We have covered how Decentralized Finance differs from Traditional Finance and the history of DeFi, and you may be thinking “What’s the use?”
The use is where DeFi and TradFi overlap. They have similar use cases, including borrowing, lending, trading, buying insurance and derivatives, and creating a savings account.
Many DeFi projects offer users a platform to manage their assets, like buying, selling, and trading crypto. With smart contracts, you control your assets and hold your private keys rather than the platform holding them. Everything in DeFi is recorded on a public ledger so everyone can see the transaction receipt, and each person’s ID is tied to a long address composed of numbers and letters.
DeFi lending is similar to TradFi lending, except you’re lending directly to someone rather than through a bank. Lenders can earn higher interest on the amounts they lend than a bank would offer. Lending allows users to borrow funds using their cryptocurrency as collateral. Here’s an example of a way to lend money using the DeFi protocol Compound:
You lend your 100 USDT stablecoin to the lending protocol Compound.
You receive 100 cTokens which is a token that represents your loaned USDT.
Your cTokens will increase based on the interest rates. Based on the APR, your wallet balance will read something like 100.2345 after a few days or even hours!
Lending in DeFi has also become a means of earning interest on savings for many.
DeFi allows for peer-to-peer borrowing, so there’s no middleman between you and the lender, and you can borrow with privacy. Borrowing has never been so seamless, with only the need for collateral to move forward with a transaction rather than surrendering your personal information with no guarantee you will get approved. To borrow, you have to put up an amount of collateral higher than the amount you intend to borrow. At first glance, this may sound absurd, but the benefits are the assets may be primed to increase in value in the future, you may be able to avoid paying capital gains tax, and funds borrowed on certain platforms can increase leverage on certain trading positions.
Is there a cap on how much I can borrow?
Yes there is a cap and it depends on how much liquidity is in the pool you’re borrowing from and how much collateral you put up.
What is pool-based borrowing?
Pool-based where lenders provide funds (liquidity) to a pool, and borrowers can borrow from that pool.
Trading in DeFi happens primarily on decentralized exchanges. Decentralized exchanges use open-source code to operate and aren’t owned by a single company. Many people trade swapping services. You can utilize swapping platforms like UniSwap and Sushiswap to engage liquidity pools and swap tokens for stablecoins without paying high gas fees.
Derivatives are contracts with value from underlying financial assets, including bonds, commodities, interest rates, market indexes, or fiat currencies. Derivatives allow investors to interact with an asset without holding it. Derivative values change with the value of the primary security.
DeFi insurance works like regular insurance because it protects you from losing money on DeFi platforms. DeFi can be risky because it’s still a fairly new technology, so having insurance can help avoid losses.
Understanding the use cases for DeFi helps understand the significance of establishing Decentralized Financial platforms in Web3. Creating systems to help users engage with cryptocurrency in a meaningful way through DeFi will increase the likelihood of cryptocurrency adoption.