Key points
With DeFi, you can access cryptocurrency financial services using only a wallet and cryptocurrency. Decentralized applications (DApps) provide loans, liquidity, swaps, staking, and more on many blockchains.
Initially, most DeFi projects were created on Ethereum. DeFi DApps can now be hosted on most blockchains with smart contract capabilities, including layer 2 solutions like Arbitrum and Optimism. Smart contracts are required for DeFi services: staking, investing, lending, savings, and more.
DeFi allows you to optimize profitability, use decentralized marketplaces and banking services, as well as provide and receive loans. However, DeFi has its risks, so it is important to always do your own research.
Introduction
The world of decentralized finance (DeFi) seems exciting, but quite confusing. Still, after hodling, you may be wondering how to get extra profit from your portfolio. This is where the DeFi field comes in handy.
DApps and DeFi projects have the potential to become powerful tools if used responsibly. But if you rush things, you can easily become overwhelmed and make unwise investment decisions. To protect yourself from mistakes, it is worth studying the risks and finding services that suit you. Let's look at the basic facts to get started with DeFi.
What is decentralized finance (DeFi)?
Decentralized finance (DeFi) is an ecosystem of financial applications built on top of blockchain networks. The goal of DeFi is to create a public, transparent, and open-source financial services ecosystem that operates without any central authority. Users maintain full control over their assets and interact with this ecosystem through peer-to-peer (P2P) decentralized applications (DApps).
The main advantage of DeFi is easy access to financial services, especially for those who are isolated from the traditional financial system. Another plus is the modular structure and compatibility of DeFi applications on public blockchains. DeFi has the potential to create entirely new financial markets, products and services.
Key Benefits of DeFi
The traditional financial system relies on banks, which act as intermediaries, and courts, which resolve disputes. But DeFi applications do not require intermediaries or arbitrators. All possible disputes are resolved by the code, and users always control their funds. This automation reduces costs and makes the financial system more convenient.
Because these financial services are deployed on blockchains, there are no single points of failure. Data is recorded on the blockchain and distributed among thousands of nodes, making censorship or shutdown of the service almost impossible.
Moreover, such financial services are easy to obtain even for those who for some reason do not have access to banks. The traditional financial system relies on intermediaries making profits, and intermediaries typically do not provide services in low-income areas of the population. However, the DeFi system significantly reduces transaction costs, so people from such communities can benefit from a wide range of financial services.
Potential Applications of DeFi
Providing and receiving loans
Open lending protocols are some of the most popular applications in the DeFi ecosystem. They have many advantages over the traditional credit system: instant transaction settlement, no credit checks, and the ability to use digital assets as collateral.
Because these services are built on public blockchains, they minimize trust requirements and provide cryptographic verification. Blockchain lending marketplaces reduce the risk of third party intervention and make borrowing and lending cheaper, faster and more accessible.
Banking services
DeFi applications are financial by definition, so banking is an obvious use case. For example, they can issue stablecoins, arrange mortgages and insurance.
As the blockchain industry develops, more and more attention is paid to the creation of stablecoins. These cryptocurrencies are usually tied to real assets and are easily transferred digitally. Since cryptocurrency prices can change quickly, decentralized stablecoins can be used in everyday life as digital currencies that are not issued or controlled by a central authority.
With smart contracts, mortgage underwriting and legal costs can be significantly reduced. Blockchain insurance can eliminate intermediaries and allow risks to be distributed among many participants. This can lower insurance premiums while maintaining the same quality of care.
Decentralized marketplaces
Some of the most popular DeFi applications are decentralized exchanges (DEXs) such as Uniswap and PancakeSwap. They allow you to trade digital assets without a trusted intermediary. Transactions are concluded directly between wallets using smart contracts.
Some exchanges, known as automated market makers (AMMs), use liquidity pools to trade without a direct counterparty. Such exchanges are easier to maintain and control, so their fees are lower compared to centralized exchanges.
Blockchain technology can also be used to issue a wide range of traditional financial instruments with title. In this case, they will work decentralized, without custodians and single points of failure.
Profitability optimization
DApps in DeFi can be used to automate and optimize income from staking, reward pools, and other interest-bearing products. This is sometimes called yield farming.
For example, you can receive regular rewards for mining Bitcoin, delegating BNB, or providing liquidity. At the same time, the smart contract is able to invest your rewards in the underlying asset and reinvest it to increase your interest and, accordingly, income.
Using a smart contract saves time and optimizes compounding. Your funds are usually pooled with the funds of other users, so gas fees are divided among all participants in a smart contract that optimizes profitability.
The role of smart contracts in DeFi
Most current and potential applications of decentralized finance involve the creation and execution of smart contracts. A regular contract uses legal terminology to define terms between entities, while a smart contract uses computer code.
Because conditions are written in code, smart contracts enforce them automatically. This allows you to reliably perform and automate many business processes that currently require manual control.
Smart contracts are faster and easier to use, reducing risk for both parties. However, they come with new types of risks. Because computer code is vulnerable and error-prone, sensitive information locked in smart contracts could be at risk.
DeFi problems
Poor performance
Blockchains are slower than their centralized counterparts. This also affects applications built on blockchains. DeFi developers need to take these limitations into account and optimize products accordingly. Second-tier solutions such as Arbitrum and Optimism have adapted to this and offer faster and cheaper transactions.
High risk of user error
DeFi applications shift responsibility from intermediaries to users. For many this may be a disadvantage. It is difficult to develop products with minimal risk of user error when they are deployed on top of immutable blockchains.
Inconvenience of use
Nowadays, using DeFi applications requires extra effort. For these applications to become a key element of the global financial system, they must provide tangible benefits and motivate users to move away from the traditional system. This is facilitated by recent improvements to interfaces and educational resources.
Cluttered Ecosystem
Finding the right application for a specific task is not so easy, and choosing the best one is even more difficult. It is necessary not only to create applications, but also to fit them into the broader DeFi ecosystem.
Risks of DeFi
DeFi offers attractive APY and decentralization, but such applications are still classified as financial services, so they have their own risks:
Third Party Intervention
If you take part in crypto loans or any other type of lending, there is a risk that the counterparty will not repay its debt.
Regulation
It can be difficult to establish the legality of certain services and projects. If you invest in a smart contract that is subsequently closed due to regulatory issues, your funds may be at risk. The actions and recommendations of global regulatory bodies influence the development and adoption of DeFi.
Risk of using tokens
Assets have different levels of risk: this is influenced by liquidity, reliability, security of smart contracts, the project itself and its team. In the DeFi space, there are many tokens with low market capitalization, which makes the risk of exploitation significantly higher.
Program operation
Code vulnerabilities can undermine the security of the smart contracts in which you invest. Your wallet can also be hacked due to connecting to a DApp and granting certain permissions. To reduce these risks, protections such as multi-signature wallets and insurance funds have emerged.
Impermanent losses
When staking in liquidity pools, you can lose some of the tokens in the pool if there is a deviation from the entered price coefficient and you decide to withdraw funds.
Access to DeFi projects
Many DeFi projects originated on the Ethereum network. However, other blockchains now also have DeFi ecosystems. Networks with smart contract capabilities such as BNB Chain, Solana, Polkadot and Avalanche, as well as newer second-layer solutions on Ethereum, are popular.
Finding DeFi projects and protocols requires a lot of research. It can be found on websites, forums and chat rooms. However, it is worth approaching any proposals critically. Always double-check the safety of any project you read or hear about.
How to access DeFi projects?
To work with DApps in DeFi you will need:
Compatible Wallet: A wallet with a browser extension like MetaMask or a mobile wallet like Trust Wallet will work. When using a custodial wallet (where you do not own the private keys), there is an increased chance that the wallet will not be able to connect to the DApp.
Crypto assets: You may need multiple assets. For example, if you want to use an Ethereum-based DApp, you will need ETH for gas fees and another token for the desired service.
DeFi (decentralized finance) and TradFi (traditional finance)
DeFi offers an open financial system to anyone with an internet connection. Traditional finance, on the other hand, is not as accessible because it relies on centralized institutions and regulatory bodies. However, DeFi and TradFi are increasingly interacting. Banks and financial institutions are starting to explore DeFi protocols and create hybrid models that take advantage of both systems.
DeFi (decentralized finance) and CeFi (centralized finance)
Even in the cryptocurrency space, not all financial services are decentralized. For example, when staking on a centralized exchange such as Binance, users give control of their tokens to the platform. Therefore, it is very important to trust a centralized organization to handle your funds.
Most of the services on decentralized and centralized platforms are the same. Most likely, they will use the same DeFi platforms that the user can access directly. However, with CeFi, users don't have to deal with the complexities of managing investments themselves. Sometimes CeFi also provide additional guarantees on deposits.
CeFi is no worse or better than DeFi. The choice between these options depends on your wants and needs. With CeFi, you have less control, but often receive stronger guarantees and relieve yourself of some of the responsibility for managing assets and executing transactions.
What is the difference between DeFi and open banking?
Open banking is a banking system that allows third-party financial service providers secure access to financial data via APIs. This allows for the consolidation of accounts and data between banks and other financial institutions. Moreover, through open banking, new products and services can be created within the traditional financial system.
However, DeFi is a completely new financial system, independent of existing infrastructure. DeFi is sometimes also called open finance.
For example, open banking allows you to manage all traditional financial instruments in one application by securely pulling data from multiple banks and institutions.
Decentralized finance can be used to manage completely new financial instruments and ways of interaction.
Finally
DeFi has quickly created a self-sustaining ecosystem that is attracting capital, developers, and new products. DeFi has the potential to revolutionize the financial sector, but the field is still in its infancy. The future of DeFi will see continued technological advancements, changing regulatory landscapes, and growing adoption. For sustainable growth and addressing the limitations and risks of DeFi, constant innovation is required.
Recommended reading
What are automated market makers (AMMs)
What are liquidity pools in DeFi and how do they work?
What is yield farming in decentralized finance (DeFi)?
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