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Decentralized Finance (DeFi), DEXs, and DApps Explained

 

By Damian David Dec 11, 2022

 

 

Finance or Money as we know it is apparently the whole essence of human interaction and relations and if it's not, then it is the biggest factor affecting human transactions and relations. Finance from its onset was actually decentralized and then centralized and then fortunately it can be decentralized again. 

 

It was decentralized from the onset because, in the early days, it was known that humans traded by a process called trade by barter. This process involves Human A wanting a product from Human B and then in order to get that product, Human A offers Human B another product of equal value, and then we have a trade. 

 

This transactional process doesn't require a middleman and that's why I said the concept of Finance was from the onset decentralized. And then there came the use of cowries, coins, gold, silver, and then finally the legendary FIAT. And this was when the centralization of Finance became dominant.

 

Fiat currencies are labelled centralized Finance because it requires a central authority, a middleman or middlemen, KYC (Know your customer), regulations, etc.

 

Overview of the Decentralized Finance Market 

 

So what is Decentralized finance, really?

 

The reason for the introduction of this evolutionary and revolutionary financial concept is because of the unhealthy control the traditional banking system has in the financial world. Centralized structures in the financial/money ecosystem have a lot of limitations and loopholes. Their processes and methods are often ambiguous, time-consuming, costly, and sometimes unsafe. 

 

The traditional banking system heavily makes use of KYC (Know your customer) and this has raised privacy concerns and issues since its onset. If I were to lay out all the problems regarding centralized finance you might get bored of the long data I'll provide but just know that the main reason for Decentralized finance is actually to revolt against the loopholes, limitations, and complications associated with Centralized finance. 

 

Don't get me wrong,  the traditional banking system and its centralized infrastructure have their upsides, but is it worth the downsides?

 

What Is Decentralized Finance?

 

Decentralized Finance is simply an infrastructure of monetary and financial operations that is void of any form of a central authority and rather shares that authority in a democratic manner amongst everyone in its infrastructure. This infrastructure is primarily designed and built using smart contracts that are integrated with a macro infrastructure called the blockchain. 

 

Decentralized Finance and Blockchain Technology made Bitcoin popular and since then there has been a widespread takeover of monetary and financial transactions by the blockchain ecosystem and its substructures. 

 

Decentralized Finance works hand in hand with Decentralized exchanges(DEXs) and Decentralized Applications (DApps). Decentralized Exchanges are websites or platforms that facilitate the exchange of financial assets in the Decentralized finance market, while Decentralized Applications (DApps) are open-source decentralized applications or protocols that facilitate diverse transaction types in the decentralized finance market. 

 

Decentralized Finance has grown to be a multi-billion dollar infrastructure and its adoption rate is soaring off the roof. It is reported that there are around five million Decentralized finance users around the globe and can bet that the number is increasing by the minute and the reason for this is quite obvious. 

 

What are the benefits of Decentralized Finance?

 

If the perks of Decentralized Finance aren't still obvious to you then just these five of its outstanding features and structural characteristics listed below will enlighten you ;

 

Open-Source:  Open-Source means transparent and free for all. Almost the whole infrastructural design and substructures of the Decentralized finance market can be found online and in distributed ledgers — everything.

 

Consensus Mechanism: This is a feature for decentralization. Consensus means everyone is involved in decision-making, and everybody's opinion matters. The decentralized finance structure is made possible because everyone has a say in its development and modification. 

 

Borderless and Limitless: Decentralized Finance is said to be Borderless, meaning that its operations are not limited by the borders of countries or otherwise. There's a reason you can send Bitcoin from Egypt to the United Kingdom and the Bitcoin still remains — Bitcoin. Also, it is limitless in the sense that while I can send $2 billion worth of Bitcoin to someone instantly, you can't because your traditional banking system placed a transfer limit on your account. 

 

Time Efficient and Friendly: The speed by which decentralized finance conducts its transactional activities is impressive — mind-blowing. To really put this in perspective, imagine you're sending $100 from your country to someone in another country, and imagine I'm sending $100 worth of Bitcoin to the same person. In a split second, my transaction will be executed while you'll be probably waiting in line in the western union section of a traditional bank.

 

No KYC Required: "Know your customer" is a method by which an organization collects every single piece of data and information about you so as to offer you a service or product. For many reasons, there are a lot of problems associated with this method. But Decentralized Finance is free from that nightmare as most of its transactions, exchange, and processes are carried out anonymously. 

 

What Are DEXs(Decentralized Exchanges)?

 

DEXs are smart contracts-powered exchanges that aid in the facilitation of transactions on the distributed ledger technology, the blockchain, without the need for an intermediary. Most decentralized exchanges rely on "user-owned" liquidities to facilitate trades, and so, with the concept of decentralized finance(DeFi), many projects have launched several financial products and services to incentivize individuals to participate and provide liquidity on DEXs. 

 

The most common model is yield farms, a revolutionary DeFi product that enables liquidity providers to earn rewards from coin inflations created on the blockchain level and liquidity mining, where users are paid swap fees for providing liquidity to DEXs. 

 

Types Of Decentralized Exchanges(DEXs) 

 

There are primarily four types of DEXs namely:

 

-Order Book DEXs

-Automated Market Makers(AMMs) 

-DEX Aggregators

-Atomic DEXs

 

These four DEX types make up the decentralized exchange market, all serving with their unique features, collectively, they contribute to the continual push for a more flexible financial economy. 

 

Order Book DEXs Explained 

 

Order Book DEXs are common internal markets where peer-to-peer transactions can be carried out directly on a blockchain network. Similar to a centralized exchanges order book, it consists of the buy orders and the sell orders. Usually, when a transaction is initiated and there is an order present in the ledger that meets the requirements of the initiated transaction, it is immediately processed, this concept is called spot trading, although more common on centralized exchanges. 

 

That said, such market environments proved quite inefficient, and time-consuming and doesn't really promote the ease and flexibility that blockchain-based products should. Famous blockchains like the Ethereum blockchain could not possibly handle such market environments as every activity requires the distributed ledger to be updated, which cost gas. This makes it expensive and given that the ledger has to be frequently updated, it is not quite functional as each operation including creating an order, closing an order, and changing an order price waits to be validated by nodes, and Ethereum throughput makes it even more inefficient. 

 

So, a new model had to be adopted, and here's where AMMs came in. 

 

Automated Market Makers (AMMs) Explained

 

Automated Market Makers(AMMs) were the solution to the inefficiency of order books DEXs, at least, for Ethereum itself as though many other chains like Hive blockchain could handle such markets pretty well with zero transaction cost and network-backed market liquidity. 

 

Automated Market Makers are powered by smart contracts, whereas instead of traders having to manually adjust trades or wait to be filled up, a smart contract holds a pool of coins that leverages blockchain oracles to determine prices of assets across all markets and facilitate trades at an instant. 

 

AMMs rely on liquidity provided by individuals, and most times these individuals are incentivized to do so, somehow, it is quite limited, especially to small markets that can't avoid deep liquidities nor have the incentivization to attract it. Some project liquidities may be greatly centralized as well, however, AMMs have solved the problem with fees and provided a way for trades to be instant provided liquidity is enough. 

 

DEXs Aggregators

 

DEXs aggregators play a huge role in creating trade balance across markets. Primarily, they aid trades to be facilitated in a single market even when liquidity is short in that market. How? When a market suffers from low liquidity, the slippage may need to be increased which basically means the trader will have to pay higher fees. 

 

If perhaps, the pair this trader wishes to buy from or sell to has other liquidity pools out of the AMM DEX he's trying to use, the solution would be to switch to a DEX aggregator. What a DEX aggregator does is to draw liquidity from cross platforms to ensure trade is processed with a minimal fee and not much market or price pressure. 

 

Atomic DEXs 

 

Atomic DEXs are quite an interesting form of decentralized exchanges. They particularly help facilitate transactions between two different chains, ensuring that no party is cheated and all conditions are met.

 

Atomic DEXs leverage Hash Timelock Contracts (HTLC) to facilitate trades. For a transaction to be processed successfully, each party will have to complete predefined conditions or else the transaction will fail, this usually includes signing transactions with a hex number generated by the hash number to both parties. If any of the two fails to sign within the specified timeframe, the transaction will fail and functions will be reverted.

 

This method is considered a fully peer-to-peer trade without any reliance on centralized liquidity or paying high gas fees for trade readjustments, however, it does have its own downsides as transactions need to be initiated and signed by two individuals respectively. 

 

What Is A Decentralized Application (DApp)? 

 

A decentralized application (DApps) is simply an application built atop a blockchain network and functions via a distributed management structure. What that means is, DApps are naturally governed by their users, there are no centralizing factors to how they operate. 

 

Examples of DApps are DEXs and DeFi Platforms, this is the relationship the two share, they are both decentralized applications that promote the powerful concept of blockchain technology. 

 

Is Bitcoin a DeFi Structure?

 

Bitcoin is one of the first financial services to be unregulated and unrestricted. This and many other features make it a decentralized finance asset, thus, in its base nature, a DeFi structure. 

 

Can you make money with decentralized finance?

 

The term "finance" in decentralized finance means it is a financially viable opportunity to leverage. And so yes, you can make money from Decentralized finance because Decentralized finance is an embodiment of a revolutionary process of earning money, it has given birth to a lot of profitable ideas like cryptocurrencies investments, NFT products, Web 3.0 incentivized platforms, and Metaverse. 

 

But more specifically, as aforementioned, DEXs and DeFi Platforms with user-owned liquidities often incentivize the participants, this gives way for more in-flow of value and the users earn for helping grow the network.

 

Is Decentralized finance safe?

 

Decentralized finance can pass as a safe type of financial operation. And this is because most cryptocurrency assets or digital assets in the Decentralized Finance market are protected by both sides of the market which are the service providers and the service consumers. The service providers make sure to protect their Decentralized finance services from hackers, fraudsters, malicious parties, and any other potential threat by proper auditing of the smart contracts codes. While on the service consumer side, decentralized finance assets are protected with "keys, a type of password that is known only to the service consumer, here's where decentralization comes in because users own and take custody of their assets. These factors and many more are part of what makes decentralized finance safe and secure for users and investors globally.

 

However, one can never be too careful as many hacks have flooded the space and billions have been exploited from bugs found on DeFi projects' smart contracts.

 

Centralized Finance vs Decentralized Finance 

 

Decentralized Finance can be seen as the imminent successor of Centralized Finance in terms of operational methods, costs, efficiency, and requirements. There are some platforms combining both DeFi and CeFi operations, a good example is Binance, which uses the operations of DeFi to provide a crypto payment and investment option, and then uses the operations of CeFi to provide an exchange where these crypto payments and investment options are regulated to some extent. 

 

In terms of efficiency and security, decentralized finance (DeFi) takes the crown as there are zero centralizing factors to worry about. However, the risks of smart contracts exploits have kept many from adopting DeFi. 

 

How to invest in DeFi

 

The Decentralized finance market is free and open for anyone to interact with. Investing in Decentralized finance means investing in anything leveraging blockchain technology to facilitate immutable and uncensored transactions in a peer-to-peer manner. 

 

What are DeFi Platforms?

 

DeFi Platforms are middlemen-free and unregulated platforms that facilitate decentralized finance operations and create opportunities for its maximization. 

 

Why Choose Decentralized Finance?

 

Decentralized Finance fits perfectly into the concept of futurism. One time it was rumored that the world powers are planning to adopt a one-world currency that will be used everywhere around the world — wait, what if it's actually happening? What if this one world currency is the decentralized finance infrastructure? 

 

But that's just a theoretical reason why you should choose Decentralized finance. More practical reasons like the ability to have total control of your finances, the ability to be limitless in your transactions, the ability to protect your privacy while making a transaction, the ability to save time while making a transaction and so much more, are the reasons why you should adopt the Decentralized Finance market.