A beginner’s guide to DeFi. What is Defi and how does it work?

A beginner's guide to DeFi. What is Defi and how does it work?
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A beginner’s guide to DeFi. Discover what Defi is and how it works

DeFi has taken the cryptocurrency industry by storm with all the innovation it brings. Here is a quick guide to help you master the basics of DeFi.

What is DeFi?

DeFi (or decentralized finance) is a term that you have seen us use several times on this platform. And for good reason. After all, it is one of the biggest trends in the crypto industry as of now.

Remember how Initial Coin Offerings ( ICOs ) used to do round after round on crypto news portals in 2017? DeFi is doing it right now. The $55.39 billion locked up in the various DeFi portals act as a testament to its popularity.

So what is it actually? DeFi is a large number of financial applications that use blockchain technology to function. It has changed the way people perceive financial transactions forever. At its core, DeFi is all about decentralization and improving the transparency of financial systems.

The open financial economy that DeFi aims to create is based on financial protocols that are built with interoperability, ease of composition, and programmability in mind. Armed with the aforementioned, DeFi is sparking the Open Finance Movement which is promoting alternative ways of thinking about finance.

The movement has shown people that they don’t necessarily have to rely on conventional financial vehicles for loans, savings, trading, insurance, and many other important aspects of finance.

The way finance as we know it has been changing points to the possibility that DeFi applications will one day overtake traditional financial markets. Being decentralized, it has unprecedented reach and scope, and that makes it accessible to the masses.

The only thing stopping DeFi from taking over is the fact that people still need to educate themselves on blockchain technology. Not understanding the system well prevents many people from using the technology. And that prevents them from taking advantage of the benefits it has to offer.

We are doing our bit to change that.

How does DeFi work?

Now that you know what DeFi is, one of the most important questions to ask yourself would be, “how does it work?”

DeFi relies on several smaller systems to function. As mentioned above, it is more of a collective space than a system in itself. A host of noncustodial financial products that have interoperability, ease of composition, and programmability in the background make up the DeFi space.

Now, you may be wondering what noncustodial really means. In the context of DeFi, non-custodial means that you are the one who manages your crypto. What that means for you as an investor is that you don’t have to give your money to anyone else for your money to earn for you.

Traditionally, you would deposit your money in a bank and the bank would trade your money and share some profits with you. Or, if you choose to opt for mutual funds, your fund manager would do the same for you. 

In the case of DeFi, you are in full control of your money. And it is you who decides what happens to your money and not some centralized body.

That said, the world of DeFi is full of experimentation. And that has attracted some of the most successful venture capitalists and big companies to invest in the projects.

What is the difference between DeFi and CeFi?

Before we talk about the difference between centralized finance (CeFi) and decentralized finance (DeFi), let’s talk about what each entails.

We have already talked about DeFi, so let’s dive deeper into what CeFi is.

The crypto industry has been around longer than DeFi. So it is no surprise that in the early days, CeFi was the standard for crypto trading. In fact, even now, most exchanges are largely centralized. 

Take Binance, for example. As a user, you must use the exchange according to the rules established by the company. Also, all the assets you have on the platform are exclusively managed by the Binance team.

And this is how centralized exchanges work. It is the exchanges that decide which coins are listed on the platform for trading, as well as the fees you have to pay for trading on the exchange.

You send your funds to the exchange and then the exchange manages them internally. They store your funds on the exchange and make sure the funds are safe.

However, is everything wrong? It depends on how much you trust centralized exchanges. 

While centralized exchanges have security measures in place to keep your funds safe, they can always fail. And when that happens, your funds are left vulnerable to threats. The Mt. Gox incident, as well as those that followed, are still fresh in investors’ minds.

On the other hand, the big exchanges have entire customer service departments hired to help you through every step of your journey on the platform. This gives you a feeling of confidence and comfort. And their problems are fixed pretty quickly.

When you want to convert your fiat currency into cryptocurrencies, you will find that centralized services are more flexible than decentralized ones.

And while this is changing, it will be a while before decentralized services catch up with centralized services in this regard.

One of the main differences between CeFi and DeFi is the fact that most centralized services require you to complete a KYC process before you can avail of the services offered by the platform.

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Decentralized services, on the other hand, are not trustworthy and do not require KYC at all (with a few exceptions). You can directly access the services with the help of a wallet and you do not have to compromise your anonymity.

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More importantly, you don’t need to trust DeFi services to use them. If you have made a transaction, you can always verify it with tools like Etherscan. In fact, the level of transparency is so high that you can audit the platform’s code yourself to verify its legitimacy.

And since the code is available, anyone can build on top of these platforms. This allows DeFi to produce innovative products at a rate that you simply don’t see in CeFi.

Those were some of the differences between CeFi and DeFi, but there are many more than you realize over time when using platforms based on the concepts of the two.

What are the main advantages of DeFi?

DeFi has many advantages that it offers both users and investors. But if we delve into each of them, the article would be painfully long to read. Therefore, we are only going to discuss the significant benefits that have helped DeFi gain the popularity and support that it is proud to have as of now.

1. You do not have permission

To make the best use of DeFi, it is imperative that we take a look at the permissionless nature of transactions on the blockchain. It helps financial products and services built on the blockchain reach a much larger number of people for whom access to centralized finance is not an option. And you’d be surprised how many people that is.

Currently, approximately one-fifth of the world’s population does not have access to banking solutions for one reason or another. Don’t have the proper documentation? You cannot access banking solutions. Don’t you have a bank where you live? You cannot access banking solutions. Don’t have a good credit score? You cannot access banking solutions.

DeFi frees you from these hassles and allows you to access financial vehicles that centralized finance cannot give you due to geopolitical restrictions in your area.

MakerDAO is one of the best examples of how DeFi can help you overcome the restrictions placed on you by centralized finance. With the help of this decentralized app, you can leverage Ethereum (ETH) to apply for a loan. And the process of doing so is surprisingly easy. All you need to do is deposit ETH on the platform.

defi

The platform would then use an automated smart contract to manage the rest of the process. This smart contract would help you create a Collateralized Debt Position (CDP) that would allow you to earn DAI tokens.

2. Improve your earning opportunities

By being flexible, DeFi allows you to add more value to your digital asset investments. Decentralized applications (dApps) Compound and Dharma are good examples of the same. They help you use digital assets like DAI and USDC by letting you lend some of your assets for others to borrow.

When you lend some of your assets to other investors on the platform, you get better interest rates than conventional banking systems offer.

3. It makes banks superfluous

The importance of banks in the world of finance cannot be denied. But banks are not always accessible to many people (as we discussed earlier).

Since DeFi solutions work much better in terms of accessibility, they are the only viable solution for many people.

By replacing banks to provide financial solutions to people, DeFi makes banks superfluous. 

4. Bring rapid innovation

The traditional financial industry has been largely the same over the years. DeFi, on the other hand, has been consistently providing the world with innovative products and services. And being an open protocol with strong community support, DeFi has the power to bring innovation quickly. 

As more and more people lend their support to the system, the ecosystem is rapidly changing and supporting a whole new generation of services in the financial world. It has brought innovation that was largely thought of as mastery of centralized financial systems.

5. It is transparent

Transparency is one of the highlights of the DeFi space. Giving everyone access to the source code makes it easier for people to trust the system better. It also makes the process of testing and testing applications built for the DeFi ecosystem easier. And it does it all while maintaining the trustless nature of blockchain technology.

6. Puts you in control

One of the defining features of the app built for the DeFi ecosystem is that it puts customers in control of their finances. Unlike banks where the bank or government sets the rules and largely takes care of your investments, DeFi gives you the flexibility to make decisions about the investments you make with your money.

What challenges does DeFi face?

While DeFi has many great things to offer, just like any other technology, it comes with its own drawbacks. Let’s take a look at them:

1. It’s slow

Blockchain technology is one of the most secure technologies out there due to its complex, encrypted, and distributed nature. Unfortunately, this security comes at a cost: speed. Transactions carried out on the blockchain are much slower than their traditional counterparts.

And while that’s acceptable to many of us, it could be something that would make many people want to say no to using the technology. That said, DeFi app developers do keep limitations in mind when working on new projects. Most, if not all, of the products and services in the DeFi ecosystem are optimized to give users the best possible experience.

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2. Errors are quite common and caused by the user.

In centralized systems, responsibility for the error-free execution of tasks rests with a single source: the organization. However, when it comes to decentralized systems, the responsibility for ensuring that there are no errors is transferred to the user. Users can (and often do) make mistakes.

The immutable nature of blockchains makes it very difficult to minimize the risk of such errors. And that makes designing the right product with minimal risk a daunting task for developers.

3. You are alone

The kind of experience you have using a DeFi app is largely up to you. 

Centralized systems often have huge customer support teams that guide you through the applications. They make sure that you have a good time while using the apps by responding to your queries promptly.

Decentralized systems have a hard time having such teams. There is a lot of documentation available. And you have a helpful community at your disposal. But at the end of the day, if you have a problem, you have to go the extra mile to resolve it. Nobody does that for you.

4. Too many options

The DeFi ecosystem produces new and innovative products on a regular basis. And while that’s great, when you have a specific use case, you have to sift through many options to make the right one. And that is quite a daunting task for an average user who is still new to the ecosystem.

This pushes developers not only to create apps that solve specific problems but also to think about how those apps would fit into the DeFi ecosystem.

How to get started with DeFi?

Getting started with DeFi is easier than you think. To start, you need a wallet. This may take some research and thought because you need a wallet that works on the blockchain of your choice.

As of now, two of the most prominent blockchains in the DeFi space are Ethereum and Binance Smart Chain (BSC). While Ethereum has been at the center of innovation in this space for a long time, things are changing.

defi

As more and more projects are found on the Ethereum blockchain, the network is slowing down. If the slow transaction speed is something that does not bother you, then it is safe to go for Ethereum.

However, if you care about transaction speed, go for BSC. Being relatively new, BSC boasts of better transaction speeds and low fees. Both of these things are inviting industry traders and developers to move their projects to BSC.

If you have chosen Ethereum as your desired blockchain, MetaMask is a great wallet to have. It is one of the most popular options for traders and investors across the industry.

If you have chosen BSC as your blockchain of choice, I would still recommend using MetaMask as your crypto wallet. While the crypto wallet started out as an Ethereum-based wallet, it does support BSC. Since people are familiar with the MetaMask interface, it is a great option for most traders.

We have written a beginner’s guide on how to use MetaMask. Feel free to check it out to know more about the crypto wallet.

That said, the industry has many options to offer. Depending on what best suits your needs, you can go for almost any crypto wallet.

Once you have selected the wallet, it is time for you to buy the cryptocurrencies you want to invest in. Remember, an Ethereum-based wallet is likely to store all of your ERC-20 and other Ethereum-based tokens. However, if your tokens are part of the BSC ecosystem, you would need to use a BSC-based wallet.

Now that you have purchased the relevant tokens, you are ready to enjoy DeFi, and there are many ways to do so.

For starters, you can lend your tokens and potentially make a profit from them. Now, you can lend your tokens to other merchants and benefit from the interest they pay.

Alternatively, you can lend your tokens to the platforms and earn a return for doing so. This is called yield farming and it is all the rage in the crypto industry as of now. One of the most popular platforms to engage in yield farming is yearn .finance. 

Also, if you want to know more about yield farming, I would recommend you check out one of our articles where we talk extensively about it.

defi

If that doesn’t sound like something you’d be interested in, you can always become a market maker on a decentralized exchange. One of the most popular decentralized exchanges where you could make a profit by adding liquidity to the platform and becoming a market maker is Uniswap. We have a  beginner’s guide that looks at the platform and its governance token, UNI. If you are interested in knowing more about it, you should read the article.

What are the possible use cases for DeFi?

Where traditional and centralized finance failed, DeFi won. And he keeps winning. There are many DeFi use cases in the world of finance, but discussing all of them would turn the article into a book. That is why we are only going to discuss some of the common DeFi use cases here.

Loans and loans

One of the most popular types of services you can find in the DeFi ecosystem is open lending protocols. When you decentralize the borrowing and lending process, you gain access to the many advantages the system has over traditional financial institutions.

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For starters, you get the ability to secure something the world of traditional finance finds hard to deal with: digital assets. It then eliminates the need for credit checks, opening up avenues for many more people to get involved. Also, transaction settlement is instant when it comes to the DeFi space. And last but not least, DeFi promises standardization (not now but in the future).

Built on public blockchains, these lending services do not require you to trust them. And to add to the trustless nature of these services and blockchain technology, in general, has methods for cryptographic verification of transactions.

This reduces counterparty risk and makes loans and borrowing much more accessible, faster, and cheaper. All because these loan markets are on the blockchain.

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money banking services

The money banking services that are part of DeFi are really a no-brainer. After all, it’s in the definition.

Be it mortgages or insurance, DeFi has solutions for everything. And the blockchain industry is growing and maturing, with an increasing number of developers focusing on creating stablecoins. If you are wondering what a stablecoin is, it is a type of crypto asset that is pegged to a real-world asset. What makes stablecoins so lucrative is the fact that despite being pegged to a real-world asset, they can be transferred digitally without a problem.

Cryptocurrencies are known to be really volatile. Their prices fluctuate all the time, sometimes swinging by huge amounts. Stablecoins, on the other hand, have fairly stable prices and can be a viable option for everyday use.

We’ll talk more about this soon, so don’t worry if you didn’t understand what I just said about stablecoins. But for now, let’s talk about how DeFi mortgage and insurance solutions perform even better than their traditional alternatives.

Starting with the mortgage, it is no secret that the whole process of obtaining one is expensive and time-consuming. But with the help of smart contracts, we can reduce legal fees to some extent.

Moving on, blockchain dilutes risk by spreading it across participants and removes the requirement for middlemen. What this means for you as a user is lower premiums without compromising the quality of service.

Decentralized markets

Decentralized exchanges (DEXs) are arguably the most important of all DeFi applications. It is not surprising, therefore, that this is the category of applications that has the most room for innovation.

DEXs allow users to go ahead and trade their digital assets without having to rely on a trusted broker to take care of their funds. On these platforms, merchants trade directly with each other, and assets are transferred directly to their wallets using smart contracts.

They do not require a lot of maintenance and that allows them to have lower trading fees compared to centralized exchanges.

Frequent questions

What are stablecoins?

When we try to recreate traditional financial products in the blockchain world, one of the biggest problems we face is price volatility. Large intraday swings in fiat cryptocurrency trading pairs make it very difficult for cryptocurrencies to be used in financial products. The USD/ETH pair, for example, often experiences intraday swings of 10% or more.

Using such an instrument for something like loans is less than ideal. You don’t want to take out a $1,000 loan only to find out it’s worth $1,100 right before it’s time to pay it back. Future planning becomes really difficult when faced with such volatility.

Stablecoins solve this problem by being pegged to a stable asset. There are three general ways to do this, which gives us three general categories:

1. Centralized stablecoins with fiat collateral:

These stablecoins are backed at a 1:1 ratio by fiat money. A good example of such a stablecoin is the USD coin (USDC) issued by Coinbase. It is backed 1:1 by the US dollar. As long as you have faith in the authority that issues the stablecoin and the fiat currency it is pegged to, you are good to go.

2. Decentralized stablecoins with crypto collateral:

These stablecoins do not have any user agreement or central operator. Anyone can use them without the permission of the government or any company. However, this increases the complexity of maintaining stability.

3. Decentralized Algorithmic Stablecoins:

These stablecoins are based on algorithms to maintain price stability and do not have any collateral backing the system. One problem with these types of stablecoins is that they can be attacked by a highly funded entity. And when that happens, people will lose their confidence in the stability of the system, causing the stablecoin to eventually die out.

However, more often than not, you will find yourself using the first two types of stablecoins.

What is compossibility?

DeFi apps are also called money Legos, as each app belongs to a specific financial service or product that can be combined with others to create a complex offering that is powerful and customized for the specific needs of users.

Most of the time, these apps are connected to each other for individual transactions. This means connections are made on the fly.

This is what composability is all about. It helps apps interact with each other in a meaningful way instead of working in silos. 

Imagine wanting to add a feature to trade tokenized assets on a platform you’re building. You can easily do this by integrating one of the decentralized exchange protocols.