The series intends to educate first-time users and current users about DeFi. The series will aim to make DeFi as simple as possible using practical examples. It will feature lessons varying from the basics of DeFi, like liquidity pools, to the more complex aspects, like lending and collateralization.
Introduction to Centralized and Decentralized Finance
A Brief History of Financial Systems and Money.
Money is a medium of exchange, a unit of measurement, and a storehouse for wealth.
The world’s current financial systems result from years of constant evolution. From the earliest times, people used the trade by bartering method to exchange goods they had for those they didn’t. The trade by bartering method was unsustainable as people had to meet with others who had the required products and wanted what they had to give. At some point, valuable metals like gold and silver were used as a store of value, and coins were made of these metals. Cowry shells were used as money in Africa and Asia, and other valuable items, such as large stones, salt, etc., were used as money in different places.
At the time of the templars, citizens deposited funds in the church because churches were the safest places. The depositor received notes that bore the value of the deposited funds, and these notes could quickly be submitted to collect back the deposited funds. If the depositor traveled, the notes could easily be turned back to funds in another branch in a different city. This system was regarded as flying money and is said to have been developed by the Chinese. Reports show that the initial debts and credit came from here. Merchant banks in Rome were created after these to fund trade, and one of the more popular Merchant banks was the Medici bank.
Financial systems have developed into financial institutions and banks that provide financial services such as payments, lending, borrowing, saving, or simply transferring wealth and funds. The current financial system is tagged TradFi (Traditional finance). TradFi, or Traditional Finance, is the mainstream financial system in which institutions operate. Some institutions include banks, hedge funds, or brokerages, for example. TradFi is characterized by a high degree of centralization, control, and exclusion of retail investors from many financial services. Some of the drawbacks of TradFi are:
- People have minimal control over their money held by banks,
- Slow transactions and the high costs of these transactions,
- Currency manipulation,
- Many people remain unbanked,
- Low transparency of these financial institutions,
- The build-up of systemic risk as the collapse of the central figure would significantly affect everyone.
The advent of cryptocurrencies has brought solutions to some of the problems of the present financial system. Some of these solutions are:
- Fast transactions and almost zero transaction fees on chains like Moonbeam and Acala,
- Ease of opening accounts,
- Complete transparency as all transactions are stored on a public ledger,
- People have full control over their funds.
Financial Systems in the Cryptocurrency Space
The two systems in crypto are Centralized finance (CeFi) and Decentralized finance (DeFi).
Centralized Finance (CeFi)
Centralized finance in crypto encompasses platforms, including centralized exchanges and centralized financial service providers, which have a lot of similarities with the world’s current economic system and banks. By this, there’s a central body in charge of providing financial services to users — examples of centralized finance platforms are Binance, Kucoin, Kraken, Celsius, and BlockFi. These platforms offer lending and borrowing services, savings, and payments. These platforms face criticism as users don’t fully control their cryptocurrencies, with decentralization being one of the goals of cryptocurrencies at their inception. These platforms have several advantages and disadvantages compared to DeFi.
Advantages of CeFi over DeFi
- Ease of fiat conversion: Centralized exchanges provide a more accessible means of turning local fiat into cryptocurrencies and back to fiat.
- Cross-chain services: Centralized exchanges also give access to more blockchains. You can get the coins for different chains directly from an exchange without using a bridge. For instance, you can easily access Polkadot, Kusama, Moonbeam, Astar, and Acala directly from Binance without bridging tokens from other chains.
- Reduced risk and higher interest rates: Bad actors in DeFi utilize malicious contracts to steal from people seeking the best APRs and interest rates. Centralized exchanges reduce this risk as you can put their cryptocurrencies in the safe pools these exchanges offer. Also, some centralized exchanges offer insurance and even FDIC insurance in USD.
- Customer Service: Centralized exchanges offer customer service to assist their customers.
Disadvantages of CeFi compared to DeFi
- Custody of tokens: You do not have complete control of your cryptocurrencies. Centralized exchanges require a username and password to access your account on their platform. Your account can be frozen and access to tokens can be lost at any time. Compared to offline wallets offered in DeFi, a 12-word secret recovery phrase is issued when creating a new wallet. You can use the 12-phrase to recover your tokens anywhere and at any time, putting you in complete control of your tokens. The famous saying goes, “not your keys, not your crypto.”
- Lack of transparency: Similar to banks, there is little to no transparency regarding what these exchanges do with your tokens.
- Lack of decentralization: This is an obvious disadvantage of centralized exchanges. Anyone in DeFi can create a wallet and access DeFi services on various platforms. On centralized exchanges, you must go through the intrusive "Know Your Customer (KYC)” process, which requires a valid ID and documents.
- Security: The security of funds solely rests in the hands of the exchange. Centralized exchanges have high liquidity and, as such, attract bad actors looking to hack and take advantage of these platforms. Some centralized exchanges combat this by having insurance on user funds.
Decentralized Finance (DeFi)
Decentralized finance involves implementing financial services such as savings, lending, getting loans, and trading using blockchain technology. You can earn interest, trade assets and derivatives, borrow, lend, buy insurance, or save. You can access the financial services offered by banks. Still, all transactions are on a public ledger and verifiable by anyone. DeFi offers complete freedom and control of your assets and what you do with them. Anyone can create a wallet and enjoy these financial services in minutes. DeFi offers decentralization, but that comes with some drawbacks, as users are exposed to different platforms and risks. As with everything, there are advantages and disadvantages to this system.
Advantages of DeFi over CeFi
· Ease of entry: DeFi offers easy access to financial services. You do not need any identification or account to access these services; you only need to create a wallet.
· Control: Unlike centralized exchanges, you have total and complete control of your assets and can move them around as you see fit.
· Security and transparency: DeFi ideally removes the need to trust people, replacing it with trust in smart contracts anyone can review. A public ledger (Subscan for Polkadot, Kusama, Etherscan for Ethereum, and the Blockchain explorer for Bitcoin) stores all transactions on a chain. Anyone can review these transactions at any time. DeFi provides full transparency of where your assets are.
· More opportunities to earn higher yields: DeFi offers you more earning opportunities not present in centralized exchanges. Centralized exchanges do not support all coins from different blockchains and, as such, do not present you with all possible earning opportunities. You can see examples of earning pools on Stellaswap on Moonbeam and Arthswap on Astar Network, which are not present on a centralized exchange.
· Faster transactions and lesser transaction fees: With the permissionless state of blockchain transactions, participation and transactions in DeFi are more rapid than in banks and centralized exchanges. You can get a loan on SiO2 Finance and buy or sell an asset on Stellaswap or even trade Real Estate on Centrifuge in seconds. Transaction fees in DeFi are cheaper than in centralized exchanges as there are fewer intermediaries.
Disadvantages of DeFi compared to CeFi
· Education: People do not have enough knowledge and understanding of how DeFi systems work. A lack of understanding of how these financial services run, including collateralization of loans, liquidity pools, and more DeFi use cases, can result in a loss of funds. This educational series intends to tackle this point.
· Risk of scams and theft: There are always bad actors waiting to take advantage of people. In DeFi, these come in fraudulent and scammy projects that offer higher yields to draw capital and then flee with users’ funds. These bad actors design these smart contracts in this way. As trust is in smart contracts, bad actors also find bugs to take advantage of these platforms to steal. The Polkadot and Kusama ecosystems combat this problem to a large extent.
· Volatility and fluctuating yields: Depending on the platform used, you could face high volatility of assets, and the yields can fluctuate.
· Code hacks: Projects often pay companies to verify that their codes are safe, bug-free, and not susceptible to hacks. Hacks still occur. Most of these occur on bridges that transfer tokens from one chain to another. You can read through some of the largest hacks here. The Dotsama ecosystem mitigates these bridges and their potential hacks with its novel XCM technology, where chains communicate trustlessly and safely.
DeFi has seen continuous growth and acceptance around the world. An estimated 320 million people around the world own some cryptocurrency. This value will continue to grow as crypto gets more endorsements and adoption.
I would like to see a union between the worlds of TradFi and DeFi. TradFi will always exist, as it allows people access to money through local banks at the lowest level. DeFi offers better yields than TradFi but depends heavily on fiat from TradFi to onboard users. A merger would see the best of DeFi combined with TradFi, providing users easier access, more transparency, and better yields than TradFi, while the regulations with TradFi provide security and help mitigate risks in DeFi.
This part of the series serves as an introduction to DeFi and the financial services available through DeFi. Further along the series, we will discuss these financial services in detail and the platforms in the Dotsama ecosystem that offer these services.
