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Getting started with DeFi and Stable Coins

Getting started with DeFi and Stable Coins

Sanjay Singh Rajpoot's photo
Sanjay Singh Rajpoot
·Oct 22, 2022·

5 min read

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What is DeFi?

Decentralized finance (often stylized as DeFi) offers financial instruments without relying on intermediaries such as brokerages, exchanges, or banks by using smart contracts on a blockchain. DeFi platforms allow people to lend or borrow funds from others, speculate on price movements on assets using derivatives, trade cryptocurrencies, insure against risks, and earn interest in savings-like accounts. DeFi uses a layered architecture and highly composable building blocks. Some applications promote high-interest rates but are subject to high risk.

Four primary types of stablecoins.

  • Commodity-Backed Stablecoins Commodity-backed stablecoins are collateralized using physical assets like precious metals, oil, and real estate. The most popular commodity to be collateralized is gold; Tether Gold (XAUT) and Paxos Gold (PAXG) are two of the most liquid gold-backed stablecoins. However, it is important to remember that these commodities can, and are more likely to, fluctuate in price and therefore have the potential to lose value.

  • Traditional Collateral (Off-Chain) The most popular stablecoins are backed 1:1 by fiat currency. Because the underlying collateral isn’t another cryptocurrency, this type of stablecoin is considered an off-chain asset. Fiat collateral remains in reserve with a central issuer or financial institution, and must remain proportionate to the number of stablecoin tokens in circulation.

  • Algorithmic Stablecoins Algorithmic stablecoins do not use fiat or cryptocurrency as collateral. Instead, their price stability results from the use of specialized algorithms and smart contracts that manage the supply of tokens in circulation. An algorithmic stablecoin system will reduce the number of tokens in circulation when the market price falls below the price of the fiat currency it tracks and vice versa.

  • Crypto Collateral (On-Chain) As the name suggests, crypto-collateralized stablecoins are backed by another cryptocurrency as collateral. This process occurs on-chain and employs smart contracts instead of relying on a central issuer. When purchasing this kind of stablecoin, you lock your cryptocurrency into a smart contract to obtain tokens of equal representative value. You can then put your stablecoin back into the same smart contract to withdraw your original collateral amount. DAI is the most prominent stablecoin in this category that makes use of this mechanism. This is realized by utilizing a collateralized debt position (CDP) via MakerDAO to secure assets as collateral on the blockchain.

What are the top 5 stablecoins by market capitalization?

Tether (USDT) USD Coin (USDC) Binance USD (BUSD) True USD (TUSD) Origin Dollar (OUSD)

Why are APYs on stablecoins so high on certain lending platforms?

We know why interest rates on actual dollars are so low. The Federal Reserve has cut interest rates to zero, so banks have no reason to pay interest on deposits. And the Fed has issued trillions of new dollars, so there are far more cash dollars circulating in conventional markets than anyone has a use for. No one wants dollars so they don’t command any interest.

But the reverse is true for stablecoins. Demand for stablecoins constantly exceeds supply. So people with stablecoins to lend can charge premium interest rates, and crypto platforms desperate for stablecoins offer high interest rates to attract new stablecoin lenders. That’s why stablecoin interest rates are so high. It’s simple economics.

All over the crypto world, there are vaults full of stablecoins. As demand from DeFi grows, more and more stablecoins are being locked up in vaults almost as soon as they are issued. That giant sucking sound you can hear is DeFi draining liquidity to support its massive derivatives pyramid. No wonder Jeremy has to keep printing. If he didn’t, the system would gradually freeze as liquidity becomes scarcer and scarcer and stablecoins less and less like actual dollars.

Dollar-pegged stablecoins are used as prime collateral in DeFi lending and staking pools. As more and more people dip their toes into DeFi and more and more new platforms appear, demand for stablecoins as collateral is rising exponentially. In December, research by The Block revealed that stablecoin issuance had risen by 388% in a year, mainly driven by demand from DeFi. If this trend continues, demand for stablecoins as collateral may outstrip use of stablecoins as safe assets on exchanges.

The crypto world rejects both central bank interference in markets and the regulation that makes it necessary. Unsurprisingly, therefore, crypto lenders are finding ways of making collateral liquid. And whether knowingly or unknowingly, they are reaching for the same tools. Rehypothecation is back. Lending platforms like Celsius use rehypothecation to generate high returns for its depositors: Celsius has been accused of “endlessly rehypothecating” pledged assets, though it denies that it does this.

But at present, rehypothecation in DeFi is small beer. Constant infusions of new stablecoins are the only significant relief for the terrible illiquidity that comes from feeding crypto’s main medium of exchange to the ever-thirsty derivatives monster.

Does a stablecoin pegged to the official currency of your country exist yet?

No, There is no cryptocurrency in that pegged INR as its parent.

What is the significance of NFTs? Use cases beyond art?

  • NFT applications have been designed specifically to aid healthcare professionals as well — one such example is NFT Birth Certificates that can be issued to newborns by healthcare providers. Issuing one of these NFTs for each child can be an effective way to quickly create a lifelong identity on the blockchain that’s linked to their birth certificate – which is then verified with NFT verification apps.

  • NFTs are great for protecting intellectual property and patents. NFT tokens also allow users to prove their ownership of any piece of content, which is not possible with traditional IP rights tools like trademarks and copyrights. Ownership of an IP can be distinguished, especially with the timestamps, the entire history of the IP. The NFT chain would be immutable, which means that the NFT owner could prove they were the original creator of a piece of work at any point in time.

 
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