Decentralized Finance is a revolutionary system that enables users to access various financial services through a wallet containing cryptocurrencies. Many DApps facilitate the process of lending, providing liquidity, swapping, staking, and more across different blockchains. Although Ethereum was initially DeFi home, several blockchains that support smart contracts now host DeFi DApps.
Smart contracts play a vital role in the provision of services that DeFi offers, which include investing, staking, lending, harvesting, and more. DeFi has already enabled people to optimize their yield, participate in decentralized marketplaces, access banking services, and engage in quick borrowing and lending.
However, it's worth noting that DeFi is not entirely risk-free. It's essential to conduct thorough research on any project before investing to avoid potential risks.
Basics
Decentralized Finance (DeFi) is an exciting yet confusing world to enter. Many investors wonder how to maximize their portfolios after holding for some time. However, DeFi is a complex field that requires careful consideration.
DeFi DApps and projects can be powerful tools when used responsibly. Still, diving in too soon can lead to poor investment decisions and becoming overwhelmed. Therefore, the best approach is to understand the risks and find what's suitable for your needs. With this in mind, let's explore the basics you need to begin your DeFi journey.
What Is DeFi?
DeFi is an ecosystem of financial applications built on blockchain networks. The term refers to a movement that aims to create a transparent, open-source, and permissionless financial service ecosystem available to everyone, without central authority. Users have complete control over their assets and interact with this ecosystem through decentralized applications (DApps).
DeFi offers easy access to financial services, particularly for those isolated from traditional finance. The modular framework of DeFi allows interoperable applications on public blockchains, creating new financial markets, products, and services.
What Are the Benefits of DeFi?
In traditional finance, institutions like banks and courts act as intermediaries and arbitrators. In contrast, DeFi applications eliminate the need for intermediaries or arbitrators by specifying the resolution of every possible dispute in the code, giving users complete control over their funds at all times. This automation reduces costs and creates a more frictionless financial system.
By being deployed on top of blockchains, DeFi services eliminate single points of failure. The blockchain records data and distributes it across thousands of nodes, making censorship or shutdown of a service complicated.
DeFi also enables easy access to financial services for low-income individuals who may not have access to traditional finance due to intermediaries' profit-seeking practices. DeFi reduces costs, making a broader range of financial services available to everyone.
Potential Use Cases
There are numerous ways for individuals to take control of their finances and participate in the DeFi revolution.
Open Lending Protocols
- Advantages over traditional credit systems
- Instant transaction settlement, no credit checks, collateralization of digital assets
- Use of public blockchains to reduce counterparty risk and increase the availability
Monetary Banking Services
- An obvious use case for DeFi applications
- Stablecoins, mortgages, and insurance among financial services that could benefit from blockchain technology
- Stablecoins as a potential digital currency for everyday use
- Smart contracts can reduce underwriting and legal fees for mortgages
- Blockchain-based insurance eliminates intermediaries, leading to potentially lower premiums
Decentralized Exchanges
- Uniswap, Pancake Swap, Sushi Swap, and others
- Trade digital assets without a trusted intermediary
- Smart contracts offer lower fees and eliminate the need for custodians
- Blockchain technology can be used to issue and allow ownership of conventional financial instruments
Yield Optimization
- Use of DeFi DApps to automate and optimize yield from staking, reward pools, and interest-bearing products
- Yield optimization, also known as yield farming
- Smart contracts are used to compound interest earned, significantly increasing returns
- Gas fees shared across members of yield optimizing smart contract
Overall, DeFi offers a more frictionless financial system with increased accessibility for all individuals.
Smart Contracts in DeFi
Smart contracts play a crucial role in DeFi, creating and executing various applications. Unlike traditional contracts, which use legal terminology to define the relationship between parties, smart contracts use computer code to specify terms.
Smart contracts offer several benefits, such as automated enforcement of terms, which reduces the need for manual supervision and makes processes faster and easier. However, they also come with risks. Because smart contracts are based on computer code, they are susceptible to bugs and vulnerabilities that can put the confidential information and value locked in the contracts at risk.
Main Challenges for DeFi
DeFi applications face several challenges that need to be addressed to become an integral part of the global financial system.
- Blockchains are inherently slower than centralized systems, which can affect the performance of DeFi applications. To counter this, developers need to optimize their products for efficiency.
- DeFi applications transfer responsibility to the user, leading to a higher risk of user error. As the blockchain is immutable, the errors cannot be corrected. Hence, designing products that minimize user error is a tough challenge.
- Using DeFi applications requires extra effort on the user's part, leading to a poor user experience. For DeFi applications to gain wider adoption, they must provide tangible benefits that incentivize users to switch over from traditional financial systems.
- With a cluttered DeFi ecosystem, finding the most suitable application for a specific use case can be a daunting task. Thus, developers must not only build the applications but also ensure they fit into the broader DeFi ecosystem and are easy to use for users.
Risks of Using DeFi
As with traditional finance, using DeFi services comes with risks, despite the potential for higher APYs. Here are some common risks:
- Counterparty Risk: When using crypto loans or any other kind of lending, there's a chance of the counterparty not repaying their debt.
- Regulatory Risk: The legality of some DeFi services and projects can be uncertain. If a smart contract you're invested in is shut down due to regulatory issues, your funds could be at risk.
- Token Risk: Each asset has different risks affected by factors such as liquidity, trustworthiness, and the security of the token's smart contract. As there are many low market-cap tokens in DeFi, token risk can be high.
- Software Risk: Code vulnerabilities can undermine the security of smart contracts, and your wallet can be compromised by connecting to DeFi DApps and granting them permissions.
- Impermanent Loss: Staking in liquidity pools can lead to impermanent loss if the price ratio changes from the time of entry, resulting in a loss of tokens when withdrawn.
DeFi Projects
With the growth of the DeFi industry, Ethereum is no longer the only blockchain to support DeFi applications. Several other networks such as BNB Smart Chain, Fantom, Solana, Polkadot, and Avalanche now have thriving DeFi ecosystems.
To find the right DeFi project or protocol on these networks, you will need to conduct research. Online resources such as forums, messengers, and websites can provide valuable insights into new opportunities. However, it is crucial to be cautious and verify the safety of any project you come across before investing in it.
How to Get Started?
To access DeFi DApps, you will need a compatible wallet and crypto assets. You can use a browser extension wallet such as MetaMask or a mobile wallet like Trust Wallet. It's important to note that a custodial wallet may not allow access to DApps since you don't own the private keys.
Different DApps may require different types of cryptocurrencies to operate. For example, BNB Smart Chain requires BNB to pay for gas fees, while Ethereum requires Ether (ETH). If you want to participate in liquidity pools and stake manually, you'll need a pair of coins with equal monetary value.
These are the basic requirements for accessing DeFi DApps. If you're not comfortable setting up the necessary tools, you can still access some DeFi services through a centralized entity, which will be discussed in a later section on centralized finance (CeFi).
DeFi vs Traditional Finance
DeFi is considered more accessible than traditional finance, mainly because it does not require sign-ups or identity verification. Anyone with some crypto can create a wallet and start using DeFi services, whereas accessing traditional finance requires completing Know Your Customer (KYC) checks and meeting other conditions. This accessibility makes DeFi a more inclusive option for the unbanked.
In addition, DeFi provides financial services that aren't available in traditional finance. By combining different DeFi services (known as DeFi legos), it's possible to create new products that utilize multiple platforms. This flexibility allows for innovative products that anyone can develop strategies for.
DeFi vs CeFi
In the crypto world, not all financial services are decentralized. For example, staking on a centralized exchange can require you to give up custody of your tokens and trust the exchange with your funds. Although most services offered are the same, CeFi removes the complexities of managing DeFi investments yourself, offering stronger guarantees on deposits. CeFi is neither superior nor inferior to DeFi, and its suitability depends on individual preferences. Although you may relinquish some control in CeFi, you can offload some responsibility for handling assets and executing transactions.
DeFi vs. Open Banking
Open banking is a financial system that grants third-party financial service providers secure access to financial data through APIs. This enables the networking of accounts and data between banks and non-bank financial institutions, allowing for new products and services within the traditional financial system. In contrast, DeFi proposes a completely new financial system that is independent of the current infrastructure. DeFi is sometimes called open finance. Open banking could allow the management of all traditional financial instruments in one application by securely drawing data from several banks and institutions. Decentralized finance, on the other hand, could allow the management of entirely new financial instruments and new ways of interacting with them.
Conclusion
Decentralized finance aims to create a financial system that operates independently from the traditional financial and political systems. This would create a more open financial system that could prevent censorship, financial surveillance, and discrimination on a global scale.
However, not every financial service is best suited for decentralization. Therefore, it is crucial to identify the use cases that can benefit the most from blockchain technology to build a valuable stack of open financial products.
If successful, DeFi could shift the balance of power from large centralized organizations to the open-source community and individuals. It remains to be seen whether DeFi will create a more efficient financial system once it is ready for mainstream adoption.