Decentralized finance (DeFi): A beginner’s guide


Are you unfamiliar with DeFi tokens, ecosystems, and protocols? We've got you covered with our comprehensive, beginner-friendly guide to decentralized finance.

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What is decentralized finance (DeFi)?

Following the launch of Bitcoin in 2009, a thriving industry grew up around the asset, its concept, and its underlying technology. The crypto and blockchain space is brimming with different niches where projects and businesses are developing solutions for various use cases.

The decentralized finance (DeFi) sector, which was created as an alternative to traditional financial services, is one such niche. DeFi is made up of smart contracts, which in turn power decentralized applications (DApps) and protocols. Many of the early DeFi applications were built on Ethereum, and the majority of the ecosystem's total value locked (TVL) is still concentrated there.

At its core, Bitcoin (BTC) embodies characteristics that have been heralded as pillars of decentralization. DeFi, on the other hand, expands on those qualities by adding new capabilities.

DeFi, a subcategory within the broader crypto space, provides many of the mainstream financial world's services in a way that is controlled by the masses rather than a central entity or entities.

Lending may have started it all, but DeFi applications now provide participants with access to saving, investing, trading, market-making, and other services. The ultimate goal of decentralized finance is to challenge and eventually replace traditional financial service providers. DeFi frequently employs open-source code, allowing anyone to build on pre-existing applications in a permissionless, composable manner.

"Finance" is simple to grasp, but what exactly is "decentralization?" In a nutshell, decentralization means that no single body has control over something. Banks and other financial institutions have some control over your funds. These entities have the ability to freeze your assets, and you are at the mercy of their operating hours and cash reserves.

The decentralization aspect of DeFi is a dispersal of risk as well as a dispersal of power. For example, if a company stores all of its customer data in one location, a hacker only needs to access that site to obtain a large amount of data. In contrast, storing that data in multiple locations or eliminating that single point of failure may improve security.

This article will define DeFi, explain how it works, and shed some light on DeFi trading and decentralized banking.

Decentralized Finance (DeFi) vs. Centralized Finance (CeFi)

Commercial banks will be used as an example in this comparison. In the traditional world, financial institutions can be used to store your money, borrow capital, earn interest, send transactions, and so on. Commercial banks have a long and illustrious track record of success. Commercial banks can offer insurance and security measures to deter and protect against theft.

On the other hand, such institutions hold and control your assets to some extent. Banking hours limit specific actions, and transactions can be time-consuming, necessitating back-end settlement. Furthermore, commercial banks require specific customer information and identification documents in order to participate.

DeFi is a financial products and services segment that operates without the involvement of banks or other third-party firms and is accessible to anyone with an internet connection. Because the decentralized financial market does not sleep, transactions take place in near real-time, 24 hours a day, seven days a week, with no intermediary having the power to stop them. You can store your cryptocurrency on computers, hardware wallets, and other devices and gain access to it at any time.

Because of the underlying technology that underpins these assets, Bitcoin and most other cryptocurrencies exhibit these characteristics. Transactions are completed faster, cheaper, and, in some cases, more securely than they would be with human intervention, thanks to DeFi's reliance on blockchain technology. Decentralized finance aims to use crypto technologies to address a slew of issues that plague traditional financial markets:

Traditional finance vs. DeFi

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The asset class and processes are managed by people or companies in centralized finance. In decentralized finance, however, assets are managed by a collection of smart protocols. It all comes down to trusting the people or organizations behind the platform. CeFi platforms, such as, are custodial, which means they hold your cryptocurrency for you. However, you can use a Coinbase wallet in the same way that you would a regular cash wallet, giving you complete control over your crypto assets.

Overall, DeFi gives participants access to borrowing and lending markets, the ability to take long and short positions on cryptocurrencies, earn returns through yield farming, and more. Decentralized finance has the potential to be a game changer for the world's 2 billion unbanked people, in particular.

DeFi solutions are built on various blockchains, with ecosystems made up of participants interacting in a peer-to-peer (P2P) fashion, made possible by distributed ledger technology and smart contracts that keep the systems in check. Such outcomes are not geographically limited and do not necessitate identifying documentation for participation.

This financial system's framework operates according to pre-programmed rules. Instead of using a bank as an intermediary, you would send amounts of a specific cryptocurrency to a secure digital location — a smart contract — as collateral for your loan, in exchange for a different asset. Your collateral assets would then be frozen until you returned the loan amount.

Though you may or may not interact in a straightforward P2P manner when using DeFi solutions, the spirit of the process is P2P in the sense that third parties are replaced with technology that is not governed by a central authority.

Why is decentralized finance(DeFi) important?

DeFi eliminates intermediaries and enables decentralized banking, which was previously impossible due to the need to get transactions approved through third parties. Customers are frequently unaware of the underlying regulations governing financial products and services, as demonstrated by the global financial crisis of 2008–09.

The goal of DeFi is to create a financial market that is open, trustless, and permissionless. Much of the DeFi technology aims to improve the current financial system, potentially improving user experience (for both businesses and their clients).

How does DeFi work?

Though DeFi is frequently associated with cryptocurrencies, it extends beyond the creation of new digital money or value. The smart contracts developed by DeFi are intended to replace traditional financial systems.

Because there are no intermediaries to authorize transactions for DeFi applications, there are no banks or institutions to manage your money. Furthermore, the code is open to scrutiny by anyone, creating a sense of transparency in DeFi protocols. There are also open networks that cross national boundaries. Users can access a plethora of applications, the majority of which are built on the Ethereum blockchain.

What makes up decentralized finance(DeFi)?

In 2020, DeFi exploded, bringing a flood of projects into the cryptosphere and popularizing a new financial movement. Because Bitcoin essentially has many DeFi characteristics, there is no firm start date for the DeFi sector other than Bitcoin's launch in 2009.

Following 2017, however, several ecosystems gained popularity, such as Compound Finance and MakerDAO, popularizing additional financial capabilities for crypto and DeFi. In 2020, the DeFi niche took off as new platforms emerged, in tandem with people utilizing DeFi solutions for strategies such as yield farming.

Decentralized exchanges (DEXs) 

DEXs enable users to trade digital assets without the need for an intermediary or third-party service provider. DEXs have been a part of the overall crypto industry for years, despite being only one component of the DeFi sector. They allow participants to buy and sell digital currency without having to open an account with an exchange.

DEXs allow you to hold assets away from a centralized platform while still allowing you to trade at will from your wallets via blockchain transactions. Automated market makers, a type of DEX, became popular in 2020 and use smart contracts and liquidity pools to facilitate the purchase and sale of cryptocurrency assets.

DEXs are typically built on top of specific blockchains, making their compatibility dependent on the technology on which they are built. DEXs built on the Ethereum blockchain, for example, facilitate the trading of Ethereum-based assets such as ERC-20 tokens.

Using DEXs necessitates the use of compatible wallets. Self-custody crypto wallets, in general, allow you to control your assets, and some of them are compatible with DEXs. This type of asset storage, however, places more responsibility on you for the security of your funds. Furthermore, some DEXs may have fewer features and higher financial fees than centralized exchanges.

DEXs have come a long way in terms of liquidity and establishing a loyal user base, which is still growing. Trading volumes are expected to rise further as DEXs become more scalable — that is, faster and more efficient.

Aggregators and wallets

The interfaces through which users interact with the DeFi market are known as aggregators. They are, in the most basic sense, decentralized asset management platforms that automatically move users' crypto assets between various yield-farming platforms to maximize returns.

Wallets are places where digital assets can be stored and traded. Wallets can store multiple assets or just one, and they come in a variety of forms, including software, hardware, and exchange wallets. Self-hosted wallets — wallets in which you manage your private keys — can be an important component of DeFi, facilitating a variety of DeFi platform uses depending on the wallet. In contrast, exchange-based wallets manage your private keys for you, giving you less control but also less security responsibility.

Decentralized marketplaces

Decentralized marketplaces are a key application of blockchain technology. They put the "peer" in peer-to-peer networks by allowing users to transact with one another in an untrustworthy manner — that is, without the need for an intermediary. The Ethereum smart contract platform is the most popular blockchain for facilitating decentralized marketplaces, but there are many others that allow users to trade or exchange specific assets, such as nonfungible tokens (NFTs).

Oracles/prediction markets 

Oracles use a third-party provider to deliver real-world off-chain data to the blockchain. Oracles paved the way for prediction markets on DeFi crypto platforms, where users can bet on the outcome of an event ranging from elections to price movements, with payouts made through a smart contract-governed automated process.

Layer 1

Layer 1 is the blockchain on which the developers choose to build. It is the location of the DeFi applications and protocols. As previously stated, Ethereum is the primary layer-1 solution in decentralized finance, but there are competitors such as Polkadot (DOT), Tezos (XTZ), Solana (SOL), BNB, and Cosmos (ATOM). As the DeFi space matures, these solutions will inevitably interact with one another.

There are several potential benefits to running DeFi sector solutions on different blockchains. Based on the performance of competing blockchains, blockchains may be forced to improve speed and lower fees, creating a competitive environment that may result in improved functionality. The existence of multiple layer-1 blockchains also allows for more development and traffic, rather than everyone trying to cram onto a single layer-1 option.

DeFi use cases 

Exploring DeFi's use cases can help answer the question "What is DeFi?" There are new ways to meet your needs, whether you want to lend or borrow, trade on DEXs, stake your digital assets, or do something else — even play games. The following is a list of some of the most important use cases for decentralized finance.

Lending platforms

Lending and borrowing have become two of the most popular DeFi activities. Lending protocols enable users to borrow money while using cryptocurrency as collateral. Massive amounts of capital have flowed through the decentralized finance ecosystem, with lending solutions commanding billions of dollars in total value locked, or TVL — the amount of capital held locked in any solution at any given time.

Payments and stablecoins

There must be a stable unit of account, or asset, for DeFi to qualify as a financial system comprised of transactions and contracts. Participants must be able to anticipate that the value of the asset they are using will not plummet. Stablecoins come into play here.

Stablecoins provide stability to common DeFi market activities such as lending and borrowing. Because stablecoins are generally pegged to a fiat currency, such as the US dollar or the euro, they are less volatile than cryptocurrencies and thus more desirable for commerce and trading.

Margin and leverage 

The margin and leverage components advance the decentralized finance market by allowing users to borrow cryptocurrencies on margin while using other cryptocurrencies as collateral. Furthermore, smart contracts can be programmed to include leverage, which can potentially increase the user's returns. The use of these DeFi components also increases the user's risk exposure, especially since the system is based on algorithms and there is no human component in the event of a problem.

DeFi-native activities 

Many decentralized exchanges rely on liquidity pools to facilitate trading. They provide trading liquidity to buyers and sellers in exchange for a fee. To join a pool, liquidity providers can send specific funds to a smart contract in exchange for pool tokens, earning passive profit based on the fees traders pay when they interact with that pool. Pool tokens are essential for recovering your deposited funds.

Yield farming, also known as liquidity mining, is another activity in the DeFi space that involves looking for profit through various DeFi projects by participating in liquidity pools. While yield farming is complicated, there is one major reason why market participants are flocking to this phenomenon: It enables you to use your cryptocurrency holdings to earn even more cryptocurrency.

When yield farming, users lend their crypto to other users and earn interest in crypto — typically "governance tokens" that give liquidity providers a say in how the protocol operates. It is a key innovation in the DeFi market that allows investors to put their crypto to work to increase returns. Yield farming has been dubbed the "Wild West" of DeFi, with market participants hunting down the best strategies, which they then often keep close to the vest so as not to give away the magic to other traders.

DeFi risks?

Despite its promise, the decentralized finance space is still a nascent market that is going through some growing pains.

DeFi has yet to gain widespread acceptance, and in order for it to do so, blockchains must become more scalable. Blockchain infrastructure is still in its early stages, with much of it being difficult to use for both developers and market participants.

Transactions on some platforms move at a snail's pace, and this will continue until scalability improves, which is the idea behind the development of Ethereum 2.0, also known as Eth2. Fiat on-ramps to DeFi platforms can also be excruciatingly slow, threatening to stifle user adoption.

DeFi has expanded significantly. Given its youth and innovation, the legal ramifications of DeFi are unlikely to be fully realized. Governments around the world may try to incorporate DeFi into their existing regulatory frameworks, or they may create new laws pertaining to the sector. DeFi, on the other hand, may already be subject to specific regulations.

In terms of adoption, it is unclear how things will unfold in the future. Traditional finance may adopt aspects of DeFi while retaining elements of centralization, rather than DeFi completely replacing mainstream financial options. Any completely decentralized solutions, on the other hand, may continue to exist outside of mainstream finance.

How do you make money with DeFi?

The most straightforward way to earn a passive income through DeFi is to deposit your cryptocurrency on a platform or protocol that will pay you an annual percentage yield.

Staking is the process of locking tokens into a smart contract in exchange for more tokens of the same type. Yield farming is yet another method of rewarding yourself with more of the same or a new token.

Your first step will be to purchase some cryptocurrency using a fiat on-ramp (i.e., using cash to buy cryptocurrencies). However, before you buy your cryptocurrency, keep in mind that the vast majority of DeFi is based on the Ethereum blockchain, so BTC is rarely accepted.

Is it safe to invest in DeFi?

In general, the lower the market capitalization of a token, the riskier it is as an investment. As a result, before committing funds, consider the liquidity of tokens. Before you invest, make sure you understand how long a DeFi protocol has been in operation and how much money it has in total deposits.

You can check the company's website to see if it has taken reasonable steps to reduce its risks. You can also search the internet for news articles about the protocol being hacked and the precautions taken to prevent it from happening again.

To be clear, there is no DeFi protocol that is risk-free, but the considerations listed above can help you assess the investment risk before investing in any protocol.

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