DeFi is a transparent open financial system accessible to all with the promise of moving us further toward the future of finance. But how do you know which DeFi protocols are the best? How does DeFi actually work? We’ve created a list of five of the most popular and widely recognized protocols in the DeFi space.
What is DeFi, and How Does it Work?
DeFi stands for decentralized finance. It’s decentralized, meaning there is no third party (or middleman) facilitating transactions. DeFi is a catch-all term for the financial products and services available on the blockchain.
In DeFi, services are available around-the-clock, on-chain, with nearly instantaneous transaction completion. DeFi uses smart contracts of programmable code to complete transactions, replacing third-party intermediaries such as banks or central governments.
Some of these services include lending, borrowing, yield farming, and generating interest on your cryptocurrencies hosted on the blockchain. It’s an alternative to traditional finance (referred to as TradFi) institutions, which are centralized and sometimes also known as CeFi.
Top Five DeFi Protocols
Ethereum’s introduction of smart contracts to the marketplace has enabled numerous blockchain protocols to create crypto-based financial products that can exist without a trusted third party. Let’s take a look at a few of them below.
- Uniswap is an Ethereum blockchain-based DEX or decentralized exchange. It’s an automated market maker (AMM). An algorithm determines the prices, and users (known as market makers or liquidity providers) supply tokens in liquidity pools and receive additional tokens in return. Other users (known as market takers or traders) place trades that tap into liquidity from liquidity pools.
- MakerDAO is one of the earliest DeFi projects on Ethereum. It is a DeFi lending and borrowing platform. Maker (MKR) is the utility and governance token for the platform. Maker is an Ethereum-based decentralized autonomous organization (DAO). The user provides ETH that is locked in a smart contract, and the borrower receives the loan issued in the stablecoin DAI.
- Aave is a DeFi lending platform. According to Decrypt.com, “Aave is a decentralized finance (DeFi) protocol that lets people lend and borrow cryptocurrencies and real-world assets (RWAs) without going through a centralized intermediary.”
- One of the key DeFi innovations is Aave’s flash loan product which are uncollateralized loans (where users borrow tokens from Aave’s lending pools). The terms of the loan executes as a smart contract on the Ethereum blockchain. The user must then pay back the loan, same day, plus Aave’s platform fees.
- Synthetix is a protocol for issuing synthetic assets. The synth or synthetic asset gives the holder exposure to an asset without actually having to hold it as well as allowing them to generate a return on the asset.
- For example, an individual can purchase Tesla synths, gain exposure, and make a considerable return without owning Tesla stock. Essentially, this is an on-chain derivatives trading of both real-world assets and digital assets.
- Compound Finance is the equivalent of having a decentralized savings account. Compound is a marketplace utilized by crypto investors to lend and borrow digital assets. According to their site “Compound is an algorithmic, autonomous interest rate protocol built for developers, to unlock a universe of open financial applications.”
Challenges for DeFi
The recent market downturn of 2022 has brought with it challenges for the crypto industry as a whole. Many of the most popular DeFi protocols and crypto tokens are run by anonymous founders and development teams which can lead to accountability and security issues for the ecosystem.
Crypto scams pose another threat to DeFi, but community policing and crypto reporting sites are helping to reduce scams and assist impacted investors.
What’s Next for DeFi?
The future for DeFi is a bright spot in the tumultuous world of crypto. As the broader adoption of cryptocurrency grows, so will the DeFi market. Advancements in interoperability offer more potential for ease of use for users doing transfers across chains. Flash loans may one day be accessible to average users instead of developers with programming skills.
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