Defi is here. Should you care?
With 5 million users and $100 billion in total value locked, 2021 saw the explosion of Defi. But, what do you know about Defi?
Decentralized finance or Defi is a financial ecosystem primarily built on the Ethereum blockchain that allows its participants to grow their financial positions by borrowing and lending funds from this ecosystem anonymously and impartially. It is the absence of a central authority with autocratic powers like banks, governments, and other financial institutions that has made it a popular financial ground. Defi is instead governed and regulated by smart contracts which are self-executing computer codes based on complex algorithms. It is these codes that a Defi user interacts with for all borrowing and lending functions.
To give you a birds-eye view of how borrowing and lending work in Defi, I have covered the 4 key elements involved in it in a very light and fun way. These elements are an AMM, a Liquidity Pool, Lenders, and Borrowers.
- Automated Market Maker(AMM) - The presence of an automated market maker is essential for a Defi ecosystem to function. It is the underlying framework on top of which all Defi activities take place. Smart contracts are also embedded in this AMM and define every attribute of a liquidity pool just like the DNAs do for living beings.
- Liquidity Pool (LP) - A liquidity pool can be described as a virtual safe where all the liquid funds from the liquidity providers/lenders are parked for borrowers to borrow from. What’s worth noting is that all lending and borrowing activities are performed without human intervention.
- Lender/Liquidity Provider - Any entity that is willing to add liquidity to a liquidity pool in the form of its accepted trading pairs is a lender. This entity could be an individual, an institution, a decentralized autonomous organization, or even a bot! These lenders are heavily incentivized for being the liquidity providers which come as accrued interests on their deposits. The tiny interest collected from thousands of borrowers daily adds up to a significant amount which is then paid to the lenders in proportion to their share in the LP.
- Borrower - All entities that take a loan from one of these liquidity pools and in return are ready to pay a small interest along with the original loan amount are borrowers. In Defi, every loan is over-collateralized and bears the risk of auto-liquidation if the borrower’s position nears the minimum collateralization ratio primarily due to market volatility.
There is more to borrowing and lending in Defi and I will cover them in future posts. This article is just a starting point for you to dive into this evolving financial world.
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