How to Invest in Decentralized Finance (DeFi): A Beginner’s Guide

It is no longer news that decentralized finance is revolutionizing the whole financial sector and opening a whole new realm of entirely decentralized transacting. 

If you have been seeking directions on investing in decentralized finance (DeFi), get strapped in tightly while we walk you through the world of decentralized finance, providing all the juicy details you need. 

For many people, entering the DeFi world may be both exhilarating and confusing. After some time, HODLing and asking how you might gain more gains from your portfolio is natural. However, there is much to unpack when it comes to Decentralized Finance.

When utilized correctly, DeFi DApps and projects can be highly effective tools. However, if you join in quickly, you can avoid being overwhelmed and making poor financial judgments. 

The best approach to getting engaged is understanding the hazards and deciding what suits you. With this in mind, let’s look at the basics needed to get started with DeFi.

What is DeFi?

DeFi is short for Decentralized finance. DeFi is a subset of the crypto and blockchain business that provides alternative financial services. 

Unlike traditional finance, DeFi is governed by the community rather than a centralized authority. It employs smart contracts to power decentralized apps (DApps) and protocols.

DeFi began with loans and has since expanded to encompass savings, investment, trading, and other activities. 

Its purpose is to challenge and replace established financial services by exploiting open-source code, which enables anyone to build on current apps without permission.

In contrast to centralized organizations that manage your funds, decentralization distributes power and risk across the community. Decentralized Finance improves security by dispersing data and removing single points of failure.

How Decentralized Finance Works 

DeFi aims to deliver many financial services that individuals and businesses enjoy — loans, interest on deposits, and payments — through decentralized technology. 

In effect, DeFi transforms the industry by changing how rather than what. DeFi develops new infrastructure to provide comparable financial goods and services.

To accomplish this, it uses blockchain technology and smart contracts, among other technologies. Blockchain is a ledger technology that records all transactions on a specific financial platform. 

Consider it a chronological record of all transactions in a particular blockchain. If Person A pays Person B, the transaction will be permanently timestamped in the ledger.

“The building blocks of DeFi are smart contracts, which are executable codes that can store cryptocurrencies and interact with the blockchain according to its rules,” explains Oleksandr Lutskevych, CEO and founder of CEX.IO. (This company supports DeFi and cryptocurrency.)

Smart contracts enable DeFi to execute transactions automatically between participants. When the contract’s terms are met, they self-execute their instructions.

“DeFi allows smart contracts on the blockchain to replace trusted intermediaries — such as banks or brokerage firms — for peer-to-peer transactions,” says David Malka, CEO of YieldFarming.com. (This company helps investors earn money using cryptocurrencies.) 

In this universe, cryptocurrency has become the de facto money for transactions and records.

If you have been walking with me through the article to this point, then it’s safe to say that the concept of DeFi is no longer hazy. Let’s quickly look at the multiple ways decentralized finance can be used. 

Use Cases of Decentralized Finance 

DeFi, with its unique features, can be used in numerous ways; let’s see a few of them below.

1. Monetary banking services 
2. Lending and borrowing
3. Yield optimization
4. Decentralized marketplaces

Monetary Banking Services 

DeFi apps are, by definition, financial applications. Therefore, monetary banking services are an obvious use case for them. These can include the creation of stablecoins, mortgages, and insurance.

As the blockchain business evolves, there is a greater emphasis on developing stablecoins. They are crypto assets typically linked to real-world assets and can be transferred digitally. 

Because cryptocurrency prices change fast, decentralized stablecoins could be used as digital currencies not issued or managed by a central body. 

Obtaining a mortgage is costly and time-consuming due to the numerous intermediaries involved. Smart contracts have the potential to cut underwriting and legal expenditures drastically.

Insurance on the blockchain might eliminate the need for intermediaries and distribute risk across numerous players. This could lead to lower premiums for the same quality of service.

Lending and Borrowing 

Open lending protocols are among the most widely used application kinds in the DeFi ecosystem. Available, decentralized borrowing and lending offer numerous advantages over the old credit system. 

These include rapid transaction settlement, no credit checks, and the option to collateralize digital assets.

Because these loan services are built on public blockchains, they demand less trust while also providing the confidence of cryptographic verification methods. 

Lending marketplaces on the blockchain eliminates counterparty risk, making borrowing and lending more affordable, faster, and accessible to more people.

Yield Optimization 

DeFi DApps can be used to automate and maximize the compound return obtained from staking, reward pools, and other interest-bearing goods. You may occasionally hear yield optimization, referred to as yield farming. 

For example, you may get regular compensation for Bitcoin mining, delegating BNB, or providing liquidity. 

A smart contract can collect your earnings, buy more underlying assets, and reinvest them. This method will compound your interest, resulting in much higher returns.

Of course, you could do it manually. However, using an intelligent contract reduces time while also optimizing compounding. 

Your funds are generally pooled with other users, which means that gas fees are split among all members of the yield-optimizing smart contract. 

Decentralized Marketplaces

Some popular DeFi applications include Decentralized Exchanges (DEXs), such as Binance DEX. 

These platforms enable users to trade digital assets without relying on a trusted middleman (the exchange) to store their monies. Smart contracts facilitate direct trades between user wallets. 

Some exchanges, known as Automated Market Makers (AMMs), use liquidity pools to enable trading without requiring a counterparty to match your trade. 

Uniswap and Pancake Swap are two of the more well-known instances. Decentralized exchanges often have lower trading fees than centralized exchanges due to the fewer maintenance and management requirements.

Blockchain technology can also issue and transfer ownership of various traditional financial instruments. These apps would operate decentralized, eliminating custodians and single points of failure.

Security token issuance platforms, for example, may offer issuers the tools and resources they need to launch tokenized securities on the blockchain with specific settings.

Other projects may enable the development of derivatives, synthetic assets, decentralized prediction markets, and many more.

Those are just some of the ways you can put decentralized finance to use. Let’s delve into how to invest in decentralized finance (DeFi) without taking any more time.

How To Invest in Decentralized Finance (DeFi)

The DeFi ecosystem offers diverse investment opportunities, allowing investors to acquire exposure to this rapidly developing financial market. Let’s look at some of the most famous examples. 

1. Investing in a DeFi index token
2. Buying DeFi tokens
3. Engaging in DeFi Lending
4. Investing Capital in Yield Farming
5. DeFi  staking 

Investing in a DeFi Index Token

Any effective investment strategy takes thorough study, and given the unpredictable nature of the crypto sector, knowledge gets obsolete fast. 

DeFi index tokens enable you to invest without the burden of tracking specific protocols. 

For example, the DeFi Pulse Index monitors some of the most used protocols. Purchasing the DPI token allows you to hold a portion of the index while the company’s investment managers allocate different assets.

Purchasing a DeFi Index gives you greater exposure to the DeFi market than buying a few DeFi tokens separately.

Buying DeFi Tokens 

The simplest and most common way to invest in DeFi is to buy DeFi tokens. Examples of DeFi tokens include protocol tokens for DeFi protocols such as Uniswap, Compand, Aave, and MakerDAO.

Adding these coins to your crypto portfolio exposes you to a subset of the most popular DeFi protocols. 

Engaging in DeFi Lending 

Instead of acquiring tokens, you could lend digital assets in the decentralized crypto lending market and earn investment income and liquidity provider benefits. 

On DeFi lending services, you can earn interest by transferring your cryptocurrency to a liquidity pool. Platforms like Compound Finance, for example, provide smart contract-based peer-to-peer lending. 

The over-collateralization requirement for DeFi lending protects you from damages caused by the borrower failing to repay the loan. 

The platforms use algorithms in their smart contracts to determine interest rates based on market movements.

Also, several DeFi lending protocols compensate lenders with protocol tokens for adding liquidity to their lending pools, which may increase lenders’ expected returns.

Investing Capital in Yield Farming 

Yield farming is depositing cryptocurrency tokens into a protocol’s liquidity pool in exchange for rewards. The awards are often distributed as the protocol’s governance token. 

As a yield farmer, you earn a specified annual percentage yield (APY) paid out according to agreed-upon dates. 

Platforms like PancakeSwap allow you to deposit assets in a liquidity pool and receive rewards in the protocol’s CAKE tokens and a cut of transaction fees. 

DeFi Staking 

DeFi staking involves locking or holding assets in a crypto wallet to participate in the functioning of a proof-of-stake (PoS)- based blockchain system in exchange for a predetermined interest rate. 

Staking is a hybrid technique in which you invest in a PoS blockchain system while earning interest. 

Let us briefly look into the risk associated with DeFi investing so that you do not proceed in ignorance.

Risks of Investing in Decentralized Finance 

While DeFi might provide attractive APYs, it is not without risks. Despite their decentralized nature, you are ultimately consuming financial services and some of the hazards are:

1. Regulatory risks
2. Counterparty risks
3. Token risks
4. Impermanent risks
5. Software risks

Regulatory Risks 

The legality of certain services and projects can take time to determine. Your cash could be endangered if you invest in a smart contract that is later shut down due to regulatory issues.

Counterparty Risks 

If you participate in cryptocurrency loans or other forms of lending, you are at the risk of the counterparty failing to fulfill their debt.

Token Risks 

The risk levels of your assets vary according to their liquidity, trustworthiness, token smart contract security, and connected project and team. 

Because the DeFi pace has many low-market-cap tokens, token risk can be particularly significant.

Impermanent Losses

If you’re staking in liquidity pools, divergences from the price ratio you entered will result in losing some tokens invested in the pool if you withdraw them.

Software Risks

Code flaws can jeopardize the security of the smart contracts you’ve invested in. Your wallet may be compromised if you connect to DeFi DApps and grant them specific access.

Final Thoughts 

Decentralized finance aims to create distinct financial services from the established economic and political systems. 

This will allow for a more open financial system and may prevent precedents of censorship, financial surveillance, and discrimination worldwide.

While decentralization is an appealing concept, it only benefits some. Finding the use cases that best fit the properties of blockchains is critical in developing a valuable stack of open financial products.

If successful, DeFi has the potential to shift power away from large centralized companies and toward the open-source community and individual users. 

Whether this will result in a more efficient financial system will be determined after DeFi is ready for widespread deployment.