What is a DeFi Stack? The most important thing you should know

Stablecoins, DEXs, DeFi synthetic assets, money market DeFi protocols, and decentralized insurance platforms comprise the DeFi stack.

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What is DeFi?

Every economic system is founded on the principle of centralization. Banks, governments, and public enterprises have all served as central authorities, and people have placed their trust in them to preserve value and keep the economy running smoothly.

We needed centralized authorities because we lacked the technological capability to conduct peer-to-peer transactions. The trust placed in those entities to maintain the financial and economic system, however, has resulted in a great deal of authority and misuse of that power in the form of entry and adoption barriers, excessive fees, and usage limits.

Decentralized Finance (DeFi) is a new experimental type of finance that is based on smart contracts on blockchains rather than a central authority or intermediaries such as brokerages, exchanges, or banks. This new system aims to improve on the principles of disintermediation by creating a financial system that is open to all, where trust is verifiable through code, and does not require users to place blind faith in it.

Decentralization does not imply that there is no center; rather, it means that nodes have the ability to select the center. DeFi, for example, combines traditional banking and investment services with decentralized technologies such as cryptocurrencies and decentralized applications (DApps) to create a global financial environment that is fast, low-cost, trustworthy, efficient, and completely transparent.

By allowing the unbanked to access financial services such as remittances and digital payments, this new decentralized ecosystem transcends status, wealth, and geographic boundaries. It allows them to use smartphones to digitally register information and obtain the information needed to open bank accounts.

Blockchain protects their digital profiles, allowing anyone, including refugees, to receive loans and start businesses regardless of where they are. Furthermore, it will contribute to the resolution of the global poverty issue. DeFi also eliminates the need for certain intermediaries, lowering international payment costs.

In this article, we will look at the DeFi stack, which includes DeFi stablecoins, decentralized cryptocurrency exchanges, DeFi synthetic assets, money market DeFi protocols, and decentralized insurance platforms.

DeFi stack

Bitcoin (BTC) and Ethereum (ETH) are two applications of blockchain technology, each with their own set of goals. The first is digital money, which can be used to make payments or stored as a store of value, whereas Ethereum is a programmable blockchain that coders can use to create valuable things.

Because of the characteristics of blockchain technology, software built on the Ethereum blockchain is referred to as DApps. DeFi, a movement aimed at transforming the current financial system into one that is more transparent, decentralized, and trustworthy, was inspired by these DApps. The following sections go over the components of the DeFi stack.

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Stablecoins in decentralized finance

Stablecoins attempt to achieve low or no volatility by tying their value to price-stable assets like gold or the US dollar. Tether (USDT) tokens are all linked to the US dollar, which means they have the same value as the US dollar.

The two main types of stablecoins are custodial-backed and algorithmic currencies. Custodial tokens, such as USDT, are pegged to a currency reserve. The backing ratio for these coins is 1:1, and USDT should not deviate from this ratio.

The other type of stablecoin is operated and stabilized using algorithms and smart contracts. This method is similar to the fiat-collateralized process, with the exception that the underlying collateral asset is a cryptocurrency rather than a commodity or fiat currency. DAI is an algorithmic cryptocurrency based on Ethereum that uses digital currencies as an economic incentive to incentivize arbitrageurs to keep the currency pegged to the US dollar.

These coins were designed to bridge the fiat-to-cryptocurrency gap and reduce the volatility associated with crypto holdings by allowing holders to switch to stablecoins at any time and keep their value essentially unchanged.

To avoid liquidity issues, the reserve asset backing these stablecoins is always greater than the stablecoins in circulation. As a result, DeFi stablecoins are an important component of the decentralized financial system because they keep the crypto market stable.

DeFi crypto exchange

In most markets, centralized exchanges and firms serve as intermediaries to facilitate asset trading, despite being under-collateralized, charging some trading fees, and causing liquidity concerns when placing orders. However, crypto assets in the DeFi market can be traded without the use of a middleman via decentralized exchanges (DEXs).

Users can trade for minor swap fees and minimal custodial risk in the crypto era by using decentralized exchanges like Uniswap while maintaining complete ownership over their assets.

Uniswap is a decentralized cryptocurrency exchange that launched in November 2018. One of the most notable aspects of this successful exchange is that it employs a revolutionary style of liquidity provision known as "automatic market making" rather than a centralized limit order book.

In an automated market maker (AMM) like Uniswap, each asset combination constitutes a separate pool or market. Agents provide liquidity by adding the pair in proportion to the existing pool. Agents demand liquidity by introducing one item and eliminating the other.

The relative proportion of the two exchanged assets defines the average price paid, which is calculated using a specified downward-sloping, convex relationship (a bonding curve). Larger orders have a greater price impact due to the convexity.

DeFi synthetic assets

Synthetics are financial assets that are designed to behave similarly to other assets. These synthetics are crypto derivatives, which means that their value is derived from and based on the value of other assets.

Swaps, options, and futures contracts are examples of synthetic products that offer investors highly configurable risk, exposure, and cash flow patterns. In decentralized finance, this type of financial instrument is required to replicate operations such as liquidity, funding, and market access.

Due to a decentralized synthetic asset trading system, there are synthetic platforms such as Synthetix.io where anyone can exchange, mint, and offer liquidity for a wide range of assets.

Curious to know how synthetic investment works? Please follow the below steps:

  • Users mint (or create) synthetic assets by placing collateral (SNX for Synthetix). The collateral is used to give the newly created synthetic asset real value.
  • Oracles feed the platform real-time data about the price of the target asset, allowing the synthetic to track value properly.
  • Synthetix is used by traders to trade assets such as the sUSD (synthetic USD).
  • Minters are compensated in SNX, the protocol's native asset, for minting and creating liquidity for exchange-traded assets.

DeFi money market

Liquidity (in the form of loans) is a critical component of any financial market in the current financial system, which banks solely provide. Loans, too, play an important role in the DeFi ecosystem. People can lend and borrow crypto assets using a variety of protocols. Decentralized lending systems are unique in that neither the borrower nor the lender are required to reveal their identities.

Furthermore, anyone can use the platform to lend money or provide liquidity in exchange for interest. As a result, DeFi loans are not subject to approval and are not reliant on trusted relationships. Money markets provide liquidity in a decentralized financial system by allowing users to borrow or lend money without the involvement of banks or a central authority.

DeFi money market projects, like Compound, use a liquidity pool architecture to allow users to lend or borrow money outside of the banking system. Borrowers must obtain a loan with an interest rate determined by supply and demand, whereas lenders can earn passive income by investing in a pool of cryptocurrency.

In contrast to centralized banks, DeFi money markets allow anyone to check the amount of loans made from a lending pool to ensure that the liquidity pool is not over-collateralized. DeFi products also provide significantly higher average returns, with some platforms providing more than a 10% average percentage yield on deposits. Furthermore, DeFi users have no credit history, ensuring borrower privacy.

DeFi insurance

Millions of people around the world now have access to financial tools that they would not have had access to under the traditional financial system. However, what exactly is decentralized insurance? And what role does it play in the world of DeFi?

Hackers with keen eyes are constantly looking for new ways to exploit, manipulate, and profit from gleaming DeFi systems like Poly Network and other major heists, resulting in significant losses for both the business and its customers. Decentralized insurance is used to limit and cover the risks associated with DeFi platforms, protecting decentralized finance users from any potential threats.

DeFi insurance applications or protocols, such as Nexus Mutual, use smart contracts to build a community-based business model in which governance determines the outcome of each insurance claim. As a result, decentralized insurance products offer comprehensive protection for DeFi deposits, hedge risk against crypto volatility, and protect crypto wallets from heists, providing investors with a sense of security.

The future of decentralized finance

DeFi addresses some of the issues plaguing the financial system, such as transaction prices, financial exclusion, slowness, and security concerns, while also providing consumers with a seamless experience from anywhere on the planet.

Large, powerful institutions wield significant power in the existing financial systems. DeFi, on the other hand, seeks to reduce or eliminate centralization as well as some of the power and control that intermediaries already have. Furthermore, the goal of this revolution is to create a permissionless and transparent financial environment that is potentially accessible to everyone, including the unbanked.

It is advantageous and novel to reform traditional financial services in a decentralized manner. This new ecosystem has a lot of promise and could have a significant impact on how people conduct financial transactions in the future.

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