Overview of DeFi applications

DeFi is one of the vibrant spaces in the Web3 world that people use to manage and grow their crypto assets. In this section, we will go through the DeFi applications we will build in this book.

Decentralized exchanges

Decentralized exchanges (DEXs) are one of the most popular DeFi applications that people use because it allows them to buy and sell cryptocurrencies on the blockchain. Different from traditional exchanges (such as stock exchanges) or centralized exchanges (CEXs), DEX applications are run on the blockchain in a decentralized manner and people can see the transactions for the smart contracts of the DEX. There is no intermediary to control the process and hold your funds. And you can get the result and/or tokens immediately after the transaction is executed by the blockchain.

A CEX for cryptos, on the other hand, is operated by financial service companies; they usually have crypto assets on blockchains to support on-chain transferring for their customers. However, the transactions and liquidities are maintained internally within the service institution and may not be visible outside of CEX.

Centralization is an issue that negatively affects security, trust, and privacy. The main reason is a lack of transparency and that people in CEXs can leverage the disclosed information (for example, upcoming promotion activities) to gain profit or even take money directly from customers. The recent bankruptcy news of FTX reported that they took at least $8 billion of their customers’ money and that this money may be lost permanently.

Automated market maker (AMM) is a type of DEX that allows cryptocurrencies to be bought and sold automatically based on the prices calculated from liquidity reserves in DEXs. AMMs are implemented with smart contracts that hold liquidity as reserves on the blockchain, which allow users to easily trade on-chain assets. They usually offer rewards to liquidity providers (the people who provide tokens that become part of liquidity in the DEX) from a small portion of trading volumes. Figure 1.4 shows the workflow of an AMM:

Figure 1.4 – Overview of AMM workflows

We will walk you through the process of building a full stack AMM (which is also a DEX) in Part 2, Designing and Implementing a DeFi Application for Trading Cryptos.

Crypto loans

Loans may be the most useful financial tools in our everyday lives. You can get property loans to purchase a new house. Meanwhile, you can deposit your money to earn interest, and banks may lend your saved money to other borrowers in the form of loans. This idea behind the scenes also applies to crypto loans.

A crypto loan is one of the most important DeFi use cases. The largest crypto loan project, AAVE, has $6 billion of TVL for their lending pool based on the information from their official website (https://aave.com/). More Web3 projects adopted crypto loans as their portfolios because of the high market potential of crypto loans.

Crypto loans have many use cases and can benefit diverse groups of DeFi users:

• For online shopping, people can borrow platform-supported cryptos by providing collateral cryptocurrencies. For example, some online shopping companies only support Bitcoin or stablecoins such as USDT. People can provide ETH or BNB as collaterals and borrow Bitcoin and stablecoins without selling the ETH or BNB they hold.
• For business, a company can raise money by providing crypto assets as collateral. In return, they can borrow stablecoins or other tokens to grow the business.
• For cryptocurrency investment, crypto loans can help people reduce the risk of fluctuation of the crypto market. For example, let’s say you found a highly rewarded program for token A, but you only have USDT at hand. You can get token A by lending USDT without selling it. You can still get the original provided USDT back, so long as you pay back token A regardless of the price fluctuation of token A.

The term collateral has been mentioned several times regarding crypto loans. Collateral is the assets that a user provides to guarantee that this user will repay the loan when they borrow. For example, you can obtain property loans from a bank for your house and the bank could be an owner of the house because the house is the collateral. Collateral can also represent the assets a user deposited to earn interest.

Figure 1.5 shows the workflow of crypto loans in DeFi:

Figure 1.5 – The workflow for crypto loans

Usually, a crypto loan should support at least four operations: Deposit, Borrow, Repay, and Withdraw. To prevent loss when the collateral loses its value or the borrowed assets become more valuable, DeFi projects utilize a borrow limit with loan-to-value (LTV) and a liquidation process by providing the borrowed assets with a percentage of rewards. We will talk more about these when we implement a crypto loan application in Part 4, Building Crypto Loans for Lending and Borrowing.

Staking, yield farming, and liquidity mining

Staking, yield farming, and liquidity mining are three DeFi technologies that can generate passive income and enable cryptocurrency holders to earn more by depositing existing assets on the blockchain. In general, the relationship between the three DeFi technologies is shown in Figure 1.6:

Figure 1.6 – The general relationships between staking, yield farming, and liquidity mining

Generally, staking means any action using some mechanism to generate passive earnings by holding users’ assets in another place (not the user’s wallet). This place could be on a blockchain or a centralized institute (for example, a CEX). Staking is a broader concept that people can earn from the three mechanisms:

• Blockchain consensus mechanisms such as proof of stake (PoS) or proof of transfer (PoX).
• Reward distribution. This means that some rewards will be distributed to certain places, such as staking smart contracts. Then, the rewards will be distributed to users with a fixed or floating APY when the user unstakes.
• DEX swapping fees. When the user adds liquidities to liquidity pools, a small portion of the transaction fees from the DEX will be used to reward liquidity pool providers as passive income. Users can earn it by holding liquidity pool tokens.

Note

In most scenarios, staking means getting rewards by depositing one type of cryptocurrency. This is what we will build later in Part 3, Building DeFi Staking and Yield Farming.

In DeFi, liquidity mining means that users can get newly mined liquidity pool tokens (LP tokens) by providing liquidity. These LP tokens represent the share of the user’s contribution to a liquidity pool. Then, they can earn a portion of swapping fees from DEX as liquidity pool rewards.

Yield farming offers a way to maximize user compensation by providing liquidity. Although liquidity mining is one of the most popular types of yield farming, yield farming can stimulate yield farmers (yield farming users) to stake LP tokens by providing extra rewards from reward distributions. This encourages yield farmers to not remove liquidity from liquidity pools and make liquidity pools more stable and healthier. For example, yield farmers can get a CAKE token in PancakeSwap yield farming, so they can get both a liquidity pool reward and a farming reward (the CAKE token).

Note

Liquidity mining is a specific type of yield farming that doesn’t provide extra farming rewards. The yield is only a liquidity pool reward in this case.

Table 1.1 summarizes the different ways of earning from staking, yield farming, and liquidity mining in DeFi:

Ways of Earning	Staking	Yield Farming	Liquidity Mining
Swapping fee (liquidity pool reward)	Yes	Yes	Yes
Reward distribution	Yes	Yes	No
Blockchain consensus mechanism	Yes	No	No

Table 1.1 – Ways of earning for staking, yield farming, and liquidity mining in DeFi

We will learn how to build a full stack DeFi application with liquidity mining in Part 2, Designing and Implementing a DeFi Application for Trading Cryptos. We will add staking and yield farming features to the application in Part 3, Building DeFi Staking and Yield Farming.

There are more interesting DeFi applications that are not covered in this book, such as insurance, stablecoins, and decentralized autonomous organizations (DAOs). Please refer to https://101blockchains.com/decentralized-finance-applications/ for more information.

In the next section, we will explore the building blocks of DeFi applications by demonstrating the DeFi application architecture.