DeFi DeMystified

Hearing a lot about Defi (decentralised finance) lately and how it would sweep CeFi (centralised finance, banks etc) but perplexed by its arcane insider terms? Here's a rough primer using legacy analogies: [Updated: fixed numerous typos, included addendum.]
  • Centralised Exchanges (CEX) - Bank. Cypto banks (Coinbase etc) sre purely custodians, they do not pay interest.
  • Liquidity Provider (LP) - Bank/ Lending Club. You deposit crypto wih a LP (BlockFi etc) to earn interest. In turn, the LP pools and lends crypto to borrowers using a particular protocol and associated smart contracts and algorithms. The pocess is fully auomated: little or no central authority or intermediaries are needed.
  • Protocols - Method and model how funds are collected, lent out, charged and rewarded. In CeFi, protocols might include conventional, syariah, co-op, loansharking etc.
  • Decentralised Exhange (DEX) - Money Changer. Change from say ETH to USDT and vice-versa. Fully automated (eg.Uniswap), does not rqquire any centralised authority.
  • Liquidity Mining /Yield Farming  - Interest / DividendsSay, a friend of yours wants to set up a money changing booth in a mall. Popular currency exchanges at the mall are between USD and EUR. You lend your friend a liquidity pair of USD and EUR to seed his business, and in return get a cut of the commissions. If a few friends pool their money together for this venture, it becomes a liquidity pool.
  • APY (Annual Percentage Yield) - DeFi's equivalent of CeFI's annual compounded interest rate.
  • Staking - Guarantor. When a new blocckchain or coin is created, you stake money on it in expectation, as it grows, you will be rewarded for your trust and confidence. In a startup space, if you see branded VCs staking investments in a startup, these VCs are staking their money and reputation on the startup in expectation of future returns. In effect, these VCs are acting as validators. Validation gives the startup credibility and a leg up to attract customers and further investors.

DeFi vs CeFi
  • Why do DeFi's APYs mostly seem higher (> 10%) than CeFi's interest rates (< 5%)? Selective quotation, frothy coin ecosystems: rising coin prices lift all boats.
  • How does DeFi ensure a loan would be repaid automatically, with no resort to courts or collection agencies? By insisting on a plus-sized collateral (eg 150% of loan amount).
  • Why borrrow 100% if you have 150%? Eaxmple: to quickly acquire a fast rising crypto for margin trading or speculation, not really for business loans etc.
  • Lending and borrowing (finance) is a very human and humanistic activity (at its purest) and has long being pondered upon since early civilisation.
  • A community or village lender might take a risk in lending money to a seemingly risky borrower without collateral by evaluating his or her venture, energy, character, parents, friends etc. Factors not currently easily amenable to computer algorithms (creepy data aggregation notwithstanding)..
  • Does this mean DeFi's future is less than rosy? Only if the 'Fi' is taken as 'finance' but as shown by the examples in the previous section, DeFi could mean Decentralised Fintech.