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Since 2020, DeFi Cryptocurrencies have become the hottest narrative within the Cryptocurrency ecosystem, and navigating yourself through DeFi may be one of the most intimidating things you will do. DeFi investing is an intermediate to advanced level activity in Cryptocurrency as it involves using newly created decentralised tools that may/may not be easy or safe, but neb is here to make the journey easy for you.
KEY TAKEAWAYS
- What is DeFi?
- How does DeFi work?
- What makes up decentralized finance(DeFi)?
- DeFi risks?
- How to use DeFi protocols?
- What are DeFi services?
- Is it safe to invest in DeFi?
What is DeFi?
After Bitcoin’s launch in 2009, a robust industry blossomed, stemming from the asset, its concept and its underlying technology. The crypto and blockchain space boasts different niches in which projects and companies develop solutions for various use cases.
One such niche is the decentralized finance (DeFi) sector, which was created as an alternative to traditional financial services. More specifically, DeFi consists of smart contracts, which, in turn, power decentralized applications (DApps) and protocols. Many of the initial DeFi applications were built on Ethereum, and the majority of the ecosystem’s total value locked (TVL) remains concentrated there.
At its core, Bitcoin (BTC) carries qualities touted as pillars of decentralization. DeFi, however, expands on those qualities, adding additional capabilities.
A subcategory within the broader crypto space, DeFi offers many of the services of the mainstream financial world in a fashion controlled by the masses instead of a central entity or entities.
Lending may have started it all, but DeFi applications now have many use cases, giving participants access to saving, investing, trading, market-making and more. Decentralized finance’s ultimate goal is to challenge and eventually replace traditional financial services providers. DeFi often harnesses open-source code, allowing anyone the opportunity to build on pre-existing applications in a permissionless, composable manner.
“Finance” is easy to understand, but what is “decentralization?” In short, decentralization means that no chief body controls something. To an extent, banks and other financial institutions have power over your funds. These entities can freeze your assets, and you are at the mercy of their hours of operation and cash reserves.
The decentralization aspect of DeFi is not only a dispersal of power but also a dispersal of risk. For example, if a company holds all of its customer data in one spot, a hacker needs only to access that particular site for a vast amount of data. In contrast, storing that data across several locations or removing that single point of failure could improve security.
This article will explain what DeFi means, how DeFi works and throw some light on DeFi trading and decentralized banking.
Read More:How can I get passive income from DeFi?
How does DeFi work?
Though DeFi is frequently mentioned in connection with cryptocurrencies, it goes beyond the creation of new digital money or value. DeFi’s smart contracts are designed to take the place of traditional financial systems.
There are no banks or institutions to manage your money because there are no intermediaries to authorize transactions for DeFi applications. Furthermore, the code is open to anyone’s scrutiny, so there’s a sense of transparency in DeFi protocols. Also, there are open networks that span national boundaries. There are numerous applications available for users, most of which are built on the Ethereum blockchain.
What makes up decentralized finance(DeFi)?
DeFi boomed in 2020, bringing an influx of projects into the cryptosphere and popularizing a new financial movement. Since Bitcoin essentially holds many DeFi characteristics, no firm start date exists for the inception of the DeFi sector, other than Bitcoin’s launch in 2009.
Following 2017, however, several ecosystems — such as Compound Finance and MakerDAO — gained prevalence, popularizing additional financial capabilities for crypto and DeFi. In 2020, the DeFi niche took off as additional platforms surfaced, in line with folks harnessing DeFi solutions for strategies such as yield farming.
Decentralized exchanges (DEXs)
DEXs allow users to trade digital assets in a noncustodial way without the need for an intermediary or third-party service provider. Although they comprise only one element of the DeFi sector, DEXs have been a part of the overall crypto industry for years. They offer participants the ability to buy and sell digital currency without creating an account on an exchange.
DEXs let you hold assets away from a centralized platform while still allowing for trading at will from your wallets via transactions that involve blockchains. Automated market makers, a type of DEX, became prevalent in 2020 and use smart contracts and liquidity pools to facilitate the purchase and sale of crypto assets.
DEXs are typically built on top of distinct blockchains, making their compatibility specific to the technology on which they are developed. DEXs built on Ethereum’s blockchain, for example, facilitate the trading of assets built on Ethereum, such as ERC-20 tokens.
Using DEXs requires having compatible wallets. In general, self-custody crypto wallets let you control your assets, and some of them are compatible with DEXs. However, this type of asset storage puts more responsibility on you for the security of your funds. Additionally, certain DEXs may have fewer features and higher associated financial fees than centralized exchanges.
DEXs have come a long way in terms of liquidity and accumulating a regular user base, which continues to grow. As DEXs become more scalable — that is, faster and more efficient — their trading volumes are expected to increase even more.
Aggregators and wallets
Aggregators are the interfaces by which users interact with the DeFi market. In the most basic sense, they are decentralized asset management platforms that automatically move users’ crypto assets between various yield-farming platforms to generate the highest returns.
Wallets are locations for holding and transacting digital assets. Wallets can store multiple different assets, or just a single asset, and can come in an array of forms, including software, hardware and exchange wallets. Self-hosted wallets — wallets for which you manage your private keys — can be a key component of DeFi, helping to facilitate various DeFi platform uses, depending on the wallet. Exchange-based wallets, in contrast, govern your private keys for you, giving you less control, but also less security responsibility.
Decentralized marketplaces
Decentralized marketplaces represent a core use case for blockchain technology. They put the “peer” in peer-to-peer networks in that they allow users to transact with one another in a trustless way — that is, without the need for an intermediary. The smart contract platform Ethereum is the top blockchain facilitating decentralized marketplaces, but many others exist that allow users to trade or exchange specific assets, such as nonfungible tokens (NFTs).
Oracles/prediction markets
Oracles deliver real-world off-chain data to the blockchain via a third-party provider. Oracles have paved the way for the prediction markets on DeFi crypto platforms where users can place bets on the outcome of an event, ranging from elections to price movements, for which the payouts are made via a smart contract-governed automated process.
Layer 1
Layer 1 represents the blockchain that the developers choose to build on. It is where the DeFi applications and protocols are deployed. As discussed, Ethereum is the main layer-1 solution in decentralized finance but there are rivals, including Polkadot (DOT), Tezos (XTZ), Solana (SOL), BNB, and Cosmos (ATOM). These solutions will inevitably interact with one another as the DeFi space matures.
Having DeFi sector solutions run on different blockchains has several potential benefits. Blockchains may be forced to improve speed and lower fees, based on the performance of competing blockchains, creating a competitive environment that potentially results in improved functionality. The existence of different layer-1 blockchains also leaves more room for development and traffic, instead of everyone trying to pile onto a single layer-1 option.
Related: The DeFi Stack: Stablecoins, exchanges, synthetics, money markets, and insurance
DeFi use cases
To help answer the question “What is DeFi?” it helps to explore its use cases. Whether you want to lend or borrow, trade on DEXs, stake your digital assets, or something else — even games — there are new ways to satisfy those needs. Below is a list of some of the key use cases for decentralized finance.
Lending platforms
Lending and borrowing have become some of the most popular activities in DeFi. Lending protocols allow users to borrow funds while using their cryptocurrency as collateral. Decentralized finance has seen massive amounts of capital flow through its ecosystem, with lending solutions commanding billions of dollars in total value locked, or TVL — the amount of capital held locked in any solution at a given time.
Payments and stablecoins
For DeFi to qualify as a financial system, comprising transactions and contracts, there must be a stable unit of account, or asset. Participants must be able to expect that the bottom will not fall out in the value of the asset they are using. This is where stablecoins come in.
Stablecoins bring stability to the activities that are common in the DeFi market, such as lending and borrowing. Considering that stablecoins are generally pegged to a fiat currency, such as the U.S. dollar or the euro, they don’t exhibit nearly as much volatility as cryptocurrencies and therefore are desirable for commerce and trading.
Margin and leverage
The margin and leverage components take the decentralized finance market to the next level, allowing users to borrow cryptocurrencies on margin using other cryptocurrencies as collateral. In addition, smart contracts can be programmed to include leverage to potentially ramp up the user’s returns. The use of these DeFi components also increases the risk exposure for the user, especially considering that the system is based on algorithms and there is no human component if there is a problem.
DeFi-native activities
Liquidity pools are a necessary tool for many decentralized exchanges to facilitate trading. They provide trading liquidity for buyers and sellers, who pay a fee for their transactions. To become part of a pool, liquidity providers can send specific funds to a smart contract and receive pool tokens in return, earning passive profit based on the fees traders pay when they interact with that pool. Pool tokens are the key to getting your deposited funds back.
Sometimes known as liquidity mining, yield farming is another activity in the DeFi space that involves searching for profit via various DeFi projects through participating in liquidity pools. While there are intricacies to yield farming, there is one key reason why market participants are flocking to this phenomenon: It allows you to use your crypto holdings to earn even more crypto.
When yield farming, users lend out their crypto to other users and earn interest that is paid in crypto — usually “governance tokens” that give liquidity providers a say in the operation of the protocol. It is a way for investors to put their crypto to work to enhance returns and is a key innovation in the DeFi market. Yield farming has been dubbed the “Wild West” of DeFi, with market participants hunting down the best strategies that they then often keep close to the vest so as not to tip their hand to other traders and lose the magic.
DeFi risks?
For all its promise, the decentralized finance space remains a nascent market that is still experiencing some growing pains.
DeFi has yet to reach wide-scale adoption, and for it to do so, blockchains must become more scalable. Blockchain infrastructure remains in its early form, much of which is clunky to use for developers and market participants alike.
On some platforms, transactions move at a snail’s pace and this will continue to be the case until scalability improves, which is the idea behind the development of Ethereum 2.0, also known as Eth2. Fiat on-ramps to DeFi platforms can also be painfully slow, which threatens to hold back user adoption.
DeFi has grown significantly. Given its youth and innovation, the legal details around DeFi have likely not yet fully materialized. Governments across the globe may aim to fit DeFi into their current regulatory guidelines, or they may construct new laws pertaining to the sector. Conversely, DeFi and its users may already be subject to specific regulations.
In terms of adoption, it is uncertain how exactly things will pan out in the future. One potential outcome might include traditional finance adopting aspects of DeFi while retaining elements of centralization rather than DeFi completely replacing mainstream financial options. Any entirely decentralized solutions, however, may continue to operate outside of mainstream finance.
How to use DeFi protocols?
Most DeFi protocols are built on top of networks like Ethereum or Binance Smart Chain, and the number of competing blockchain networks with support for smart contracts is increasingly growing. Before deciding to use services on DeFi, it’s important to choose a network.
Most large protocols now support various blockchains, with the difference between them often being ease-of-use and transaction fees. Networks like Etheruem, Binance Smart Chain and Polygon are all accessible through wallet extensions like MetaMask, and only a few parameters need to be changed to switch networks.
These wallet extensions essentially allow users to access their funds directly on their browsers. They are installed just like any other extension and often require users to either import an existing wallet — through a seed phrase or a private key — or create a new one. To bolster security, they are also password-protected. Some web browsers come with these wallets built-in.
Moreover, these wallets often have mobile applications that can be used to access DeFi projects. These applications are wallets with built-in browsers ready to interact with DeFi applications. Users can synchronize their wallets by creating them on one device and importing it to the other using the seed phrase or private key.
To make things easier for users, these mobile applications often also integrate the open-source WalletConnect protocol. This protocol allows users to connect their wallets to DeFi applications on desktop devices simply by scanning a QR code with their phones.
Before getting started, it’s worth pointing out that this is a highly experimental space with a number of risks associated with it. Exit scams, fraudulent projects, rug pulls and other scams are common, so always do your own research before putting your money in.
To avoid falling for these schemes, here’s how to go a step further on security: It is best to find out if the projects have been audited. Finding out this information may involve some research, but often a direct search for the name of the project plus “audits” will reveal whether it has been audited or not.
Audits help weed out potential vulnerabilities while deterring bad actors. Less-than-stellar projects are unlikely to waste their time and resources to get audited by reputable firms.
Buying crypto
DeFi applications are built on top of networks and each network has its own native tokens that are easily identifiable through the ticker symbol they use on exchanges: Ethereum (ETH), Polygon (MATIC), Binance Coin (BNB) and so on.
These native tokens are used to pay for transactions on these blockchains, so you’ll need some of those tokens to move funds around. You can choose to just buy these native assets before delving into DeFi, or you can add stablecoins or other assets.
After buying the funds on a centralized exchange, you need to move them to a wallet you control that supports that network. It’s important to avoid moving funds to the wrong network, so before withdrawing, make sure you are using the correct network
Some exchanges let users, for example, withdraw Bitcoin (BTC) to an Ethereum address, or Ethereum to the Binance Smart Chain. These withdrawals are for tokenized versions of BTC or ETH on those networks, which can be used in DeFi.
Every transaction taken on DeFi protocols needs to be manually approved and incurs a transaction fee, so it’s important to choose a network with low transaction fees.
What are DeFi services?
After selecting an application to interact with and funding a wallet, it’s time to start using DeFi services. The simplest actions would be to either trade using a decentralized exchange (DEX), provide liquidity and earn fees over time, or lend funds using a lending protocol.
There are hundreds of possibilities out there, so instead of individually going over every project, here’s an overview of which products and services are available to use and what you should consider before using them.
To start using a wallet compatible with DeFi protocols, all you need to do is head over to the website of these protocols and connect your wallet to them. This is either done via a pop-up window or through a button that says “connect” on one of the upper corners of the website.
Connecting your wallet is comparable to “logging in” to the service using your account — in this case, your wallet address. Before lending, borrowing, or trading tokens on DeFi protocols, you will need to enable each token individually, so the protocol can access them on your wallet. This connection process incurs a small fee.
Is it safe to invest in DeFi?
In general, the smaller a token’s market capitalization is, the riskier it is as an investment. Therefore, look at the liquidity of tokens before committing your funds. Ensure you know how long a DeFi protocol has been in operation and how much money it has in total deposits before you invest.
You can look at its website to see if the company has taken reasonable steps to reduce its risks. You can also look for news items about the protocol being hacked on the internet and their precautions to prevent it from happening again.
To make it clear, there is no DeFi protocol without risk, but the above considerations can help you to evaluate the investment risk before you put your money into any protocol.
