Entering the DeFi world can be exciting to many but confusing as well. After some time HODLing, it's common to wonder how you can squeeze some extra gains out of your portfolio. However, there's a lot to unpack when it comes to DeFi.
When used responsibly, DeFi DApps and projects can become powerful tools. But if you jump in too soon, it's easy to become overwhelmed and make unwise investment decisions. The best way to get involved is to learn the risks and find what's suitable for you. With this in mind, let's explore the basics you'll need when starting your DeFi journey, such as how DeFi crypto works and learning about the potential risks of DeFi.
What is Decentralized Finance (DeFi)?
Decentralized finance (or simply DeFi) refers to an ecosystem of financial applications built on blockchain networks.
More specifically, the term DeFi may refer to a movement that aims to create an open-source, permissionless, and transparent financial service ecosystem. One that is available to everyone and operates without any central authority. The users would maintain complete control over their assets and interact with this ecosystem through peer-to-peer (P2P), decentralized applications (DApps).
The core benefit of DeFi is enabling easy access to financial services, especially for those who are isolated from the traditional financial system. Another advantage of DeFi is the modular framework it’s built upon, with interoperable DeFi applications on public blockchains. These have the potential to create entirely new financial markets, products, and services.
How DeFi Crypto Works
DeFi offers higher levels of financial access by offering the possibility of a suite of financial products built on permissionless (i.e. anyone is free to participate) blockchains. Financial products and services can be programmable on the blockchain and participants can interact with each other cutting out the middleman of financial institutions who traditionally provided the service of intermediation.
In addition to providing alternative access to traditional financial products (borrowing, lending, saving, exchange, insurance etc) it offers a platform for new innovation and challenges for regulation. The field has recently seen phenomenal growth in the blockchain and cryptocurrency space and is increasingly being recognised as a potential disruptor to traditional centralized finance.
DeFi vs Traditional Finance
Arguably the most significant difference between DeFi and traditional finance is accessibility. Anyone can create a wallet and begin using DeFi services so long as they have some crypto. There are no sign-ups or identity verification needed. To access traditional finance services, Know Your Customer (KYC) checks must be completed and other conditions met. This fundamental difference makes DeFi accessible to the unbanked, improving financial inclusion.
DeFi also offers financial services that aren't available in the traditional realm. By layering different DeFi services (sometimes known as DeFi legos), it's possible to create brand new products that utilize multiple platforms. This flexibility allows for innovative products that anyone can develop strategies for.
DeFi vs Centralized Finance (CeFi)
Even in the crypto world, not every financial service is decentralized. For example, staking through 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 deals with your funds.
The majority of the services offered will be the same. They likely are done through the same DeFi platforms that a user can access directly. However, CeFi takes away the often complicated nature of managing DeFi investments yourself. You may also have extra guarantees on your deposits. CeFi is neither worse nor better than DeFi as its suitability depends on your wants and needs.
What are the Potential Use Cases for DeFi?
Borrowing and Lending
Open lending protocols are among the most popular application types in the DeFi ecosystem. Open, decentralized borrowing and lending have many advantages over the traditional credit system. These include instant transaction settlement, no credit checks, and the ability to collateralize digital assets, no credit checks.
Since these lending services are built on public blockchains, they minimize the amount of trust required and have the assurance of cryptographic verification mETHods. Lending marketplaces on the blockchain reduce counterparty risk and make borrowing and lending cheaper, faster, and available to more people.
Monetary Banking Services
As DeFi applications are, by definition, financial applications, monetary banking services are an obvious use case for them. These can include the issuance of stablecoins, mortgages, and insurance.
As the blockchain industry matures, there's an increased focus on creating stablecoins. They are crypto assets usually pegged to real-world assets that are easily digitally transferable. As cryptocurrency prices can fluctuate rapidly at times, decentralized stablecoins could be adopted for everyday use as digital currencies that are not issued and monitored by a central authority.
Because of the number of intermediaries involved, getting a mortgage is expensive and time-consuming. With smart contracts, underwriting and legal fees could be reduced significantly.
Insurance on the blockchain could eliminate the need for intermediaries and allow the distribution of risk between many participants. This could result in lower premiums with the same quality of service.
Decentralized Marketplaces
Some of the most popular DeFi applications available are Decentralized Exchanges (DEXs). These platforms allow users to trade digital assets without needing a trusted intermediary (the exchange) to hold their funds. The trades are made directly between user wallets with the help of smart contracts.
Some exchanges, known as Automated Market Makers (AMMs), use liquidity pools to facilitate trading without directly needing a counterparty to match your trade. Uniswap and Pancake Swap are two of the best-known examples. Since they require less maintenance work and managing, decentralized exchanges typically have lower trading fees than centralized exchanges.
Blockchain technology may also be used to issue and allow ownership of a wide range of conventional financial instruments. These applications would work in a decentralized way that cuts out custodians and eliminates single points of failure.
Security token issuance platforms, for example, may provide the tools and resources for issuers to launch tokenized securities on the blockchain with customizable parameters. Other projects may allow the creation of derivatives, synthetic assets, decentralized prediction markets, and many more.
Yield Optimization
DeFi DApps can be used to automate and optimize the compound of yield gained from staking, reward pools, and other interest-bearing products. You may sometimes hear yield optimization referred to as yield farming.
For example, you might receive regular rewards from Bitcoin mining, delegating BNB, or providing liquidity. A smart contract can take your rewards, purchase more of the underlying asset, and reinvest it. This process will compound your interest, often significantly raising your returns.
Of course, you can do this manually. Using a smart contract, however, saves time and optimizes compounding. Your funds are usually pooled togETHer with other users’, meaning that gas fees are shared across all members of the yield optimizing smart contract.
Potential Risks of DeFi
While the DeFi world can offer appealing APYs, it is not without risks. Even though they are decentralized, you are essentially consuming financial services, and some of the risks are familiar:
1. Counterparty Risk: If you take part in crypto loans or any other kind of lending, you’re at risk of the counterparty not repaying their debt.
2. Regulatory Risk: The legality of certain services and projects can be difficult to ascertain. If you are invested in a smart contract that is subsequently shut down due to regulatory problems, then your funds can be at risk.
3. Token Risk: The assets you hold have different risk levels affected by their liquidity, trustworthiness, token smart contract security, and associated project and team. As the DeFi pace has many low market-cap tokens, token risk can be particularly high.
4. Software Risk: Code vulnerabilities can undermine the security of smart contracts you’re invested in. Your wallet could also be compromised due to connecting to DeFi DApps and giving them certain permissions.
5. Impermanent Loss: If you’re staking in liquidity pools, divergences away from the price ratio you entered at will cause you to lose some tokens deposited in the pool if you withdraw.
What Do I Need to Access DeFi Projects?
To connect to DeFi DApps, you'll need:
1. A compatible wallet: A browser extension wallet like MetaMask or a mobile one such as Trust Wallet will do the job. A custodial wallet (one where you don't own the private keys) is less likely to allow you to connect to DApps.
2. Crypto: This seems obvious, but you might need a mixture of assets. For example, using any DApp on BNB Smart Chain will require BNB to pay your gas fees. ETHereum will require Ether (ETH). If you want to get started with liquidity pools and stake manually, you'll need a pair of coins of equal monetary value.
At its most basic, that's all you'll need. If you don't feel comfortable setting this up yourself, you can still access some DeFi services through a centralized entity.
Closing Thoughts
And that’s it for today’s article on how DeFi crypto works. Decentralized finance is focused on building financial services separate from the traditional financial and political system. This would allow for a more open financial system and could potentially prevent precedents of censorship, financial surveillance, and discrimination worldwide.
If successful, DeFi could take power away from large centralized organizations and put it in the hands of the open-source community and the individual. WhETHer that will create a more efficient financial system will be decided once DeFi is ready for mainstream adoption.
