Key takeaways
DeFi allows users to access crypto financial services with just a wallet and some crypto. Decentralized applications (DApps) enable lending, liquidity provision, swapping, staking and more on many blockchains.
While Ethereum was the original home of DeFi, most blockchains with smart contract capabilities now host DeFi DApps, including layer 2 solutions like Arbitrum and Optimism. Smart contracts are essential to the services offered by DeFi, including staking, investing, lending, harvesting, etc.
DeFi allows users to maximize yield, join decentralized marketplaces, access banking services, and engage in rapid borrowing and lending. However, DeFi is not without risks. You should always do careful research before taking any risks.
Introduction
Entering the world of decentralized finance (DeFi) can be exciting, but also confusing. After some time of HODLing, it is common to wonder how you can generate additional earnings through your wallet. However, there are many things to understand when it comes to DeFi.
When used responsibly, DApps and DeFi projects can become powerful tools. But if you get started too early, it's easy to get overwhelmed and make unwise investment decisions. The best way to get involved is to learn to distinguish the risks and find what works for you. With that in mind, let's explore the basics you'll need to start your DeFi journey.
What is decentralized finance (DeFi)?
Decentralized finance (DeFi) refers to an ecosystem of financial applications built on blockchain networks. Specifically, DeFi aims to create an open, permissionless, and transparent financial services ecosystem that is accessible to everyone and operates without a central authority. Users would retain full control of their assets and interact with this ecosystem through peer-to-peer (P2P) decentralized applications (DApps).
The main advantage of DeFi is to enable easy access to financial services, especially for those who are isolated from the traditional financial system. Another advantage is the modular framework it is built on, with interoperable DeFi applications on public blockchains. These have the potential to create entirely new financial markets, products and services.
Main benefits of DeFi
Classic finance relies on institutions such as banks, which serve as intermediaries, and courts, which mediate. DeFi applications do not need intermediaries or mediators. The code specifies the resolution of any possible disputes, and users remain in control of their funds at all times. This automation reduces costs and enables a smoother financial system.
As these new financial services are deployed on blockchains, single points of failure are eliminated. Data is recorded on the blockchain and spread across thousands of nodes, making it difficult to censor or potentially shut down a service.
Another important advantage of such an open ecosystem is the ease of access for people who would otherwise not have access to any financial services. Since the traditional financial system relies on intermediaries making profits, their services are generally absent in places where low-income communities live. However, with DeFi, costs are significantly reduced and low-income individuals can also benefit from a wider range of financial services.
Potential use cases for DeFi
Borrowings and loans
Open lending protocols are among the most popular types of applications in the DeFi ecosystem. Open and decentralized borrowing and lending have many advantages over the traditional credit system, including instant settlement of transactions, no credit checks, and the ability to collateralize digital assets.
As these lending services are built on public blockchains, they minimize trust requirements and provide cryptographic verification. Blockchain borrowing marketplaces reduce counterparty risks, make borrowing and lending cheaper, faster and accessible to more people.
Money Banking Services
Since DeFi applications are financial applications by definition, money banking is an obvious use case. Examples include the issuance of stablecoins, mortgage loans and insurance.
As the blockchain industry matures, the focus is on the creation of stablecoins. These are cryptoassets that are typically backed by real-world assets and are easily transferable digitally. Since cryptocurrency prices can sometimes fluctuate quickly, decentralized stablecoins can be adopted for everyday use because they are digital currencies not issued or controlled by a central authority.
With smart contracts, underwriting and legal fees for mortgages could be significantly reduced. Insurance on blockchain could eliminate middlemen and allow risk to be distributed among many participants, which could result in lower premiums with the same quality of service.
Decentralized marketplaces
Some of the most popular DeFi applications are decentralized exchanges (DEXs), such as Uniswap and PancakeSwap. These platforms allow users to trade digital assets without relying on a trusted intermediary to hold their funds. Trades are carried out directly between user wallets using smart contracts.
Some exchanges, known as automated market makers (AMM), use liquidity pools to facilitate trading without the need for a direct counterparty to match your trade. Since they require much less maintenance work, decentralized exchanges generally have lower trading fees than centralized exchanges.
Blockchain technology can also be used to issue and enable ownership of a wide range of conventional financial instruments. These applications would operate in a decentralized manner, without custodians and eliminating points of failure.
Yield optimization
DeFi DApps can be used to automate and optimize the compound yield earned through staking, reward pools, and other interest-bearing products. This is sometimes called yield farming.
For example, you can regularly receive rewards from mining Bitcoin, delegating BNB, or providing liquidity. A smart contract can take your rewards, buy more of the underlying asset and reinvest it. This process will increase your interest, which will often significantly increase your returns.
Using a smart contract saves time and optimizes composition. Your funds are generally pooled with those of other users, meaning that gas fees are shared among all members of the yield optimization smart contract.
Role of smart contracts in DeFi
Most existing and potential applications of decentralized finance involve the creation and execution of smart contracts. While a regular contract uses legal terminology to specify the terms of the relationship between the entities entering into the contract, a smart contract uses computer code.
Because their terms are written in computer code, smart contracts can enforce those terms in an automated manner. This enables the reliable execution and automation of a large number of processes that currently require manual supervision.
Using smart contracts is faster, easier and reduces risks for both parties. However, smart contracts also introduce new types of risks. Since computer code is susceptible to bugs and vulnerabilities, the value and confidential information locked in smart contracts are at risk.
Challenges faced by DeFi
Poor performance
Blockchains are inherently slower than their centralized counterparts, which affects applications built on them. DeFi app developers should consider these limitations and optimize their products accordingly. Layer 2 solutions like Arbitrum and Optimism solve these problems by providing faster and cheaper transactions.
High risk of user error
DeFi applications shift responsibility from intermediaries to the user. This can be a negative aspect for many. Designing products that minimize the risk of user error is a difficult challenge when products are deployed on immutable blockchains.
Bad user experience
Using DeFi applications currently requires additional effort from the user. For DeFi applications to become a key part of the global financial system, they must offer a tangible benefit that incentivizes users to switch from the traditional system to another. Recent improvements to user interfaces and educational resources are helping to alleviate this problem.
Cluttered ecosystem
Finding the best app for a specific use case can be intimidating, and users need to be able to find the best choices. The challenge is not only creating the applications, but also thinking about their place in the DeFi ecosystem as a whole.
Risks of DeFi
Although the world of DeFi can offer attractive APYs, it is not without risks. Even though they are decentralized, you are essentially consuming financial services, and some of the risks are well known:
Counterparty risk
If you participate in crypto lending or any other type of lending, you risk that the counterparty will not repay their debt.
Regulatory risk
The legality of certain services and projects may be difficult to determine. If you invest in a smart contract that is then closed due to regulatory issues, your funds may be at risk. Recent measures and directives from global regulatory authorities are influencing the development and adoption of DeFi.
Token risk
The assets you hold have different levels of risk affected by their liquidity, reliability, security of the token's smart contract, and the associated project and team. As the DeFi space has many low-cap tokens, token risk can be particularly high.
Software risk
Code vulnerabilities can compromise the security of the smart contracts you invest in. Your wallet may also be compromised due to connecting to DeFi DApps and certain permissions. Security practices, such as multi-signature wallets and insurance funds, are emerging to address these risks.
Non-permanent losses
If you stake in liquidity pools, divergences from the price ratio you entered will cause you to lose tokens deposited into the pool if you withdraw them.
Access to DeFi projects
Ethereum has long been the historic home of DeFi. However, many blockchains now have healthy DeFi ecosystems. Networks with smart contract capabilities such as BNB Chain, Solana, Polkadot, Avalanche, and new layer 2 solutions on Ethereum are popular choices.
Finding DeFi projects and protocols requires research. Online forums, messengers and websites can help you discover new opportunities. However, be extremely careful with any information you find. Always check the security of any project you read about or hear about.
What do I need to access DeFi projects?
To start using DeFi DApps, you will need the following:
A compatible wallet: A browser extension wallet like MetaMask or a mobile wallet like Trust Wallet will do the trick. A custodial wallet (where you don't own the private keys) is less likely to allow you to connect to DApps.
Cryptoassets: This seems obvious, but you might need a mix of assets. For example, if you are looking to use Ethereum-based DApps, you will need ETH for gas fees and another token for the service you are using.
DeFi vs. Classic finance (TradFi)
DeFi offers a financial system open to anyone with internet access, unlike traditional finance, which relies on centralized institutions and regulatory bodies. However, DeFi and classic finance are increasingly interacting. Banks and financial institutions are beginning to explore DeFi protocols, 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 via a centralized exchange like Binance often requires you to give up custody of your tokens. In this case, you must trust the centralized entity that manages your funds.
The majority of services offered will be the same. They are likely done through the same DeFi platforms that a user can access directly. However, CeFi removes the often complicated nature of user management of DeFi investments. You can also benefit from additional guarantees on your deposits.
CeFi is neither worse nor better than DeFi. Its suitability depends on your wishes and needs. Although you can sacrifice some control by using CeFi, you often benefit from stronger safeguards and offload some of the responsibility for asset management and trade execution.
What is the difference between DeFi and Open Banking?
Open Banking refers to a banking system in which third-party financial service providers are granted secure access to financial data via APIs. This allows accounts and data to be networked between banks and non-bank financial institutions. In short, it allows the existence of new types of products and services within the traditional financial system.
DeFi, on the other hand, offers an entirely new financial system, independent of current infrastructure. DeFi is sometimes also called “open finance”.
For example, open banking could allow the management of all classic financial instruments via a single application by drawing data from several banks and institutions in a secure manner.
On the other hand, decentralized finance could allow the management of new financial instruments and new ways of interacting with them.
Conclusion
DeFi has quickly created a self-sustaining ecosystem of value that attracts capital, developers, and new products. Although DeFi promises to revolutionize the financial sector, it is still an emerging field. The future of DeFi lies in ongoing technological advancements, regulatory developments, and growing mainstream adoption. To ensure sustainable growth, it is essential to continuously innovate to address the limitations and risks associated with DeFi.
For more information
What is an Automated Market Maker (AMM)?
What are DeFi liquidity pools and how do they work?
What is yield farming in decentralized finance (DeFi)?
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