A guide on the first steps in decentralized finance: How do I get started with DeFi?


Decentralized finance (DeFi) is a cryptocurrency industry sector that focuses on providing decentralized financial services. 

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Decentralized finance (DeFi) is a cryptocurrency industry sector that focuses on providing decentralized financial services. It is made up of a variety of financial services created by developers that anyone can use. These services differ from centralized alternatives in that they are managed by groups of people through decentralized organizations and give users more control over their funds.


Every week, new decentralized and non-custodial financial services are added to the DeFi sector, which is a hotbed of innovation. These services are available to anyone, anywhere in the world.


According to World Bank data from 2017, approximately 1.7 billion adults worldwide were estimated to be unbanked — that is, without a financial institution account. Because there are no entry requirements for financial services on DeFi protocols, anyone can use them. In essence, the only barrier to entry is knowledge.


The DeFi ecosystem is built on top of public distributed networks and employs self-executing agreements written into lines of code known as smart contracts to democratize access to financial service s.s.


How to use DeFi protocols?


The majority of DeFi protocols are built on top of networks such as Ethereum or Binance Smart Chain, and the number of competing blockchain networks that support smart contracts is growing. It is critical to select a network before using DeFi services.


Most large protocols now support multiple blockchains, with the main differences being ease of use and transaction fees. Networks such as Etheruem, Binance Smart Chain, and Polygon are all accessible via wallet extensions such as MetaMask, with only a few parameters changing to switch networks.


Users can use these wallet extensions to access their funds directly from their browsers. They are installed in the same way as any other extension and frequently require users to either import an existing wallet — via a seed phrase or a private key — or create a new one. They are also password-protected for added security. Some web browsers include built-in wallets.


Furthermore, these wallets frequently include mobile applications that can be used to access DeFi projects. These apps are wallets with built-in browsers that can interact with DeFi apps. Users can sync their wallets by creating them on one device and importing them onto another using the seed phrase or private key.


These mobile applications frequently incorporate the open-source WalletConnect protocol to make things easier for users. By scanning a QR code with their phones, users can connect their wallets to DeFi applications on desktop devices.


Before we begin, it is important to note that this is a highly experimental space with a number of risks. Exit scams, fraudulent projects, rug pulls, and other types of scams are common, so always do your own research before investin g.g.


To avoid falling for these schemes, here's how to take security a step further: It is best to find out whether or not the projects have been audited. Finding out this information may require some research, but often a direct search for the project's name plus "audits" will reveal whether or not it has been audited.


Audits help to identify potential vulnerabilities while discouraging bad actors. Projects that are less than stellar are unlikely to waste time and resources by being audited by reputable firms.


Buying crypto


DeFi applications are built on top of networks, and each network has its own native tokens that can be identified on exchanges by the ticker symbol: Ethereum (ETH), Polygon (MATIC), Binance Coin (BNB), and so on.


Because these native tokens are used to pay for transactions on these blockchains, you'll need some of them to transfer funds. You can either buy these native assets first and then dive into DeFi, or you can mix in stablecoins or other assets.


After purchasing funds from a centralized exchange, you must transfer them to a wallet under your control that supports that network. It is critical to avoid moving funds to the incorrect network, so check that you are using the correct network before withdrawing.


Users can withdraw Bitcoin (BTC) to an Ethereum address, or Ethereum to the Binance Smart Chain, on some exchanges. These withdrawals are for tokenized versions of BTC or ETH that can be used in DeFi on those networks.


Every DeFi protocol transaction must be manually approved and incurs a transaction fee, so it is critical to select a network with low transaction fees.


What are DeFi services?


It's time to start using DeFi services after choosing an application to interact with and funding a wallet. The most basic actions would be to trade on a decentralized exchange (DEX), provide liquidity and earn fees over time, or lend funds through a lending protocol.


There are hundreds of options available, so rather than going over each project individually, here's an overview of which products and services are available to use and what you should consider before using them.


To begin using a wallet compatible with DeFi protocols, simply go to the websites of these protocols and connect your wallet to them. This is done through a pop-up window or a "connect" button in one of the upper corners of the website.


Connecting your wallet is the equivalent of "logging in" to the service with your account — in this case, your wallet address. Before lending, borrowing, or trading tokens on DeFi protocols, you must enable each token separately so that the protocol can access them on your wallet. There is a small fee associated with this connection process.


Making your crypto work for you with DeFi


While there are numerous products and services in DeFi, the sector is highly interconnected and composable, which means that complex strategies to improve yields are possible, but a bug in one protocol can result in losses in another.


However, the main advantage of using DeFi is that there are no trusted third parties. Because most DeFi protocols are run by decentralized autonomous organizations (DAOs) rather than centralized companies, anyone can review the code written in the smart contracts used by these protocols.


Before venturing into space, potential users should be aware of a few services provided by the DeFi ecosystem.


Lending


DeFi protocols aim to make it simple to lend and borrow cryptocurrencies without the use of intermediaries. Interest rates are determined by supply and demand and thus fluctuate over time. Most protocols require borrowers to overcollateralize their loans in order to ensure that lenders are paid in the event of market turmoil.


Assume a user requires $1,000 to meet a short-term obligation. They may be forced to sell their Bitcoin or Ethereum holdings if DeFi is not available. They can use DeFi lending services to deposit, for example, $1,500 in BTC into a protocol to obtain a $1,000 loan in a stablecoin. They can meet their obligations without losing exposure to BTC, and then simply repay the loan with interest.


If the value of their collateral falls below $1,000, the DeFi protocol's smart contracts will liquidate the coins to repay the lender. If the price of Bitcoin rises while the loan is being repaid, the move was justified because the user did not lose exposure.


Liquidity mining and yield farming


Some of the most popular DeFi protocols are decentralized exchanges. Instead of using order books like centralized exchanges, they use a model known as an automated market maker (AMM) to execute trades on the blockchain via smart contracts.


Traditional order books are replaced by pre-funded liquidity pools that include the assets in a trading pair in the model. Users provide liquidity in these pools in exchange for commissions on trades executed on that pair. Users earn money by simply providing liquidity to these pools, which is known as liquidity mining.


Liquidity mining involves risks that lending does not, such as impermanent loss. Impermanent loss occurs when liquidity providers must deposit both assets of a trading pair into a liquidity pool alongside, say, ETH and stablecoin DAI. When trades are executed that reduce the amount of one asset in the pool — in this case, ETH — and its price rises, the liquidity provider suffers a temporary loss because they now hold less ETH while its value increased.


The loss is temporary because the asset's price could return to when it was first added to the pool, and the fees collected could compensate for the loss over time. However, it is a risk that must be considered.


The distribution of a DeFi protocol's governance token is frequently combined with liquidity mining. Over time, some protocols distribute governance tokens to anyone who interacts with them, resulting in a process known as yield farming. It began with Compound's COMP governance token and has since spread to the majority of major DeFi protocols.


Asset management


Users can monitor, deploy, and manage their capital using a single interface with DeFi asset management platforms. When lenders and liquidity providers deposit funds on a DeFi protocol, they are given tokens that represent these interest-earning positions — which are frequently referred to as compound tokens (cTokens) and liquidity provider tokens (lpTokens).


These tokens must then be redeemed for the invested principal, or the original amount invested. When a user deposits 100 DAI into a platform, they will receive a variable amount of cDAI worth 100 DAI in their wallets. Likewise, if a user deposits 100 DAI and 100 ETH into a liquidity pool, they will receive lpETHDAI in their wallets.


Asset management platforms make it easier to manage multiple positions across various DeFi protocols and to carry out more complex strategies. For example, a cToken from one protocol can be used to provide liquidity in another, significantly increasing the generated yield.


Assume you have 1000 DAI and 1 ETH in your wallet to help you understand this complex strategy. You would deposit the DAI and ETH using protocol A, and you would receive 1000 cDAI and 1 cETH, representing our lending positions on this protocol and allowing us to earn interest.


After that, you can deposit cDAI and cETH into a liquidity pool on protocol B to earn more cDAI and cETH from trading fees. When cashing out, you would withdraw 1100 cDAI and 1.1 cETH from protocol A because you earned more cTokens from protocol B fees. These tokens would then be redeemable for the principal amount invested plus interest accrued.


Complex strategies increase yield while increasing risk due to their modularity. DeFi protocols build on each other's publicly available code and services, resulting in "lego money." Each component is linked.


Staying safe


The DeFi sector is exploding with innovation, and, as with ICOs, malicious actors try to take advantage of users by maximizing their earnings through various schemes.


Before using a DeFi application, users should check to see if it has been audited, but there are several questions they should ask themselves before interacting with a protocol or purchasing its governance token.


Triple-digit annual percentage yields (APYs) are not uncommon in the DeFi space, thanks in part to the opportunities associated with yield farming. A golden rule of investing, however, is that risks equal rewards: Above-average APYs are normal, but if they seem too good to be true, they should be investigated further.


That deeper look would involve researching the team that originally created the DeFi protocol. Before protocols move to become DAOs, a centralized team works on its smart contracts. It’s not uncommon for anonymous teams to develop projects, so the best way to gauge whether the team can be trusted or not is to analyze their transparency as to what’s being done in the protocol.


Finally, it’s important to understand if the project’s community is authentic. Deploying bots on social media to hype up a project has been done before, but an active community that openly discusses governance proposals, future implementations, user experience and more cannot be faked.


To quantify risks in permissionless lending protocols on DeFi, open-source projects such as DeFi Score have been created. These can assist users in understanding how to access the risk in these protocols.

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