Welcome to Crypto-4-Beginners, in this article we will explore Decentralized Finance, often referred to as DeFi in the crypto-space.
DeFi is the idea that financial institutions or mechanisms can be decentralized, and this just means there is no barrier to entry and anyone can participate. Today we'll look three concepts; a DEX, a Liquidity Pool, and Staking.
A DEX is a decentralized exchange, where individuals are able to buy, sell, or swap various cryptocurrencies. DEX's, unlike centralized exchanges such as Coinbase, require no KYC (Know Your Customer), and as a result, DEX's are permission-free, with no barrier to entry. Trading cannot be halted on a DEX nor can any individual be banned from using the platform.
The most popular DEX to date is Uniswap, but there are a few others. Uniswap, about to launch version three, allows its users to swap any ERC-20 token. An ERC-20 token is any fungible token that exist on the Ethereum blockchain. An example of such is Ether (ETH), the main cryptocurrency of the Ethereum blockchain, as well as others such as Chainlink (Link), Decentraland's MANA, and many others.
Typically, individuals would use the Uniswap platform to swap ETH for some other ERC-20 token in anticipation the token they bought would appreciate in value, over time. But, there's more to DeFi than just DEX's, there's liquidity pools.
A liquidity pool is a collection of funds that are "pooled" together, and provides capital that can borrowed by various individuals. When a person wants to borrow crypto, they can use their own crypto-savings as collateral and borrow up to 75% against that collateral.
For example, if a person is holding 1000$ worth of Ethereum in their digital wallet. They could use that as collateral and borrow up to 750$ worth of Ethereum (or any cryptocurrency available) from a liquidity pool. The collateral gets locked into a smart contract and is returned once the loan is repaid with interest, within the agreed duration of the contract. If the loan isn't repaid, the collateral gets absorbed into the liquidity pool.
The way liquidity pools get funded is through individual lenders. A person that owns crypto is able to put that crypto into a liquidity pool, and collect interest for as long as its in the liquidity pool.
For example, if a person has 1000$ worth of Ethereum sitting in a digital wallet, it may be more profitable for them to move that 1000$ worth of Ethereum to a liquidity pool and earn interest. This is called "Staking". Although staking can refer to validator nodes, in this context, and to avoid confusion, we'll use it in the context of liquidity pools. The interest collected is calculated in the form of an annual yield percentage, or APY. Liquidity pools offer high APY, which can vary between 5% and 20% depending on the pool and various factors. Overall, crypto liquidity pools offer better returns than most traditional financial bodies.
All of this is possible because of smart contracts. A smart contract is computer program that executes parameters of an agreement. It eliminates the need for a trusted third party to verify and enforce the parameters of the contract. It is because of smart contracts why lenders do not worry about borrowers repaying the loan. It's also why borrowers do not need to issue identification in order to take a loan. Both borrower and lender are bind to the agreements of the smart contract, such that, neither can opt out of the agreement, once the smart contract has been established.
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