Decentralized Finance Categories Explained

Zainab Hasan

Zainab Hasan

September 30, 2020

 |8 min read

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Decentralized Finance categories explained

In this article, you will get to know about the Decentralized Finance categories and projects associated with each category.

Introduction:

Decentralized Finance (DeFi), is finance but on the blockchain. In simpler terms, DeFi is permissionless dealing with finance, meaning, the intermediary such as banks, insurance companies, brokers, and more in real finance are replaced by smart contracts in Ethereum.

Read more about Decentralized Finance here.

Decentralized Finance Categories:

DeFi projects fall into different categories, these categories are:

1. Lending:

In Centralized Finance (CeFi), lending is when you allow someone or an organization to utilize assets by borrowing and paying it back later on. The Decentralized Finance categories also include lending, which is not that different. In DeFi, as the name suggests, the assets are cryptocurrencies or tokens, with no central authorities. Lending protocols allow the lender to earn interest as an incentive.

In the traditional finance system, you have to give proof of your identity in order to take out a loan. DeFi removes all of this friction. The collateral amount is all you need to take out a loan, there is no need for proof of identity.

The number of tokens or cryptocurrencies you can take out as a loan varies depending upon the rate of that token or cryptocurrency. At times, the amount of collateral put is greater than the loan.

A new lending protocol lets you borrow money without submitting collateral, i.e. via flash loans.

Flash loans or zero risk loans are contracts lending money. But there is one catch, it has to be paid back by the end of the execution of the same transaction. If he or she fails to do so the whole transaction will be reverted as if it never happened. This is only possible in the blockchain. The interest in flash loans is either zero or nominal.

Projects:

Some of the leading Decentralized Finance lending projects are:

2. DEXes:

Decentralized Finance categories also include DEXes, which deals with the exchange or trading of cryptocurrencies or tokens. Being part of the blockchain there is no need for a central authority. As a result, DEXes don’t have one point of failure. Your cryptocurrencies or tokens stay in your wallet, hence it reduces the number of risks. You are not putting your assets under someone else’s control, like in centralized exchanges where you put your assets in the exchange. The only time your assets leave your wallet is when a transaction takes place. DEXes don’t require some long procedure to verify your identity and provide legal documentation, as long as you have assets, you can trade them without restrictions. Smart contracts help to make all of these features possible.

DEXes use the concept of either order books or liquidity pools.

Using Order Books:

Order books are essentially just books with trade orders in it. The process of using order books is as below.

  1. Users willing to exchange submit a buy or sell request, this request is stored in order books. This ordering turns the user into a “maker”. 
  2. These order books hold records about which tokens the user is willing to exchange and for what in return.
  3. To validate the order, makers sign it with the private key.
  4. This order is broadcasted through the exchange network and takers come forward with a trade.
  5. If the maker is satisfied they confirm the order, and the smart contract takes care of the rest of the process.

Using Liquidity Pools:

The problem with order books is that they bring back the obstacle of centralization.

Decentralized Finance projects jump over this obstacle with the help of liquidity pools. The market makers are referred to as liquidity providers in this model.

Let’s look into how liquidity pools work.

Take a simple pool, this pool holds two tokens, when a new liquidity pool is created, a liquidity provider supplies both tokens of equal value to the liquidity pool and sets their initial price. Every person adding tokens to the liquidity pool will provide an equal value of both tokens. Liquidity providers earn LP tokens, based on how much liquidity they provide to the pool, when a trade takes place, a fee value is distributed among all LP token holders. With each trade, the deterministic price algorithm adjusts the price of the tokens. This mechanism is known as Automated Market Making.

Projects:

Some of the leading DeFi DEXes are:

3. Derivatives:

Derivatives are contracts with their values based on something else. By definition,

“The derivative itself is a contract between two or more parties, and the derivative derives its price from fluctuations in the underlying asset” – Investopedia.

To understand derivatives completely, let’s consider an example:

When the price of wheat increases, the price of bread will increase, similarly when the price of wheat decreases, the price of bread will decrease. Now, a wheat seller will have an advantage when the price of wheat increases whereas a bread seller will be at a disadvantage. The opposite is true when the price of wheat decreases. Suppose, the wheat seller estimated that the price of wheat will decrease, and the bread seller estimated that the price of wheat will increase in the future. So they enter into a contract that regardless of the price of wheat in the future, for a specified period, they will make the trade at a certain fixed price. This is derivative in finance.

Now you must be thinking that if these people wouldn’t have signed the contract, one of them would have earned more. It’s true, however, both the parties saw risk and minimized it. 

In DeFi, derivatives are the same as in CeFi.

The prices of cryptocurrencies are volatile, hence derivatives make great use in DeFi. 

Synthetic Assets:

The values of assets fluctuate in both CeFi and DeFi, If you think about today’s financial markets, there are things you can buy or sell in one area or country. Let’s take gold or shares as an example, the local legal infrastructure makes it hard or impossible to buy them. Synthetic assets make it possible, let’s say these shares or gold is represented by an ERC, you can buy that from anywhere through the internet. You don’t need to have a safe or a brokerage account.

Projects:

Some of the leading projects working on Decentralized Finance derivatives are:

4. Payments:

In finance, payments refer to the transferring of assets or services in return for assets or services. In other words, payments are just transactions.

Transactions are plausibly the foundation of the blockchain, more specifically peer-to-peer transactions or payments. The idea behind DeFi payments is to facilitate the unbanked and underbanked population as well as institutions. Decentralized Finance payments are secure and direct.

Projects:

Some of the leading DeFi payment protocols are:

5. Stable Coins:

Stablecoins are cryptocurrencies that provide stability to the prices of cryptocurrencies. As you know the price of cryptocurrencies is volatile. Collateral is deposited in the smart contracts and then a portion of the value of those deposited collateral is paid out as a newly minted stablecoin. Of course, these can be traded like any other cryptocurrency. This collateral can be a commodity, a fiat asset, or some other cryptocurrency.

Projects:

Some projects that are based on stablecoins are:

6. Insurance:

Decentralized Finance categories also cover Insurance. Insurance is a safety net. The company provides compensation or reimbursement for specified loss, fraud, or accidents. DeFi is still emerging and may contain faults or bugs or is even prone to hack attacks, many examples of exploitation occurred this very year. The assurance that in such a case, you will be compensated was much needed. People are still hesitant to invest large amounts in DeFi projects, with insurance projects coming forward, DeFi will have the opportunity to grow further.  

Projects:

Some of the leading DeFi insurance projects are:

7. Index Funds:

Indexing, in finance, is the statistical change in market or stocks. Consider it a basket of stocks measured together, for example, the FTSE 100 index represents 100 major companies listed on the London stock exchange. The rise or fall of stock’s rate of the companies listed on this index has the same effect on the index. Indices can be country-based, or they could be the exchange-based they are listed on, then there are regional indices. Index funds are funds that track a market’s index. This market can be a market of stock, bonds, currencies, commodities, or other assets.

In simple terms index funds are buying shares with funds. In DeFi, it is the same. Then a market expert invests this money or funds to buy cryptocurrencies, you don’t have to keep track of risks, calculate returns. An index fund does all of this for you. But DeFi Index funds are more suitable for long runs. Index funds give the advantage of simplified investing without having to worry about maintaining a portfolio.

Projects:

Some of the leading DeFi lending projects are:

Conclusion:

CeFi came into existence much earlier than DeFi, so while Decentralized Finance categories are similar to Centralized Finance, it is still emerging. DeFi is one of the greatest uses of blockchain and in the near future we will get to see more applications of DeFi.

DeFi projects are dominating the blockchain markets, a total of $9.06B USD are locked in DeFi projects as of 18th September 2020. Uniswap dominates the market by holding 15.52% of the market.

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