What Is Decentralised Finance? The 4 Pillars of DeFi

You might have come across the acronym DeFi. If these letters fazed you, then let me tell you that they stand for Decentralised Finance. 

Traditional Centralised Finance System

In the past, we have always used centralized finance which is where a central authority controls the flow of money– the governments or the banks control it. They can print more money if they want to. They can stop you from borrowing it. They can even stop you from having a bank account. If they wanted to, they can have your money.

We give them our money. This relationship is based on trust. If you’re running a business, they can limit what you can do. They can tell you not to bring any of the money from the business into the bank which seriously limits you. It means you can’t deposit it or invest it.

Also, traditional finance is quite expensive. Payday loans go up to 500%. Credit cards can average 25% and even personal loans can cost you 18% of the value. These are really high rates but you pay them because you need to. The alternative is decentralized finance. Here, there are no banks.

Instead of that, there are pieces of code that act like banks. They’re open to anyone. They don’t require you to trust them. They are also censorship-resistant and lastly, they are much cheaper than traditional centralized finance.

The Four Pillars of Decentralised finance

Decentralized finance is built on three main things– cryptography, blockchain technology and smart contracts. Assuming you know what they are, I’ll move forward to explaining the four pillars of decentralized finance. 

Stablecoins

The first is stablecoins. These are the bridge between centralized and decentralized finance. It is a cryptocurrency that is matched to a real-world asset. For example, Dai, tether, and USD are all that we call stablecoin. This is because their price is tied to the United States Dollar.

The purpose of this is to have a reliable way to buy and sell certain coins without having to buy and sell them at all. Instead, we can just trade them. The traditional way of selling cryptocurrency through the centralized finance system takes up a lot of time and fees. instead, you can use a decentralized exchange to trade. That would cost you less time and money. It is also more secure because it is just code, it does not change.

Lending and Borrowing

The next pillar is lending and borrowing. One of the reasons we can reliably lend and borrow with banks is because we usually put something down like 20% collateral so that if we never pay back the full loan, our government can come after us and throw us in jail or make us pay that money.

In short, there are legal consequences for not paying a loan back. Well, with crypto this is a problem. Because of anonymity, you could put down 20% and run away with the rest of the money. So we have to find a way to solve this. With smart contracts in the picture, we can actually allow others to use our funds while still keeping custody of it.

Decentralised Exchanges

The next is decentralized exchanges. If you go to trade your dollars to euros at any foreign exchange booth, you might be charged with as much as 15% of it as fees. That is what foreign exchange traders do. Tourists who do not know any better and are looking for local money are taken advantage of.

In decentralized finance, there is what is called decentralised exchange where you can exchange your coins and tokens for other coins and tokens. The fees are generally very small like less than half of a per cent which is a great benefit for anyone who regularly wants to trade their crypto assets.

Most popular decentralised exchanges or dexes work in a manner where investors pool their money together and then traders can trade that money. The fee of trading goes back to the investors. Because all of this is written in code, it does not change. The government also can’t step in and stop you from buying anything.

Insurance

The last is Insurance. For example, with car insurance, you pay 100 a month to protect your new car. If you damage the car, the insurance company will give you the money to buy a new car. They use statistics to predict how many of their drivers would cash their car and then use this data to predict how much they would have to pay each year to determine what the monthly price of the insurance would be.

But with decentralized finance, the insurance company can be the code. People can buy their insurance through smart contracts. The code knows when to pay and how much to pay.

Hopefully, now you can see the value that DeFi adds to the world and why so many investors are piling billions of dollars into this new technology.

Written by Anika Sharma