DeFi (Decentralized Finance) explained

DeFi (Decentralized Finance) explained
DeFi (short for “decentralized finance”) refers to financial services provided by public blockchains, most notably Ethereum.
DeFi (Decentralized Finance) explained
DeFi (Decentralized Finance) explained

You can earn interest, borrow, lend, purchase insurance, trade derivatives, exchange assets, and more with DeFi, but it’s faster and doesn’t involve paperwork or a third party. DeFi is global, peer-to-peer (directly between two people, not through a centralized system), pseudonymous, and available to anyone, just like crypto in general.

It is an open, global financial system designed for the internet era, offering an alternative to a system that is opaque, tightly managed, and based on decades-old infrastructure and processes. It allows you to have complete control and visibility over your finances. It exposes you to global markets and provides you with alternatives to your local currency and banking options.

DeFi products allow anyone with an internet connection to access financial services, and they are mostly owned and maintained by their customers. DeFi applications have already processed tens of billions of dollars in cryptocurrency, and the number is growing every day.

By allowing people, merchants, and corporations to perform financial transactions using developing technologies, decentralized finance eliminates intermediaries. Peer-to-peer financial networks that use security protocols, connectivity, software, and hardware developments are used to achieve this.

You can lend, trade, and borrow using software that records and validates financial transactions in distributed financial databases from anywhere you have an internet connection. A distributed database is accessible from multiple locations; it collects and aggregates data from all users and verifies it with the help of a consensus process.

Decentralized finance uses this technology to abolish centralized finance models by allowing anybody, regardless of who or where they are, to access financial services.

Through personal wallets and trade services tailored to people, DeFi applications provide users more control over their money. DeFi has a lot of great features, and we’ll go over a few of them in this article.

Without further ado, let’s dig into what DeFi is and why it’s such a well-known term in the cryptosphere.

What is DeFi and why you should get involved?

Decentralized finance (DeFi) has opened up a whole new universe for customers who have been deprived of returns in traditional finance for decades.

DeFi has a lot of promise for passive income, and there are a lot of changes in this dynamic field of constantly changing platforms, protocols, and exchanges.

However, this new testing ground is not without its hazards, and navigating it demands a steady hand. We’ve broken down the process into its most basic components to assist you in finding your path.

MakerDAO, a platform that launched in 2015 and allowed users to utilize cryptocurrencies as collateral for loans, is frequently credited with launching DeFi.

DeFi protocols, like regular cryptocurrencies, offer to cut out the middlemen. Until now, the market has been propelled by this libertarian viewpoint and the desire of investors to make money.

Why you should get involved in DeFi

Everyone is betting on blockchain projects, from Tesla, Square, and Microstrategy to small-scale traders. And why shouldn’t they? Within a decade, the crypto sector has risen tremendously to a market capitalization of more than a trillion dollars.

Blockchain technology is utilized for more than just creating currency or tokens. Companies such as Amazon, IBM, Google, and others are embracing blockchain, the underlying technology behind cryptocurrencies, to improve their IT services.

Another common misconception is that bitcoins are solely used as a means of exchange. DeFi, on the other hand, has introduced every financial service you can think of to the blockchain, whether it’s lending, borrowing, payment, or derivatives.

Decentralized finance, sometimes known as DeFi, refers to financial applications created on top of blockchains using smart contracts. These are self-executable blockchain programs that are pre-programmed to do specific operations when certain criteria are satisfied.

Consider DeFi to be an alternative to traditional financial infrastructure built with blockchain technology.

How Does DeFi Work?

DeFi, often known as “open finance,” eliminates the middleman in financial transactions. Rather than having your bank or credit card provider act as an intermediary between you and a retailer when you make a transaction, you use the digital currency directly and own it. DeFi is mostly built on Ethereum, which is the second most popular cryptocurrency after Bitcoin.

There are no banks or institutions to manage your money because there are no intermediaries. The code is open to anyone’s scrutiny, so there’s a sense of transparency. There are open networks that span national boundaries.

There are numerous applications available for users, most of which are built on Ethereum. Though DeFi is frequently mentioned in connection with cryptocurrencies, it goes beyond the creation of new digital money or value. DeFi’s smart contracts are designed to take the place of traditional financial systems.

“DeFi is all about code. With the help of things called smart contracts, your money is programmed to perform various [functions]. It creates a unique opportunity for anyone with a computer and internet connection to participate in the global economy,” notes Mozgovoy.

For many of these financial activities, one of the most appealing aspects of DeFi is that it removes the barrier to entry. You don’t have to have your money managed by the government or a corporation, and you don’t have to meet particular criteria to get certain financial goods.

You apply for a loan using standard financial procedures and may be denied depending on your credit. You have a bank account or a brokerage account with a company that manages your funds.

Certain financial transactions are carried out using DeFi’s smart contracts if certain requirements are met. Borrowing, lending, and other transactions are all possible with smart contracts, and the terms of the transaction are literally encoded in the code. While this makes transactions easier to use and more efficient, it also makes them more vulnerable to unfixable failures.

How to earn from DeFi

Depositing your cryptocurrency onto a platform or protocol that will pay you an APY (annual percentage yield) for it is the simplest approach to make a passive income through DeFi.

This is nearly comparable to depositing money into a savings account at a traditional bank, but interest rates are now a thing of the past in much of the developed world, thanks to central banks’ prolific money printing over the last decade.

On a DeFi platform, you can deposit a wide range of coins and tokens, but not fiat currency (traditional currency). As a result, your initial step will be to use a fiat on-ramp to purchase some cryptocurrency (i.e. buying crypto with cash). Before you go out and buy your crypto, keep in mind that the vast bulk of DeFi is based on the Ethereum blockchain, so Bitcoin (BTC) is rarely accepted.

Is it risky to invest in DeFi?

Even billionaire investors aren’t immune to risk when it comes to decentralized finance, or DeFi, despite having potentially more resources.

Mark Cuban, for example, claimed that he was trading a DeFi token from Iron Finance called titan, which crashed to zero in a single day.

Some in the crypto community assumed it was the consequence of a rug pull, a form of fraud in which creators abandon a project and walk away with investors’ monies. Those allegations were refuted by Iron Finance. According to the project’s blog post, the crash was caused by a “bank run,” or panic selling, as well as the token’s mathematical programming.

Regardless, Cuban’s experience serves as a stark reminder of how fickle and perilous crypto, particularly DeFi, can be.

It’s critical to recognize that DeFi is a high-risk investment.

“I think every DeFi protocol and every DeFi project has a different level of risk and a different level of reward,” said Demirors. But, “it’s important to understand the reason the reward is high is that the risk is higher. The reason we see high yield is there is a risk here.”

According to Demirors, there are three basic forms of risk to consider.

1. The dangers of using technology

DeFi applications require smart contracts, which are collections of code that carry out a set of instructions on the blockchain. However, if a developer’s code is flawed, there may be flaws in the DeFi protocol.

“At the end of the day, software is only as good as the coding that was done,” Demirors said, adding that “occasionally there are undisclosed faults in the code that governs these protocols.”

2. The risk of losing an asset

When applying for a DeFi loan, you usually put up other crypto assets as collateral. DeFi protocol Maker, for example, demands borrowers to collateralize their loans for at least 150 percent of the loan value.

Because cryptocurrencies are volatile, their value varies a lot. If there is a downturn, the crypto assets used as collateral may lose a significant amount of value, and certain positions may be liquidated. That’s why some people utilize stablecoins, which are supposed to be less volatile and tethered to fiat.

3. Product risks

“Typically, less mature pools or newer protocols will have higher yields because they’re untested,” said Demirors. “There’s a significant amount of risk related to how the yield you’re earning is being generated.”

It’s also worth noting that, unlike with a typical bank, when you use DeFi, your money is neither regulated or insured. Despite the fact that DeFi loans are secured by other crypto assets, borrowers who use DeFi protocols cannot be held liable if they are unable to repay a loan properly.

These risks are part of the reason why experts advise investing just what you can afford to lose and performing thorough research before investing.

Top DeFi applications 

There are quite a number of DeFi applications, however, in this article, we’ve listed 15 out of the many DeFi applications available.

  • PancakeSwap
  • NFTHive
  • Katana
  • GoodDollar
  • Trader Joe
  • DRIP
  • VVS Finance
  • Raydium
  • Sushi
  • 1inch Network
  • BiSwap
  • ApeSwap
  • Metamask Swap
  • Tinyman
  • Polygon POS Bridge

Opportunities in DeFi

Lending Protocols 

Compound and Aave are peer-to-peer lending platforms that don’t keep the money for people. Both platforms let users borrow money by putting up their crypto assets as collateral, and they can also lend their crypto for interest rates that are a million times higher than those in traditional finance. People who use Aave know that they can get flash loans, which are short-term loans that don’t require any collateral if the loan is paid back in full before the block is over. Aave is known for this.

When you give Aave money in the form of USDC, you get 6.27 percent APR right now, which is 7.22 percent on average since Aave started. If you want to make money by giving USD liquidity on Aave, you’re getting paid 32.5 percent.

During the summer of 2021, Aave launched Aave Pro, which lets institutional investors have direct access to decentralized lending markets through pools of money that have been vetted by them. They will be separate from existing liquidity pools on Aave in order to meet institutional and regulatory rules.

Trading in Digital Assets

Exchanges that function without the involvement of a central authority include decentralized exchanges, automated market makers, and token swapping aggregators. These exchanges allow users to interact peer-to-peer while maintaining control over their finances.

DEXs, such as Uniswap, Sushiswap, 0x, ParaSwap, and many others, are addressing the issue of being able to access crypto assets from anywhere in the world as long as you have an internet connection and a wallet, such as MetaMask, in order to facilitate the transfer of crypto assets. They are also giving centralized exchanges a run for their money, which is becoming increasingly common.

As part of its S-1 filing, Coinbase, the popular cryptocurrency exchange that went public in Q2, listed decentralized exchanges as one of the most significant dangers to the company’s operations.

It’s no surprise that DEXs experienced their highest-ever volume in Q2 2021, with May alone recording a massive $173 billion in volume and a total of $343 billion in volume for the quarter. This exceeded Coinbase’s total trading volume of $335 billion in the first quarter of 2021. This is significant since DEXs only allow for trade in EVM-compatible assets, buy Bitcoin accounts for 58 percent of Coinbase’s trading volume.

Yield Farming 

Yield farming is one example of a DeFi investing strategy. It entails lending or staking your bitcoin coins or tokens in exchange for transaction fees or interest in the form of transaction fees. You’re essentially lending money to the bank, so it’s akin to getting interested from a bank account. Compared to keeping money in a bank, just yield farming can be riskier, variable, and difficult.

Yield farming entails shifting cryptocurrency between exchanges. There’s also a yield farming factor, where the method gets less effective as more people become aware of it. However, yield farming is presently the most important development engine in the DeFi sector, enabling it to grow from a $500 million market worth to $10 billion by 2020. A primer on yield farming can be found here.

The Ethereum platform is where the majority of yield farming takes place. As a result, the payouts are an ERC-20 token.

While lenders can spend the tokens however they like, the majority of them are currently speculators looking for arbitrage possibilities by profiting from the token’s market swings.

Wrapping up

Decentralized Finance aims to create financial services that are distinct from the established financial and political systems. This would allow for a more transparent banking system, potentially preventing censorship and discrimination around the world.

While decentralization is a seductive idea, it does not help everything. Identifying the use cases that are best suited to the properties of blockchains is critical to developing a useful stack of open financial products.

If DeFi is effective, it will decentralize authority away from huge centralized corporations and place it in the hands of the open-source community and individuals. When DeFi is ready for widespread use, it will be determined whether this will result in a more efficient financial system.