main ideas
Decentralized finance allows users to access digital currency financial services using a wallet and some digital currencies, and decentralized applications provide lending services, liquidity provision, exchanges, storage, and more across multiple blockchains.
While Ethereum was the original home of DeFi, most blockchains with smart contract capabilities now host decentralized applications related to DeFi, including Layer 2 solutions like Arbitrum and Optimism. Smart contracts are essential to the services DeFi provides, including storage, investing, and lending. Harvesting and more.
DeFi allows people to optimize returns, join decentralized markets, access banking services, and engage in rapid lending and borrowing. However, DeFi is not without risks, you should always do careful research before taking a risk.
the introduction
Entering the world of decentralized finance can be interesting but also confusing. After a while of holding cryptocurrencies, it is common to wonder how you can make additional gains from your investment portfolio. In any case, decentralized finance has a lot to discover and learn about.
DeFi and DeFi projects can be powerful tools when used responsibly, but when you rush, you may not be able to make things work and you may make unwise investment decisions. The best way to get involved is to know the risks and find what works for you, and based on that, let's explore the basics you'll need when starting your journey in the world of DeFi.
What is decentralized finance (DeFi)?
Decentralized finance refers to an ecosystem of financial applications built on blockchain networks. More specifically, decentralized finance aims to create an open source, transparent, permissionless financial services ecosystem that is available to everyone and operates without any central authority. Users retain full control over their assets and interact with each other. With this ecosystem through peer-to-peer (P2P) trading options and decentralized applications (DApps).
The primary advantage of DeFi is to facilitate access to financial services, especially for those isolated from the traditional financial system. Other features include the standard framework upon which DeFi is built, with operationally compatible DeFi applications on public blockchains, which can create financial markets, products, and services. Brand new.
Key advantages of decentralized finance
Traditional finance relies on institutions such as banks to act as intermediaries, and courts to provide arbitration services, while decentralized finance applications do not need any intermediaries or arbitrators, as the code determines the solution to every potential dispute, and users retain the right to control their money at all times, and this system works to reduce costs and provide a smoother financial system.
Since these new financial services are deployed on blockchains, there are no opportunities for single points of failure, and data is recorded on the blockchain and spread across thousands of nodes, making oversight or potential service interruption difficult.
Another important advantage of this open system is the ease of access for individuals who do not have access to any financial services. Since the traditional financial system depends on making profits for intermediaries, its services are usually not available to low-income communities. As for decentralized finance, it is characterized by its greatly reduced cost. Hence, low-income individuals can also benefit from a wide range of financial services.
Potential use cases for decentralized finance
Lending and borrowing
Open lending protocols are one of the most common types of applications in the DeFi ecosystem. Open, decentralized borrowing and lending have many advantages over the traditional credit system, including instant settlement of transactions, no credit checks, and the possibility of collateralizing digital assets.
Because these lending services are built on public blockchains, they reduce trust requirements and provide cryptographic verification, and blockchain lending markets reduce counterparty risk, making lending and borrowing less expensive, faster, and more accessible to more individuals.
Cash banking
Since DeFi applications are financial applications, by definition, fiat banking is an obvious use case, and this could include the issuance of stablecoins, mortgages, and insurance.
As the blockchain space booms, there is an increasing focus on creating stablecoins, which are digital assets that are usually tied to real assets and can be easily transferred digitally. Since digital currency prices can fluctuate quickly, decentralized stablecoins can be adopted for everyday use as digital money that is not issued by a central authority. or subject to its control.
With smart contracts, underwriting and legal fees for mortgages can be significantly reduced, and through blockchain insurance, the need for intermediaries can be reduced and allow risk to be spread among many participants, potentially providing lower premiums for the same quality of service.
Decentralized markets
Decentralized exchanges (DEXs), such as Uniswap and PancakeSwap, are among the most popular applications of decentralized finance. These platforms allow users to trade digital assets without the need for a trusted intermediary to hold their funds. Trades are conducted directly between users' wallets with the help of smart contracts.
Some trading platforms, known as automated market makers (AMMs), use liquidity pools to facilitate trading without needing a direct counterparty to match your trade, and because they require less maintenance and administration, decentralized trading platforms typically charge lower trading fees than centralized trading platforms. .
Blockchain technology can also be used to issue and allow ownership of a wide range of traditional financial instruments. These applications would operate in a decentralized manner that would eliminate custodians and single points of failure.
Improve returns
DeFi DApps can be used to automate and optimize compound returns earned from staking, reward pools, and other products of interest, sometimes referred to as revenue capture.
For example, you may receive regular rewards from mining Bitcoin, delegating BNB, or providing liquidity, and a smart contract could take your rewards, purchase more of the underlying asset and reinvest it. This process will double the interest you receive, and often increase your returns exponentially. big.
Using smart contracts saves time and improves multiplication, as your funds are usually pooled with other users' funds, so processing fees are distributed to be borne by all members of the smart contract used to optimize returns.
The role of smart contracts in decentralized finance
Most current and potential applications of decentralized finance involve the creation and execution of smart contracts, and while a traditional contract uses legal terminology to define the terms of the relationship between contracting entities, a smart contract uses computer code.
Because their terms are written in computer code, smart contracts can enforce these terms in an automated manner, enabling 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, but smart contracts introduce new types of risks. Computer code is vulnerable to bugs and vulnerabilities, which makes the values and confidential information stored in smart contracts vulnerable.
Challenges faced by decentralized finance
Poor performance
Blockchains are inherently slower than their centralized counterparts, which affects the applications built on them. DeFi developers must take these limitations into account and improve their products accordingly. Layer 2 solutions, such as Arbitrum and Optimism, address these issues by offering faster and fewer transactions. Cost.
High risk of errors on the part of users
DeFi applications shift responsibility from intermediaries to the user, this can be a downside for many, and designing products that reduce the risk of user errors is an extremely difficult challenge when deploying products on top of immutable blockchains.
Bad user experience
Currently, using DeFi applications requires additional effort on the part of the user. For DeFi applications to be a staple within the global financial system, they must provide a tangible feature that encourages users to switch from the traditional system. Recent improvements in user interfaces and educational resources help reduce this. the problem.
A crowded integrated system
Finding the best-suited app for a particular use case can be daunting, and users need to be able to find the best options. The challenge is not just in building apps, but also in thinking about the design that makes them fit into the broader DeFi ecosystem.
Decentralized finance risks
Although DeFi can offer attractive annual return rates, it is not without risks, and even though it is decentralized, you are essentially consuming financial services, and some of the risks are familiar:
Counterparty risk
If you engage in cryptocurrency loans or any other type of lending, you are at risk of your counterparty not paying their debts.
Regulatory risks
It may be difficult to verify the legitimacy of some services and projects. If you invest in a smart contract that is later closed due to regulatory issues, your funds may be at risk. It is worth noting that recently issued measures and guidelines from global regulators affect the development and adoption of decentralized finance.
Token Risks
The assets you hold have different levels of risk, depending on the liquidity, reliability and security of the token's smart contract and the project and team associated with it. Since the DeFi space has a lot of tokens with low market capitalization, the risks related to tokens in particular can be high. .
Software risks
Vulnerabilities in the code can affect the security of the smart contracts you invest in. Your wallet may also be compromised due to connecting to and granting permissions to DeFi DApps. Some security practices have emerged that address these risks, such as multi-signature wallets and lockboxes.
Non-permanent loss
If you are storing in liquidity pools, deviations from the price ratio you enter will result in you losing some of the tokens deposited in the pool if you make a withdrawal.
Access to decentralized finance projects
Ethereum has long been the original home of DeFi, however, many blockchains now have healthy DeFi ecosystems, and networks with smart contract capabilities, such as BNB Chain and Solana, Polkadot, Avalanche, and recent Layer 2 solutions on Ethereum, have become Popular options.
You should do some research to find suitable DeFi projects and protocols, and forums, messaging, and websites may help you identify the best new opportunities. However, you should be very careful with any information you find, and you should always verify the integrity of any project you read or use. You hear about him.
What do I need to access DeFi projects?
To get started using DeFi DApps, you will need:
Compatible Wallet: A browser extension wallet like MetaMask or a mobile wallet like Trust Wallet will do the trick. A custodial wallet (one where you don't have the private keys) will likely not allow you to connect to decentralized applications.
Digital Assets: This seems obvious, but you may need a variety of assets. For example, if you're looking to use Ethereum-based decentralized applications, you'll need ETH to pay for processing fees and another token for whatever service you use.
Decentralized Finance (DeFi) vs. Traditional Finance (TradFi)
DeFi offers a financial system that is open to anyone with access to the internet, compared to traditional finance that relies on centralized institutions and regulatory bodies. However, the interaction between DeFi and traditional finance is becoming increasing, as banks and financial institutions begin to explore DeFi protocols and create hybrid models. Combines the advantages of both systems.
Decentralized Finance (DeFi) vs. Centralized Finance (CeFi)
Even in the world of cryptocurrencies, not all financial services are decentralized. For example, storing through a centralized exchange like Binance usually requires you to give up custody of your tokens, and in this case, you must trust the central entity that handles your funds.
Most of the services offered will be the same, likely offered through the same DeFi platforms that the user can access directly, however, centralized funding removes the complexities often associated with managing DeFi investments yourself, and you may also get additional guarantees on your deposits.
Centralized finance is no worse or better than decentralized finance. Whether it's appropriate depends on your wants and needs. In centralized finance, you may sacrifice control, but you often receive stronger guarantees and relieve yourself of the burden of handling assets and executing transactions.
What is the difference between decentralized finance and open banking?
Open banking refers to a banking system in which external financial service providers are given secure access to financial data through application programming interfaces (APIs), allowing accounts and data to be linked between banks and non-bank financial institutions, mainly helping to introduce new products and services within the financial system Traditional.
However, DeFi proposes a completely new financial system that is independent of existing infrastructure. Decentralized finance is also sometimes referred to as open finance.
For example, open banking could allow all traditional financial instruments to be managed in one application by securely pulling data from multiple banks and institutions.
On the other hand, decentralized finance can enable entirely new financial instruments to be managed and new ways to interact with them.
Concluding thoughts
DeFi has created a self-sustaining value ecosystem that attracts capital, developers and new products, and although DeFi promises to revolutionize the financial sector, it is still an emerging field. The future of DeFi depends on ongoing technological developments, regulatory developments, and increasing public uptake, and to achieve sustainable growth, innovations must continue to address the limitations and risks associated with DeFi.
Related articles
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What are Liquidity Pools in DeFi? What is its mechanism of action?
What is revenue capture in DeFi?
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