The main point

• DeFi allows users to access crypto financial services with just a wallet and some crypto. Decentralized applications (DApps) enable lending, liquidity provision, swaps, staking, and more across multiple blockchains.

• While Ethereum was the original home of DeFi, most blockchains with smart contract capabilities now host DeFi DApps, including layer 2 solutions such as Arbitrum and Optimism. Smart contracts are a critical component to the services DeFi offers which include staking, investing, lending, harvesting, and more.

• DeFi enables people to optimize yields, engage with decentralized marketplaces, access banking services, and take out and provide loans quickly. However, DeFi still has risks. You should always do careful research before taking the plunge.

Introduction

Entering the world of decentralized finance (DeFi) can be exciting, but also confusing. After HODLing for a while, it's common to want to know how to get additional profits from your portfolio. However, there is a lot to cover when it comes to DeFi.

If used responsibly, DApps and DeFi projects can be powerful tools. However, if you rush into it, you will easily become overwhelmed and make unwise investment decisions. The best way to get involved is to learn the risks and find an option that works for you. With this in mind, let's explore the basics required when starting your DeFi journey.

What Is Decentralized Finance (DeFi)?

Decentralized finance is an ecosystem of financial applications built on a blockchain network. More specifically, DeFi aims to create an open source, permissionless and transparent financial ecosystem that is available to everyone and operates without a central authority. Users maintain full control of their assets and interact with this ecosystem through peer-to-peer (P2P) decentralized applications (DApps).

The core benefit of DeFi is easy access to financial services, especially for those who cannot access traditional financial systems. Another advantage is the modular framework on which it is based to enable DeFi applications with interoperability on public blockchains. This has the potential to create entirely new financial markets, products and services.

Main Advantages of DeFi

Traditional finance relies on institutions such as banks acting as intermediaries and requires arbitrage. DeFi applications do not require intermediaries or arbitrators. The code determines the resolution for each possible dispute. Additionally, users maintain control of their funds at all times. This automation reduces costs and allows for a more frictionless financial system.

As these new financial services are implemented on the blockchain, single points of failure disappear. Data is recorded on the blockchain and spread across thousands of nodes, making censorship or potential service shutdowns complicated to implement.

Another significant advantage of an open ecosystem is the ease of access for individuals who would not otherwise have access to any financial services. Because the traditional financial system relies on for-profit intermediaries, their services are usually not available to low-income people. However, with DeFi, costs are reduced significantly and low-income individuals can also benefit from a wider range of financial services.

Potential Uses for DeFi

Borrowing and lending

Open lending protocols are one of the most popular types of applications in the DeFi ecosystem. Open, decentralized lending and lending has many advantages over traditional credit systems, including instant transaction settlement, no credit checks, and the ability to collateralize digital assets.

Because it is built on a public blockchain, this lending service minimizes trust requirements and provides cryptographic verification. A lending marketplace on the blockchain reduces counterparty risk and makes taking and granting loans cheaper, faster and available to more people.

Banking monetary services

Since DeFi applications are by definition financial applications, monetary banking services are an obvious use. These services can include stablecoin issuance, mortgages, and insurance.

As the blockchain industry matures, there is an increasing focus on creating stablecoins. These crypto assets are usually pegged to real-world assets and are easily transferable digitally. Because cryptocurrency prices can fluctuate rapidly, decentralized stablecoins can be adopted for everyday use as digital currencies that are not issued or monitored by a central authority.

With smart contracts, underwriting and legal fees for mortgages can be significantly reduced. Insurance on blockchain can eliminate intermediaries and enable risk distribution among multiple participants, potentially resulting in lower premiums with the same quality of service.

Decentralized marketplace

Some of the most popular DeFi applications are decentralized exchanges (DEX), such as Uniswap and PancakeSwap. The platform allows users to trade digital assets without needing a trusted intermediary to store their funds. Trading is carried out directly between user wallets with the help of smart contracts. 

Some exchanges, known as Automated Market Makers (AMM), use liquidity pools to facilitate trading without requiring a direct counterparty to match trades. Because there is less maintenance and management required, decentralized exchanges typically have lower trading fees than centralized exchanges.

Blockchain technology can also be used to issue and allow ownership of a variety of conventional financial instruments. The application will function in a decentralized manner eliminating custodians and eliminating single points of failure.

Yield optimization

DeFi DApps can be used to automate and optimize compound yields earned from staking, reward pools, and other interest-bearing products. This activity is sometimes referred to as yield farming.

For example, you might receive regular rewards from mining Bitcoin, delegating BNB, or providing liquidity. Smart contracts can take your rewards, buy more of the underlying asset, then reinvest them. This process will double your interest and often increase your yield significantly.

The use of smart contracts saves time and optimizes multiplication. Your funds are usually pooled with other users' funds. This means that the gas fee is shared among all members of the smart contract optimizing the yield.

The Role of Smart Contracts in DeFi

Most existing and potential decentralized finance applications involve the creation and execution of smart contracts. Ordinary contracts use legal terminology to define the terms of the relationship between the entities entering into the contract, whereas smart contracts use computer code.

Because the terms are written in computer code, smart contracts can enforce those terms automatically. This enables reliable execution and automation of many business processes that currently require manual oversight.

Using smart contracts makes the process faster and easier, and reduces risk for both parties. However, smart contracts also introduce new types of risks. Because computer code is prone to bugs and vulnerabilities, the value and confidential information locked in smart contracts is at risk.

Challenges Faced by DeFi

Poor performance

Blockchains are inherently slower than centralized blockchains, which impacts applications built on top of them. DeFi application developers need to consider these limitations and optimize their products. Layer 2 solutions like Arbitrum and Optimism address this problem by offering faster and cheaper transactions.

High risk of user error

DeFi applications transfer responsibility from intermediaries to users. This can be a negative aspect for most people. Designing products that minimize the risk of user error is a tough challenge when the product is deployed on top of an immutable blockchain.

Bad user experience

Users currently require extra effort to use DeFi applications. To become a core element of the global financial system, DeFi applications must provide tangible benefits that incentivize users to switch from traditional systems. Recent improvements in the user interface and educational resources help mitigate this issue.

The ecosystem is not yet neat

Finding the most suitable application for a particular use can be difficult, and users should be able to find the best choice. The challenge is not just building the application, but also thinking about how it relates to the broader DeFi ecosystem. 

DeFi Risks

While it can offer attractive APYs, the world of DeFi is not without risks. Even though it is decentralized, you are essentially consuming financial services, so some of the risks are well known:

Counterparty risk

If you participate in a crypto loan or other type of loan, there is a risk that the counterparty will not repay the debt.

Regulatory risks

The legality of certain services and projects can be difficult to ascertain. If you invest in a smart contract that is later closed due to regulatory issues, then your funds could be at risk. Recent actions and guidelines from global regulators influence the development and adoption of DeFi.

Risiko token

Owned assets have varying degrees of risk that are influenced by the liquidity, trustworthiness, security of the smart contract token, as well as the associated project and team. Since the DeFi field has many tokens with low market capitalization, the risk of the tokens can be very high.

Software risks

Code vulnerabilities can compromise the security of the smart contracts you invest in. Your wallet can also be compromised because it is connected to a DeFi DApp and grants it certain permissions. Security practices, such as multisignature wallets and insurance funds, emerged to address this risk.

Loss is not permanent

If you stake in a liquidity pool, divergence beyond the entry price ratio will cause you to lose the amount of tokens deposited in that pool if you make a withdrawal.

Accessing DeFi Projects

Ethereum has long been a traditional platform for DeFi. However, most blockchains now have healthy DeFi ecosystems. Networks with smart contract capabilities such as BNB Chain, Solana, Polkadot, Avalanche, and newer layer 2 solutions on Ethereum are becoming popular choices.

Research is required to find DeFi projects and protocols. Online forums, messengers and websites can help you find new opportunities. However, be careful with any information you find. Always double check the safety of any project you read or hear about.

What is Required to Access DeFi Projects?

To start using a DeFi DApp, you need:

• Compatible wallets: Browser extension wallets like MetaMask or mobile wallets like Trust Wallet are suitable options. Custodial wallets (wallets that don't allow you to have their private keys) are less likely to allow you to connect to a DApp.

• Crypto assets: This seems obvious, but you will need a mix of assets. For example, if you want to use an Ethereum-based DApp, you will need ETH for gas fees and other tokens for any services used.

DeFi vs. Traditional Finance (TradFi)

DeFi offers an open financial system for anyone with internet access, in contrast to traditional finance which relies on centralized institutions and regulatory bodies. However, DeFi and traditional finance are increasingly interacting. Banks and financial institutions are starting to explore DeFi protocols, thereby creating hybrid models that combine the benefits of both systems.

DeFi vs. Centralized Finance (CeFi)

In the crypto world, not all financial services are decentralized. For example, staking through a centralized exchange like Binance often requires you to hand over custody of your tokens. In these cases, you have to trust the centralized entity that handles your funds.

Most of the services offered will be the same. These services tend to be carried out through the same DeFi platforms that users can access directly. However, CeFi takes the hassle out of managing DeFi investments yourself. You may also have extra security on your deposit.

CeFi is neither worse nor better than DeFi. Suitability depends on your wants and needs. While you may sacrifice some control in CeFi, you often receive stronger collateral and relinquish some responsibility in handling assets and executing transactions.

What is the Difference Between DeFi and Open Banking?

Open banking is a banking system that provides financial service providers with secure access to financial data via APIs. This enables account and data networking between banks and non-bank financial institutions. Essentially, this system enables new products and services within the traditional financial system. 

However, DeFi proposes a completely new financial system that does not rely on currently existing infrastructure. DeFi is also sometimes referred to as open finance.

For example, open banking can enable the management of all traditional financial instruments in one application by securely pulling in data from multiple banks and institutions. 

On the other hand, decentralized finance can enable the management of completely new financial instruments with new ways to interact with them.

Closing

DeFi is quickly creating a self-sustaining value ecosystem that is attracting new capital, developers, and products. Despite promising to revolutionize the financial sector, DeFi is still an emerging field. The future of DeFi depends on continued technological advancements, regulatory developments, and increasing mainstream adoption. For sustainable growth, continuous innovation is essential to overcome the limitations and risks associated with DeFi.

Further Reading

• What is an Automated Market Maker (AMM)?

• What Are Liquidity Pools in DeFi and How Do They Work?

• What Is Yield Farming in Decentralized Finance (DeFi)?

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