The Ultimate Beginner’s Guide to Decentralized Finance or DeFi
DeFi, short for decentralized finance, is the latest hot trend in the crypto industry, and rightly so. An emerging market that surged from $1 billion to $13 billion in less than eight months cannot go unnoticed for too long.
As you are reading this beginner’s guide to DeFi, the sector is adding more protocols, increasing value, and becoming an even more challenging rival to the traditional finance system.
It may be a bit too early to bet your bottom dollar on it, but we may very well be on the brink of a financial revolution eagerly spearheaded by decentralized finance. If you don’t want to miss out on it, understanding what DeFi is and how it works should be at the top of your must-know list.
DeFi in a Nutshell
- DeFi is short for Decentralized Finance.
- DeFi is an open-source, permissionless, and transparent financial ecosystem
- DeFi is an up-and-coming financial sector of the crypto industry that uses finance protocols built on blockchain technology
- DeFi focuses on developing alternative financial service to the traditional, centralized finance system
- DeFi enables financial operations between users without the need for intermediation from a central authority or another third-party entity
- DeFi projects support various financial use cases like asset management, borrowing and lending money, margin trading, as well as increasing passive income, among others
- DeFi is open to anyone regardless of race, gender, religion, age, or country of origin
- DeFi is a safe emerging financial market, especially for those who do their due diligence before investing
- DeFi is expected to become a serious rival of the classic centralized finance system once it is ready for mainstream adoption
What is DeFi?
The best way to describe Decentralized Finance (DeFi) and its works are to understand its rival and potentially future predecessor, centralized finance.
Also known as the traditional economic model, centralized finance (CeFi) is a financial ecosystem that includes all the legal, financial operations such as banking, loans, interest rates, derivatives, trading, budgeting, and asset ownership.
All of these financial instruments have a central point of convergence. This radial point is usually a bank, a governmental institution, a company, or any other third-party entity that claims full custody and governance over the operations.
These centralized financial institutions act as an intermediary in any financial enterprise you may have, whether trading assets, borrowing, or lending money. They have been in control for centuries, dictating transaction times and fees, interest rates, and commissions on asset trading and ownership.
The definition of decentralized finance should be easier to grasp now.
Decentralized Finance, or DeFi, is a financial ecosystem built on top of blockchain networks. It supports the same financial instruments and operations as centralized finance. Still, contrary to the traditional model, it doesn’t involve a central authority that would claim a cut out of each transaction or trade taking place on its platform.
In layman’s terms, DeFi is where you go if you want to trade assets, lend or borrow money, all legally and without the banks or the government meddling in your business.
A DeFi protocol is a blockchain-based network where users engage in peer-to-peer (P2P) exchanging, trading, or lending of their assets, among other financial operations.
By deploying immutable smart contracts on the blockchain, the participants are free to use their crypto assets for borrowing, lending, investing, and making payments in a trustless manner.
DeFi is a paradigm shift in our understanding of the financial world. It expands a decentralized, open-source, permissionless, and transparent technology that already includes two of the biggest innovations of our present time: blockchain and cryptocurrency.
Why is DeFi so Hot Right Now?
Decentralized Finance is less than 3-years old. While it started slowly, it really blossomed in 2020 when a great number of DeFi protocols flooded the cryptocurrency market.
Today, DeFi has become a stand-alone niche with over $13 billion stored in locked value protocols. This rapid ascent has taken the crypto industry by surprise. However, while a few voices fear that the bubble will burst and leave everyone empty-handed, most investors and traders believe that this is just the beginning of a future major financial market.
DeFi is quickly gaining support because the absence of a central authority makes a broad range of financial operations available to anyone connected to the Internet.
Also, decentralized finance makes it possible to use your crypto assets in ways that your real-world possessions wouldn’t allow it.
For example, you may lend cryptocurrency to developing a startup project and gain interest from it without ever risking losing it. However, you couldn’t do that with your car, your stocks, or your gold bullions.
DeFi also gives access to a wide range of new applications, including:
- Decentralized exchanges
- Synthetic assets
- Flash loans
- Peer-to-peer transfers
- Crypto payments
- Lending and borrowing platforms
- Trading pools for stablecoins
- Tokenized BTC
These are just a few features available in the rapidly expanding DeFi universe. The best part about it is that anyone has access to a broad inventory of financial instruments. As a result, developers, institutions, and individuals can access financial opportunities with possible substantial profits. Needless to say, doing your due diligence and understanding the risks is fundamental to any successful operation in decentralized finance.
A Brief History of DeFi
In May 2018, the platform for crypto lending and savings, Dharma, hosted a meeting in San Francisco called the “Decentralized Finance Meetup.”
Several companies and startups from the crypto industry were present at the meet-up, including the Maker Foundation, Compound Labs, 0x, dYdX, and Wyre. At the end of a long set of productive discussions, the participants concluded that decentralized finance is an independent sector within the cryptocurrency market.
It took less than two years for their conclusion to become acknowledged by the rest of the industry. In February 2020, the up-and-coming niche reached $1 billion, and within the next six months, it witnessed a tenfold increase.
The Benefits of Decentralized Finance (DeFi)
The advantages of decentralized finance increase with every project that appears on the market. Obviously, its biggest benefit is convenient access to financial services for those who could not penetrate the classic, centralized system for various reasons.
Thanks to its underlying network, blockchain technology, DeFi is bound to give birth to innovative products, services, and other industry niches in the long term.
For now, we can observe these essential benefits of decentralized finance:
Ease of use
The decentralized architecture of blockchain makes smart contracts and the data that they contain permanent and unalterable. This factor increases the security and “auditability” of every DeFi protocol.
Most DeFi protocols are specifically developed to integrate and complement each other. This feature enables developers to build new applications on top of others and diversify the offer of services in the DeFi ecosystem.
The DeFi protocols abide by the Ethereum blockchain rule of transparency. It means that while the identity of the participants in a transaction remains partially hidden, the transaction itself is visible for the entire network. This feature makes decentralized finance an open-source platform that anyone can access, view, or audit.
In decentralized finance, you don’t need to make trips to the bank, nor do you need their approval to trade your assets or to borrow and lend them as you please. In DeFi, you only need a valid connection to the Internet, a crypto wallet, and a good understanding of how cryptocurrencies work.
Contrary to centralized finance, in DeFi, you have full control and custody over your assets. As a result, there isn’t a central authority that could put a lock on them or charge a fee whenever you move them on the market.
Compliance and KYT
The DeFi ecosystem employs the next generation of compliance regulations and imposes Know-Your-Transaction (KYT) mechanisms, which protect users and assets against cybercrimes and fraud.
How the DeFi Ecosystem Works
In decentralized finance, real-world banking operations are possible between participants through smart contract technology. Everything from payments to loans and derivatives is easy and fast to complete, thanks to smart contracts that execute automatically without the need for manual supervision.
At the moment, there are more than 300 DeFi projects more or less popular in the crypto industry. Many of them feature native tokens, with at least 100 digital assets available on the market through various protocols.
Most of these DeFi projects have been created on the Ethereum blockchain, where they still run today. However, a small number of them have evolved as cross-chain solutions, such as Band Protocol and Cosmos. Then there is the Lightning Network, which is the closest that any application built on Bitcoin has gotten to decentralized finance.
DeFi is available for everyone and makes things even easier. It uses similar storage solutions as the rest of the crypto industry. Users can save their digital assets in:
All in all, the DeFi ecosystem works by bringing together most of the innovations in blockchain and cryptocurrency technology. This expanding universe then lets users trade, lend, and borrow capital under the umbrella of trustless, permissionless, and transparent synergy.
DeFi Use Cases
In Robin Hood-like fashion, DeFi has ransacked the vault of centralized services and offered them free to people across the globe. As a result, plenty of individuals and companies that had their asset management restricted by traditional regulations can finally use their financial power as they please.
This list of decentralized finance use cases shows that the DeFi market is more than a fad!
When dealing in the DeFi market, you have full control over your assets. You can sell, lend, or trade them as you please without going through an intermediary. More than that, you pay smaller transaction fees, and you get to maintain your anonymity.
Some of the most popular platforms for asset management in the DeFi space include:
The DeFi space is a fertile ground for decentralized autonomous organizations (DAOs). These entities abide by strict transparency rules encoded in the blockchain, a feature that makes centralized administration obsolete.
Data and analytics tools
The evolution of the DeFi ecosystem has led to the development of versatile tools for data analysis, financial forecasts, and tools. This way, users better understand the financial value, risk, and yield when managing their assets.
In the DeFi market, derivatives are the correspondents of real-world assets such as fiat currencies, bonds, commodities, and cryptocurrencies. Users can tokenize and trade through smart contracts while maintaining a permanent pegged value to their real counterparts.
Some of the most popular platforms for derivatives platforms in the DeFi space include:
DeFi doesn’t offer alternatives for the centralized system only, but some other applications within the cryptocurrency industry. Decentralized exchanges (DEXs) are just some of them. These crypto exchanges function through peer-to-peer mechanisms and do not require a central authority to validate transactions between users.
Some of the most popular decentralized exchanges in the DeFi space include:
Some DeFi protocols like Aave allow users to loan capital from lending pools without presenting collateral for them. Instead, the platform ensures that the loan is paid back by placing the data about borrowing and returning the loan plus a small interest in the same transaction.
This feature enables borrowers to make a small profit from the difference in the price of an asset by trading it on different exchanges.
Lending and borrowing
One of the most popular DeFi use cases involves peer-to-peer lending and borrowing of crypto assets. Protocols like PoolTogether, Argent, and Dharma enable users to supply each other with funds in a trustless and transparent manner.
The Compound protocol allows participants to place their assets in lending pools where other users and developers can borrow from to fund their projects. Everyone wins as the lenders receive interest in their assets without losing proprietary rights over them. In addition, the loaners get to build their enterprises without going through the hassle of applying for traditional bank loans.
Some of the most popular lending and borrowing DeFi platforms include:
Decentralized, non-custodial lending protocols like Compound and dYdX allow users to automatically leverage their trades through smart contracts. This way, they do not have to resort to traditional brokers for borrowing funds.
DeFi protocols provide access to financial operations for people who, for various reasons, are financially isolated by the classic centralized system. One of them is peer-to-peer payment, which enables many users to exchange cryptocurrency securely and directly with one another, without intermediaries.
Some of the most popular DeFi platforms for crypto payments include:
Another popular use of DeFi regards prediction markets, which enables users to vote on the outcome of real-world events and trade value on the blockchain by using the crowd’s wisdom. Platforms like Augur make betting on the results of anything from elections to sports games easy and widely accessible.
DeFi platforms also help people earn considerable APY (annual percentage yield) on their assets by depositing them into savings mechanisms like Yield Farming.
Yield farming works by moving your idle cryptocurrency assets between various liquidity protocols to maximize returns. It is a reliable and exciting strategy for users who do not want to engage in crypto trading or massive investments.
Decentralized finance aims to incorporate all the innovations in the cryptocurrency space. As a result, the implementation of stablecoins by several DeFi protocols does not come as a surprise. Today, they are the primary tools on platforms that provide remittance payments, lending, and borrowing services.
Stablecoins are cryptocurrencies pegged to real-world fiat currencies or other stable assets. Curve Finance is just one of the many DeFi platforms that use pools of stablecoins to enable easy asset transactions between users.
Once the Ethereum network undergoes the 2.0 update, DeFi users will stake their Ether and gain rewards through staking providers or by validating blocks on the Ethereum blockchain.
Besides stablecoins, another crypto asset class is collateralized to real-world assets like gold and various fiat currencies. These tokens are also known as synthetic assets, locked into Ethereum-based smart contracts with built-in agreements and incentive mechanisms. This way, participants get access to a wide range of assets that would otherwise be unattainable.
Some decentralized finance protocols enable users to create, issue, and manage their tokens on the blockchain. Moreover, by locking their functionalities in smart contracts, they can use these tokens for various economic possibilities.
Trading is possibly the economic activity in which most DeFi users engage regularly. From derivatives trading to margin trading and token swaps, there are numerous transfers and transactions that participants can execute through decentralized exchanges, liquidity pools, and marketplaces.
Wrapping is the practice of making one asset from a blockchain compatible with another blockchain. For example, DeFi projects like WBTC enable users to wrap Bitcoin to be ERC-20 compatible and backed 1:1 in value to increase liquidity on the network and widen the spectrum of economic operations.
Is Decentralized Finance (DeFi) safe?
Like every new financial market, DeFi doesn’t come without risks for those who venture into it. Unfortunately, however, you can lose capital in this new sector just as easily as you can squander it in traditional, centralized finance.
More so, there is no emerging market out there that doesn’t get the rarely welcomed visit of scammers, hackers, and other cybercriminals. Therefore, you will need to understand this niche in the crypto industry before you can differentiate between serious, profitable enterprises and hidden scams.
Decentralized finance is as safe as you make it be. In this market, you, as a participant, have more responsibility to research and analyze every financial venture. Unfortunately, there is no central authority to turn to if you fall victim to a scam. So, your best choice is to do your due diligence before opening your digital wallet.
The Bottom Line – The Ultimate Beginner’s Guide to DeFi
Decentralized finance is the answer to financial discrimination that the traditional, centralized system has often imposed in various corners of the world. This new sector defies an outdated structure and aims to make financial services globally and equally available for anyone regardless of race, ethnicity, gender, age, country of origin, or employment status.
It might not be ripe for mass adoption yet, but DeFi already looks like a fruitful enterprise. Moreover, its rapid ascent is a good sign that the world will soon become an open-source community with instant access to a broad range of financial products.
If you are interested in investing in decentralized finance protocols, make sure that you first understand how the DeFi market works. This blockchain-based innovation gives you more control over your assets, which is why you should approach it with an equally high level of responsibility.