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, Author: Mason Nystrom, Compiler: Xi Yu, released with authorization.

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Table of contents

• Image credit: Pixabay

• Feel free to jump to the sections that interest you most, but we recommend reading through the entire guide for a comprehensive understanding of how decentralized finance protocols and applications work together. Note: This article is not exhaustive, but a powerful introduction to the Ethereum DeFi ecosystem through specific examples.

• Table of contents

• How does the decentralized finance definition work?

• What are stablecoins?

• Does Decentralized Finance Work?

• How much money is locked in decentralized finance applications?

• What are stablecoins?

• What is a DEX (Decentralized Exchange)?

• What are synthetic assets?

• What is a prediction market?

• What is a Lossless Lottery?

• What are synthetic assets?

• DeFi for payments

• What are databases (Oracles)?

How to participate in DeFi?

Other FAQs

What is Decentralized Finance/Open Finance?

Decentralized finance (or open finance) refers to the paradigm shift from today's closed financial systems to an open financial economy based on interoperable, programmable, and composable open protocols.

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1. Interoperable

How does decentralized finance work?

Decentralized finance leverages three key principles of the Ethereum blockchain to revolutionize the existing financial system to empower individuals and provide greater financial freedom.

The current financial system consists of walled gardens (e.g. financial institutions) with limited transferability or two-way access. Where interoperability is possible, it is controlled by middlemen and rent-seekers. Open finance is defined by platforms that can work together with a degree of transparency and have complementary capabilities.

3. Can be combined

Bitcoin has revolutionized money by creating an asset that is self-sovereign and free from political influence. Ethereum enables new types of financial instruments and assets that are more customizable than existing products and services. Digital assets and securities will usher in a new era of financial mechanisms and growth.

3. Can be combined

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Is decentralized finance (DeFi) useful? How will it affect the world economy?

How much money is locked in decentralized finance applications?

What are stablecoins?

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What are stablecoins?

Stablecoins are cryptocurrency assets that maintain a stable value relative to a target price, such as the U.S. dollar. Over the past two years, several categories of stablecoins have emerged.

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• What types of stablecoins are there?

• Here are some stablecoin types:

• Fiat collateral - backed by a single currency or a basket of fiat currencies

Crypto-Asset Collateral - backed by a crypto-asset (most commonly ether)

Resource backed - a stablecoin backed by another asset (e.g. gold)

Most stablecoins in development focus on the fiat-collateralized model because it is easier to maintain stability and integrate into existing financial systems. Banks and financial institutions can more easily use stablecoins denominated in a single currency or a basket of currencies rather than those backed by cryptocurrencies such as bitcoin or ethereum.

Many companies are trying to create stablecoins that can be used around the world. Facebook is getting ready for Libra. Walmart is getting ready for Walmart Coin. USDC issued by Coinbase, available in more than 80 countries. Binance recently announced its stablecoin initiative, Venus. JP Morgan has created a digital asset to settle transactions between institutional clients. Institutions across the globe recognize the potential impact of stablecoins, with the International Monetary Fund noting: “Stablecoins pose a threat to banks and cash.”

Cryptocurrency-collateralized stablecoins, such as the Dai stablecoin, have seen relative success over the past few years. Dai is designed to be as decentralized as possible so that it is not controlled by any single entity or group of entities. The MakerDAO Foundation, which designs and develops the protocol that runs the Dai stablecoin, utilizes a separate token called Maker (MKR) to help Dai maintain its price peg.

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One of the groundbreaking use cases of decentralized finance (DeFi) is the ability to obtain loans without a trusted party or middleman such as a bank or large corporation. MakerDAO was one of the first apps to enable users to get loans from anywhere. Maker Vault needs to deposit Ether before lending Dai to users. One caveat to note is that users must maintain a collateralization ratio of at least 150% - so if you put 1 ETH in Maker Vault at $162/ETH, when ETH drops below $89, the CDP will be automatically liquidated. Although this type of loan requires more capital to be deposited upfront, it allows individuals to keep their underlying asset (Ether). So imagine a situation where you park some sort of asset that you plan to hold for a while, such as an S&P 500 index or a potential portion of a 401k. With this loan structure, you can get the loan out of capital without having to sell. While this isn't particularly useful for borrowing large amounts of money, it has the potential to help individuals borrow small amounts.

More recently, more types of lending protocols have been built on top of Ethereum, including Compound, Fulcrum, Aave, and more. Both Compound and Fulcrum create pools that allow users to borrow or lend Dai, USDC (Coinbase’s stablecoin), ether, and other crypto assets.

Crypto lending protocols essentially break down barriers to accessing funds. Getting a loan in the traditional financial system involves going to a bank and meeting the necessary requirements (credit score, job, etc.). Often, these requirements can hurt those who need the loan most, such as the self-employed, students, local entrepreneurs, or people in disenfranchised communities. Access to capital is a fundamental prerequisite for achieving financial freedom, which is often guarded and controlled by traditional institutions.

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Anyone can take advantage of the Compound protocol by downloading MetaMask or another cryptocurrency wallet. Dharma, a company that originally competed with Compound, now leverages Compound's protocol to offer its customers the best possible rates. Dharma achieves this with its "smart wallet," which automatically deposits customers' funds into the Compound protocol.

Recently, many cryptocurrency exchanges such as Binance have also started offering lending services for various crypto assets. While using a cryptocurrency exchange is a more centralized option than using Compound, it is arguably less centralized than traditional banks because Binance and other exchanges are using decentralized currencies that are not controlled by a single country (such as the U.S. dollar). Centralized stablecoins and crypto assets.

These different protocols demonstrate the power of composability: 1) Dharma provides an open platform on top of Ethereum by 2) utilizing Compound’s open protocol, 3) primarily offering and borrowing the Dai stablecoin created by the MakerDAO protocol . Welcome to this new financial system.

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What are the best crypto lending/paying companies and protocols?

However, DeFi lending is more than chasing the best interest rate. Several factors should be considered before using the lending protocol, including the risk of the smart contract and the sum of the liquidity pools.

To help individuals and new users in the community, ConsenSys created the DeFi Score, a consistently comparable value that measures platform risk based on factors such as smart contract risk, collateral, and liquidity. DeFi Score is a framework for quantifying risk in permissionless lending pools. Originally conceived by a team at ConsenSys, the project is now open source and open to the community.

You should evaluate all these factors before deciding on an agreement/company that you decide to lend your loan to.

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What is a DEX (Decentralized Exchange)?

Decentralized exchanges (DEX) provide a new model of trading and exchanging assets without relying on a single intermediary or oligopoly (controlled by a small number of individuals/companies).

Uniswap this year became a decentralized exchange (DEX) for trading cryptocurrencies without intermediaries. Uniswap reported that over 24 periods in November 2019, Uniswap traded over $8 million in volume. Uniswap currently accounts for 33% of the total DEX volume (more than IDEX and Kyber). Another decentralized exchange, dYdX, has developed a platform that combines trading, lending, and borrowing. The dYdX decentralized exchange aggregates spot prices and loan liquidity across multiple exchanges for its multiple users. Other Zong Xinhua exchanges or protocols include 0x, AirSwap, Bancor, Kyber, IDEX, Paradex, and Radar Relay.

Blockchain analytics firm Alethio created DEXWatch to monitor decentralized exchange (DEX) activity, including tokens, traders, and transactions. DEXWatch displays graphs of decentralized exchange (DEX) activity.

What is a prediction market?

Prediction markets are platforms that enable individuals to bet or gamble on the outcome of events, games, elections, etc. Predictit is one of the most famous prediction market apps, although users from various countries are not allowed to create accounts and use the app. Many jurisdictions around the world do not allow individuals to gamble or bet on specific events, including elections, sports, judicial outcomes and other disputed events.

Ethereum enables prediction markets to operate outside of jurisdictions, thereby providing a true prediction market for everyone in the world. Why is this important? Prediction market platforms and applications rely on the "wisdom of the crowd" to determine the likelihood of any outcome. The concept is based on solid scientific evidence that many people (crowds) are almost always more accurate than a single expert in predicting the outcome of a general event.

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Augur is a prediction market platform where anyone can create or bet on markets (games, events, elections). The Augur protocol, running on top of the Ethereum blockchain, allows individuals to buy or sell shares of a potential outcome.

In Numerai’s stock prediction tournament, data scientists create models that trade on the stock market, requiring data scientists to stake their own predictions with personal capital in the form of NMR tokens. Data scientists are then rewarded based on the accuracy of their predictions and the amount of money invested. The stronger the belief, the more willing an individual is to bet or bet on their trading model.

Additionally, Numerai created the Erasure Protocol, which provides a data marketplace where individuals can use their specific knowledge to sell predictions or information about the world that are transparent and contractually enforceable. Numerai Tournaments and the Erasure Marketplace provide opportunities for any individual to earn income based on their skills or unique personal knowledge.

How do prediction markets work?

For example, a market creator could generate a market for: "Which team will win the Champions League?"

The creator of the marketplace can define a set of possible outcomes, such as "Juventus" or "Real Madrid". At the beginning, the options are divided into parts, and the sum of all shares is $1.00, which is 100% probability. Earn $1.00 for owning the winning part. For example, if Real Madrid had a 51% chance of winning (and they did win in the end), each Real Madrid shareholder would receive $1.00 per share.

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PoolTogether is a lossless lottery built on Ethereum that enables people to buy lottery tickets using Dai. PoolTogether allows anyone to buy lottery tickets using Dai, and then keep the proceeds in Compound (earning interest) for a certain period of time (week, month, year). The winner of the lottery receives accrued interest on all pooled funds, and everyone else (the loser) gets their money back.

What are synthetic assets?

Although no-loss lotteries limit the likelihood that anyone can win a prize, this type of lottery prevents the long-term losses that many people experience when they gamble on the lottery.

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What are synthetic assets?

However, this is not to say that speculative instruments and financial mechanisms are inherently bad. Speculative instruments and mechanisms are an essential part of any new asset class, especially one that aims to be the foundation of an open financial system. The 2008 financial crisis was in some ways more dire because much of the information—from how bonds are priced to how assets are priced—is controlled by opaque, centralized entities. A key aspect of Ethereum is that these protocols are open and accessible to anyone.

Currently, many companies are creating protocols to create synthetic assets and derivatives encoded in smart contracts. UMA (Universal Market Access) is creating a derivatives platform that provides standardized contracts for financial products. Another crypto firm, Synthetix, is developing a protocol that enables the creation and issuance of synthetic assets such as cryptocurrencies, fiat currencies, and commodities.

The synthetic assets and derivatives offered by the open-source protocol will create value for investors looking to hedge risk, diversify their capital allocation, and find mechanisms to increase their return on investment. There is no limit to the types of derivatives that can be created using cryptoassets. For example, there already exist more than a dozen variations of Dai created by other DeFi protocols. Ethereum’s data transparency and potential to build on top of and partner with other Ethereum-based protocols opens up endless possibilities for what can be created within the decentralized finance ecosystem.

DeFi for payments

As the world naturally shifts to digitally native payments, the mechanism of making payments in cryptocurrencies (which could eventually become the native currency of the internet) will see greater use in everyday transactions. Ethereum naturally allows anyone to make cross-border payments or transactions without the intermediary fees common in traditional financial services.

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Which companies accept Bitcoin and Ethereum for payment?

As the crypto ecosystem expands, more and more companies are accepting Bitcoin, Ethereum or Dai as payment methods. Lolli enables users to earn bitcoins while shopping online. While you can't pay with ether or tokens on Amazon, more companies will offer this option in the coming years.

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What is a decentralized bank?

Decentralized banking refers to the concept of eliminating the need for a bank account. 70% of Filipinos remain unbanked and do not have access to checking or savings accounts. This is not uncommon, as billions of people around the world do not have access to the same financial systems as more developed economies.

Banking the unbanked requires a combination of IoT and blockchain technologies to provide financial services to everyone. DeFi is building many applications and services of decentralized banking, including lending, payments and investing. Other important functions, including identity, crypto wallets, insurance, data storage, etc., are developed by individuals or companies within the broader Ethereum ecosystem.

• What are Oracles?

• An oracle is any system that provides external data for use on-chain. Without oracles, smart contracts on Ethereum would only be able to perform operations on on-chain data. Oracles expand potential use cases for smart contracts, including insurance, finance, and more powerful prediction markets.

How Oracles are activated

How Oracle Responds

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How do you participate in DeFi?

If you want to participate or increase Ethereum adoption, start by buying Dai and using it where you can/live. If you're a developer, please contribute to the open source projects and tools that bring Dai and stablecoins to the world. If you are an audiophile, educator, writer or translator. What makes cryptocurrencies unique is this open source global community, and everyone is welcome to join.

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Other FAQs

How important is blockchain to the world economy?

Blockchain networks, especially Ethereum, will fundamentally change the way the world's economies work by reducing operating costs, eliminating middlemen and creating new markets. Obviously, it is impossible to predict the future ten years from now, however, blockchain technology will become an integral part of business functions and everyday life. Read more about how blockchain technology will impact various global industries including supply chain management, energy, government, real estate and more.

Can You Profit From Investing in Dai or USDC Stablecoins?

Stablecoins are designed to reduce the instability of cryptocurrencies (i.e. Bitcoin, Ethereum) by maintaining a constant value. Therefore, buying Dai or USDC and keeping it in your wallet does not add value. However, various crypto lending protocols such as Compound and Fulcrum generate interest on lending stablecoins such as Dai or USDC. So while you won't be able to profit from stablecoins that increase in price, it's possible to benefit indirectly by lending out stablecoins that you don't use, similar to how banks offer interest rates for depositing cash in a bank. The difference is that banks offer very low interest rates whereas loan agreements can generate returns of around 4–9% depending on the agreement. Using any crypto lending protocol comes with increased risk, which you can learn more about at Defi Score.

Do cryptocurrencies pay dividends?

Most cryptocurrencies do not pay dividends in the traditional sense. Ethereum, the native cryptocurrency of Ethereum, does not pay a dividend, nor does Bitcoin. However, depending on the design, security tokens and other financial cryptoassets may pay dividends or entitle owners to a share of company revenue.

Is there a better DeFi blockchain than Ethereum?