or brokerage firms. You can use DeFi applications to lend or borrow crypto from peers, trade crypto assets without any centralized entity, earn high interest, and much more. In this guide, we will focus on how to use DeFi protocols to earn a safe yield on USDC.
The main differences between CeFi and DeFi
In general, CeFi models are highly centralized, which often leads to high levels of regulation, KYC (know your customer), and compliance measures. Since the beginning of human history, there has been centralized finance. This is when people would use goods and assets as currency. As human negotiation models evolved, CeFi became represented by fiat currencies. These are currencies that are controlled by governments and financial institutions, such as banks. CeFi models are usually very centralized. This often leads to there being a lot of regulation, KYC (know your customer), and compliance measures.
The financial institutions are the ones who provide us with loans, investments, insurance, and other financial products that we use and rely on in our lives. There is always a central exchange going on behind the scenes.
Some institutions also exchange cryptocurrency. Unlike a digital wallet like Metamask, which makes these trades decentralized, organizations like Binance and Coinbase act as intermediaries for these transactions. They act as a bank’s broker, facilitating standard web3 trades for their customers.
Organizations that work with a DeFi model use blockchain networks to set up businesses that follow pre-programmed conditions, instead of the intermediaries that were talked about in the previous paragraph. In other words, DeFi models use smart contracts to make sure that they don’t need any middlemen.
The current problems with CeFi
Centralized finances provide some return, such as interest on savings, and it is a simple process. On the other hand, there are some risks to be aware of:
- If you store your cryptocurrencies with a CeFi institution, such as an exchange, they will be the ones holding your cryptocurrencies. This means that you could be at risk if the organization is hacked or mismanaged.
- There could be not enough backed insurance.
- Some CeFi providers may require you to hold your crypto assets for a certain period of time, depending on market conditions.
- Users do not have total control over their funds.
- CeFi providers may charge high fees.
Although you might use a CeFi system for either buying crypto or for carrying out regular financial operations using FIAT currency, it’s important to remember that financial institutions are not infallible. A perfect example of this is what happened in 2008 when a lot of trusted organizations collapsed during the world’s worst economic crisis.
A hot wallet is a good choice to use because centralized systems can be dictatorial. They have the power to confiscate money, limit cash withdrawals, and artificially inflate the money supply.
An example of this hyperinflationary tendency can be seen in nations such as Venezuela and Argentina.
The holistic vision for DeFi
The Decentralized Finance (DeFi) concept was designed to address some of the shortcomings of the traditional CeFi (Centralized Finance) model. Specifically, DeFi aims to be more transparent, accessible, and faster than CeFi.
Although it is not perfect, DeFi is learning from past experiences, crashes, new legislation, and evolving technology to become more holistic.
The entire process is being called Defi 2.0 and we have written extensively about it in this article.
DeFi growth
As of the beginning of 2022, CoinMarketCap has listed over 505 altcoins and stablecoins with DeFi operations. In one year, the DeFi market grew by 47 percent, surpassing $170 billion in November 2021.
The expansion of Decentralized Finance, or DeFi, did not happen by chance. The main proposal of DeFi vs Centralized Finance, or CeFi, is to make financial products and services accessible to everyone. And there is no need for a third party to be involved, such as a bank or a custodial agent.
DeFi markets are open 24/7, unlike stock exchanges which are only open during business hours on weekdays.
Programming conditions to execute operations is all that is required to create a Decentralized Autonomous Organization (DAO). These organizations can offer services such as investments, credit, payments, purchasing, crowdfunding, and insurance.
Decentralized finance, or DeFi, is a financial system built on the Ethereum blockchain that allows anyone to lend or borrow Ethereum and other cryptocurrencies without having to go through a traditional financial institution. DeFi does this by replacing financial institutions with cryptocurrencies and smart contracts, which hold funds and send & refund payments based on certain conditions.
How to leverage DeFi solutions in your favor
There are several decentralized finance solutions available that can provide excellent outcomes and benefits to your business. Here’s how you can start adopting DeFi solutions in your company:
Hackathons
A hackathon is a marathon programming session, which is the perfect way to test and validate ideas and MVPs, as well as to recruit specialized talent and attract users to a platform, framework, protocol, or blockchain.
There are two types of hackathons:
- They typically last a day or two. The goal of open hackathons is to broaden your talent pool and get new perspectives on how to bring your project to life. Open hackathons are events that anyone with the necessary skills and profile can attend to help develop a project or concept. They usually last for one or two days. The aim of open hackathons is to get more people involved in your project and to get new ideas about how to make it a reality.
- An internal hackathon is a marathon event for company employees only. They can be great for fostering innovation and new ideas within the organization.
Hackathons are a great way to attract and recruit developers who are knowledgeable about the differences between DeFi and CeFi environments. The Telos Foundation, for example, recently hosted an online hackathon at TAIKAI to invite Ethereum-based developers to bring tools and apps to the Telos EVM (tEVM), a scalable Ethereum Smart Contract platform.
It has provided developers with an opportunity to create DeFi innovations as well as other web3 projects. The best projects were rewarded with so-called “token bounties,” demonstrating that an increasing number of developers are interested in being rewarded in cryptocurrency.
Bounties
Testing new platform designs and identifying bugs on blockchain platforms can be done effectively through short-term programming challenges.
Organizations encourage developers to work on open-call projects with specific objectives. Those who complete the objectives are rewarded with bounties, which are usually compensated in the form of crypto tokens.
Here is an example:
Recently, the open-source metaverse infrastructure Caduceus began the public testing phase. To identify any potential bugs before their Beta release, they hosted a hackathon at TAIKAI and paid developers according to the level of (in)security for each bug found.
Blockchain analysts are rewarded with bounties for submitting security reports and solutions.
By offering bounties for testing new DeFi solutions and products, DAO organizations can attract qualified blockchain and web3 developers who are in high demand.
The Bepro Network has a bug bounty program where people can get rewards for finding and reporting bugs.
The program offers cash rewards to people who find and report errors in contracts or security. The amount of the reward depends on the importance of the discovery, and ranges from 500 Euros to 50,000 Euros.
Dappkit
If you already have an idea for a DeFi solution, you can use dappkit to speed up development. Dappkit is an open-source web3 software development kit that helps create web3 products in as little as 3 lines of code.
Dappkit allows you to build decentralized applications platforms, non-fungible token collections, predictive markets, DAOs, and create your own cryptocurrency tokens.
Our dappkit connects an entire integration, allowing for faster project development because:
- It’s user-friendly, as it’s a very simple way to create web3 apps/products.
- Help developers save hours of work by eliminating the need to create web3 code from scratch.
- It is simpler and faster than developing a custom smart contract.
- We provide team/community support as well as easy access to documentation and guides.
- Access to a template library
- By being open-source, it receives regular updates and features from the developer community.
Challenges during the CeFi vs DeFi transition
One of the most important issues related to the shift from centralized finance (CeFi) to decentralized finance (DeFi) is how governments and traditional financial institutions will respond.
Some countries may believe that cryptos and DeFi operations threaten their monetary policy sovereignty. Russia, for example, proposed banning cryptos in early 2022 – but this has not actually been done yet.
While some people advocate for the decentralization of currency, central banks are proposing the creation of Central Bank Digital Currency (CDBCs). CDBCs would be a virtual version of a country’s currency that is centralized and regulated by the monetary authority. This would be a competitor to the decentralized finance (DeFi) system.
One of the challenges that still needs to be overcome is convincing the general public that DeFi operations are just as safe as CeFi operations. Since most people are unaware of the existence of DeFi, they may see the transition from CeFi to DeFi as a way to avoid inflation and other financial problems.
The conflict between Ukraine and Russia has resulted in increased DeFi operations by civilians of these two countries, due to bank and stock exchange closures, inflation, and devaluation of the local currencies.
One issue with decentralized operations is that they can be used to finance criminal activities, such as money laundering and terrorism. While it may appear difficult to track these activities in a decentralized environment, the public data of the blockchain can be accessed to see the entire history of payments made by organizations that are behind crimes.
The Securities and Exchange Commission in the United States has said that it plans to use artificial intelligence to monitor illegal activity on DeFi protocols.
What Are Stablecoins?
The large amount of volatility in popular cryptocurrencies has been a major obstacle to their wider adoption. Volatile prices make it difficult to use cryptocurrencies for everyday transactions, as their value can change significantly from one day to the next. Stablecoins are designed to solve this problem by maintaining a relatively stable value.
Stablecoins are a type of cryptocurrency whose value doesn’t fluctuate. The value of stablecoins is based on and pegged to stable real-world assets. Usually, stablecoins are backed by currency like the U.S. dollar.
Stablecoins that are backed by government-issued currency are often referred to as fiat-collateralized stablecoins. This is because the value of the stablecoin is directly linked to the stability of the economy of the country whose currency is being used to back the stablecoin. For example, USD-backed stablecoins will be more stable as long as the United States economy remains stable.
Stablecoins that are backed by fiat currencies are collateralized 1:1. This means that for every stablecoin in circulation, there is one unit of currency held in a bank account to back it up. If you want to trade in your stablecoin for cash, you can contact the issuer to receive the equivalent amount of cash, or you can purchase it on a cryptocurrency exchange. The stablecoins that you redeem will be taken out of circulation.
Stablecoins can be a part of your cryptocurrency portfolio and used in decentralized finance protocols, but it’s important to remember that fiat-backed stablecoins are not truly decentralized finance coins. This is because their value is dictated by centralized systems (fiat pegged).
Even though there are a lot of idle assets, DeFi projects and market participants can still benefit from them. If they keep the assets as part of their savings accounts, they can earn interest from them (passive income).
Stablecoins are a great way to earn interest while you wait for better investment opportunities. DeFi protocols offer interest accounts that yield farmers can use to safely earn passive income. Let’s take a more in-depth look at how to earn yield with DeFi projects.
Earn Yield With DeFi: Lending
In DeFi, one of the main ways to earn a return on your investment is by lending your funds to someone else and charging interest. Lending works similarly to how it does in traditional finance, but there are a few key differences to be aware of. First, DeFi lending is often done using cryptocurrency rather than fiat currency. This means that there is a higher degree of risk involved, as the value of cryptocurrency can be volatile. Secondly, DeFi lending platforms are often decentralized, which means that there is no central authority overseeing the transactions. This can be beneficial in terms of security and privacy, but it also means that you need to be extra careful about who you lend your money to. Make sure to do your research and only lend to borrowers who you trust. Finally, remember that DeFi lending is still a relatively new field, so there is a lot of uncertainty about how it will develop in the future. Be prepared for the possibility that lending platforms could shut down or experience technical problems.
You could agree to lend a friend $1,000 with the understanding that they would pay you back $1,100 after one year. This would give you a 10% return on your investment.
If you were to give $1000 to a stranger on the internet, there is a high chance that you would never see that money again. In the same vein, if somebody wants to borrow funds through the decentralized finance system, they must first put up collateral.
I would need to put down $2,000 worth of ETH as collateral if I wanted to borrow $1,000 worth of USDC. This would let the other party know that I wasn’t planning on running off with their money.
The author knows what the reader is thinking – that it doesn’t make sense to exchange $2,000 worth of ETH for $1,000 of USDC when they could just sell the ETH. The author assures the reader that they will understand the reasoning soon.
Understanding Crypto Borrowing
At first glance, crypto borrowing might not seem that reasonable. However, there are many reasons for a borrower to use ETH as collateral to borrow crypto instead of selling it. Some of these reasons include wanting to keep ETH for future price appreciation or borrowing against it to get a different type of cryptocurrency.
- Liquidity Needs: Let’s say I am a long-term holder of BTC and ETH and I have most of my net worth in crypto while holding very few fiat currencies like the U.S. dollar to pay for day-to-day expenses. However, an unforeseen event like a car accident happens and I need a great amount of USD to repair my car or buy a new one. I could sell $20,000 worth of BTC to satisfy my liquidity needs and buy it back after a year. However, if BTC appreciates in value by 30% in that year, I would incur a 30% loss. Instead of selling, I can use my BTC as collateral and borrow the amount of USD I need while paying a 5% annual fee. This way, I can be exposed to BTC capital appreciation while still having the liquidity I need to pay the unforeseen expense.
- Investment Leverage: Another popular reason to borrow crypto is to have some investment leverage. For example, let’s say that I hold $20,000 worth of BTC. If Bitcoin appreciates by 30% in one year, I earn $6,000. However, if I use $20,000 BTC as collateral to borrow $10,000 USDC, I can then use that to buy another $10,000 worth of BTC. If Bitcoin appreciates by 30% in one year, I earn $9,000 and, after paying $500 worth of interest, I have a net gain of $8,500 instead of just $6,000. This is the same concept of using leverage as you would see in traditional finance. However, instead of getting the leverage via a broker, I get it via a decentralized liquidity protocol.
Understanding Smart Contracts
Now that you know why someone would use stablecoins for collateral, there are some other pieces to the puzzle. For example, if the borrower gave you $2,000 worth of ETH as collateral to borrow $1,000 in USDC, what’s to stop you from running away and selling the ETH on the market? Also, what would happen if you received ETH as collateral, but then its value dropped significantly?
A smart contract is a contract that is written in code and stored on the blockchain. When certain conditions are met, the code is automatically executed. This means that you can program a smart contract to lend money to someone and they will only be able to access the money if they repay it within a certain time frame. If transactions only happened between the lender and the borrower, they would need to trust each other. However, blockchains and DeFi don’t work like that. Instead, we need a trustless system where things can work without needing trust and without any centralized institutions. This is where smart contracts come in. A smart contract is a contract that is written in code and stored on the blockchain. When certain conditions are met, the code is automatically executed. This means that you can program a smart contract to lend money to someone and they will only be able to access the money if they repay it within a certain time frame.
When certain conditions are met, a smart contract, or a piece of code on a blockchain, is executed. This is how it works:
- You (the lender) deposit $1,000 worth of USDC into the smart contract using a blockchain application (we’ll see later how to do this).
- The borrower deposits $2,000 worth of ETH as collateral into the smart contract.
- The smart contract gives the borrower $1,000 worth of USDC while locking the ETH deposit. This way, you cannot run away with the borrower’s ETH.
- When the borrower deposits $1,000 worth of USDC back in the smart contract, the code will give him back the ETH deposited minus the interest needed to pay you.
- You receive the $1,000 deposited plus any interest.
- If, in the meantime, the value of ETH drops below a certain threshold, the smart contract will automatically sell ETH and pay you back. This way, your funds are protected against any market drop thanks to the code that runs automatically.
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