Key Points
Through DeFi, users only need a wallet and some cryptocurrencies to enjoy cryptocurrency financial services. Decentralized applications (DApps) can realize functions such as lending, liquidity provision, exchange and staking on most blockchains.
Although DeFi originally originated on Ethereum, today, most blockchains with smart contract capabilities can host DeFi DApps, including Layer-2 solutions such as Arbitrum and Optimism. Smart contracts are essential for the staking, investing, lending, and yield services provided by DeFi.
DeFi can help users optimize yields, access decentralized markets, gain access to banking services, and increase borrowing speed. However, DeFi is not risk-free; please do your research carefully before taking risks.
Introduction
The decentralized finance (DeFi) space is exciting, but also confusing. After holding on for a while, you usually think about how to squeeze extra yield out of your portfolio. However, there are many things in DeFi that need to be explored carefully.
DeFi DApps and projects can be powerful tools if used properly. But if you jump in without thinking, it’s easy to get lost and make unwise investment decisions. It’s best to understand the risks first and find a way to participate that’s right for you. With that in mind, let’s first explore the basics you need to know to get started on 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-source, permissionless, and transparent financial services ecosystem that is accessible to everyone and does not require any central authority to operate. Users have full control over their assets and can interact with the ecosystem through peer-to-peer (C2C) and decentralized applications (Dapps).
The core advantage of DeFi is that it makes financial services accessible, especially for people who do not have access to the traditional financial system. Another major advantage of DeFi is that it is based on a modular framework and builds highly interoperable DeFi applications on public blockchains, which is expected to create new financial markets, products and services.
Key benefits of DeFi
Traditional finance relies on institutions such as banks as intermediaries and requires courts to provide arbitration. DeFi applications can directly skip intermediaries and arbitration institutions. The code can provide clear solutions to various possible disputes, and users can also have full control over their funds. This automated solution reduces costs and creates a more harmonious financial system.
This new type of financial service is deployed on the blockchain, eliminating single points of failure. Data is recorded in the blockchain and widely distributed across thousands of nodes, increasing the complexity of censorship or shutting down services to reduce risks.
In addition, another important advantage of DeFi is that it deepens the openness of the financial ecosystem and can cover more groups that cannot enjoy financial services. The main way for the traditional financial system to obtain income is through intermediaries, which generally do not provide services to low-income groups. However, DeFi can significantly reduce costs, and low-income people can also benefit from various financial services.
DeFi potential use cases
Borrowing
Open lending protocols are one of the most popular applications in the DeFi ecosystem. Compared with the traditional credit system, open decentralized lending has many advantages, such as instant transaction settlement, no credit check, and support for collateralized digital assets.
The lending service is built on a public blockchain, minimizing trust requirements and protected by a cryptographic verification scheme. The blockchain-based lending market reduces counterparty risk, reduces borrowing costs, speeds up loan disbursement, and makes the service accessible to a wider audience.
Currency Banking Services
As the name suggests, DeFi is a type of financial application with monetary banking services as its typical use cases, which may include issuing stablecoins, mortgage loans and insurance.
As the blockchain industry matures, the creation of stablecoins has received more attention. Stablecoin assets are usually pegged to real-world assets and can be transferred digitally with relative ease. The prices of cryptocurrencies can sometimes fluctuate wildly, but decentralized stablecoins can be used as digital currencies for daily use that are not issued or monitored by a central authority.
With the advent of smart contracts, the underwriting and legal costs of mortgage loans may be greatly reduced. Insurance on the blockchain can skip intermediaries and allow many participants to share risks. Therefore, policyholders may be able to enjoy the same quality of service at a lower premium.
Decentralized Market
The most popular applications in the DeFi space are decentralized exchanges (DEXs), such as Uniswap and PancakeSwap. Through these platforms, users can directly trade digital assets without entrusting a trusted intermediary to hold their funds. With the help of smart contracts, users can complete transactions directly through their personal wallets.
Some exchanges, called automated market makers (AMMs), facilitate trading through a pool of liquidity without the need for a counterparty to directly intervene to match your trade. Decentralized exchanges require less maintenance and management, and transaction fees are typically much lower than centralized exchanges.
Blockchain technology is also often used to issue and empower various traditional financial instruments. These applications operate in a decentralized manner, without the need for custodians and completely eliminating single points of failure.
Yield Optimization
DeFi DApps can automatically optimize compound returns from staking, reward pools, and other interest-bearing products. This is sometimes referred to as liquidity mining.
For example, you can earn regular rewards by mining Bitcoin, delegating BNB, or providing liquidity. The smart contract can then use your rewards to buy more of the underlying asset and reinvest it. This process allows you to earn compound interest, often significantly increasing your returns.
Smart contracts help you save time and optimize the effect of compounding. Your funds are often pooled with other users' funds, which means that all members of the yield-optimizing smart contract share the gas fees.
The role of smart contracts in DeFi
Most existing and potential decentralized financial applications involve the creation and execution of smart contracts. While regular contracts use legal terms to spell out the relationships between the different entities in the contract, smart contracts use computer code.
The terms in smart contracts are written in computer code and can take effect automatically. Many business processes that originally required manual supervision can now be executed automatically with guaranteed reliability.
Using smart contracts, both parties can reach a deal more easily and quickly, and the risks that were common in the past are reduced. However, smart contracts also bring new risks. Computer code is prone to errors or vulnerabilities, which may leak important confidential information locked in the contract.
Challenges facing DeFi
Poor performance
Compared to centralized competitors, blockchains are inherently much slower, which also affects the applications built on them. Developers of DeFi applications need to take these limitations into account and take corresponding measures to continuously optimize their products. Layer-2 solutions such as Arbitrum and Optimism attempt to solve this problem by providing faster and lower-cost transactions.
Higher risk of user error
DeFi applications shift the responsibility of intermediaries to users, which is not a good thing for many people. Because the products are deployed on an immutable blockchain, it is difficult to minimize the losses caused by user mistakes through product design.
Poor user experience
Currently, using DeFi applications is still quite laborious for users. If DeFi applications want to become a core element of the global financial system, they must bring tangible value to users and attract them from the traditional financial system. Its recent efforts to optimize the user interface and educational resources can help alleviate this problem.
Ecosystem in disarray
Finding the most suitable application for a specific use case is like looking for a needle in a haystack, and users must have the ability to find the best solution. The challenge comes not only from building the application, but also from how to integrate it into the vast DeFi ecosystem.
The risks of DeFi
Although DeFi can provide a considerable annual rate of return, it is not without risks. Although it is decentralized finance, users are still consuming financial services, some of which may be familiar to you:
Counterparty Risk
If you engage in collateralized lending or any other type of lending, you are exposed to the risk that your counterparty will not repay your debt.
Regulatory risks
The legality of some services and projects may be difficult to determine. If the smart contract you invested in is subsequently shut down due to regulatory issues, your funds will be at risk. Recent actions and guidelines from global regulators will affect the development and adoption of DeFi.
Token Risk
The assets you hold have different levels of risk depending on their liquidity, credibility, token smart contract security, and their associated projects and teams. Due to the large number of low-market-cap tokens in the DeFi space, token risk can be quite high.
Software Risks
Code vulnerabilities can weaken the security of the smart contracts you invest in. Your wallet may also be compromised by connecting to a DeFi DApp and granting it certain permissions. To address such risks, security measures such as multi-signature wallets and risk protection funds have emerged.
Impermanent loss
When staking in a liquidity pool, if the value of the token deviates from the price ratio when you stake, you may lose some of the tokens you staked in the pool when you withdraw funds.
Participate in DeFi projects
Ethereum has long been the home of DeFi. But now, many blockchains have robust DeFi ecosystems. Popular choices include smart contract-enabled networks such as BNB Chain, Solana, Polkadot, Avalanche, and recent Layer-2 solutions on Ethereum.
Finding reliable projects and DeFi protocols requires a lot of research. Online forums, messaging tools, and websites can help you learn about new opportunities. However, be cautious with any information you find. Always be vigilant and double-check the safety of any project you read or hear about.
What do you need to prepare to participate in DeFi projects?
To use DeFi DApp, you need to prepare:
Compatible wallets: Browser plugin wallets (such as MetaMask) or mobile wallets (such as Trust Wallet) can be used. Custodial wallets (wallets in which the user does not hold the private keys themselves) usually will not allow you to connect them to DApps.
Crypto assets: This may seem self-explanatory, but you may need to prepare multiple assets. For example, if you want to use a DApp built on Ethereum, you need to prepare ETH to pay for gas fees, and you also need to prepare another token to pay for the services you use.
DeFi vs. Traditional Finance (TradFi)
DeFi provides an open financial system that anyone with access to the network can join, in stark contrast to traditional finance, which relies on centralized institutions and regulators. However, DeFi and traditional finance are increasingly interacting with each other. Banks and financial institutions are beginning to explore DeFi protocols, combining the advantages of the two systems to create a hybrid model.
DeFi vs. Centralized Finance (CeFi)
Even in the cryptocurrency space, not every financial service is decentralized. For example, when staking through a centralized exchange like Binance, you typically give up custody of your tokens. In this case, you must trust a centralized entity to handle your funds.
Both offer much of the same services, often on the same platform, through a DeFi platform that users can access directly. However, CeFi takes on the complexities of managing DeFi investments on your behalf and can also provide additional security for your deposits.
CeFi and DeFi are neither good nor bad. Users should choose the right service based on their personal ideas and needs. While you may sacrifice some control when using CeFi, you generally get stronger guarantees and offload some of the responsibility for handling assets and executing transactions.
What is the difference between DeFi and open banking?
Open banking refers to the banking system authorizing third-party financial service providers through application programming interfaces (APIs) to allow them to securely access financial data. In this way, banks and non-bank financial institutions can link their accounts and data. In essence, it can give rise to innovative products and services in the traditional financial system.
However, the new financial system proposed by DeFi is completely independent of the existing infrastructure. DeFi is sometimes also called "open finance."
For example, open banking can securely access data from multiple banks and institutions, managing all traditional financial instruments in the same application.
Decentralized finance can manage new financial instruments and create new ways of interaction.
Conclusion
DeFi is rapidly creating a self-sustaining ecosystem of value, attracting capital, developers, and new products. While DeFi has the potential to revolutionize the financial industry, it is still an emerging field. The future development of DeFi depends on continued technological advancement, improved regulation, and continued mainstream adoption. Sustainable growth requires continued innovation to address the limitations and risks associated with DeFi.
Further reading
What is an Automated Market Maker (AMM)?
What are liquidity pools in the DeFi space and how do they work?
What exactly is liquidity mining in decentralized finance (DeFi)?
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