Key aspects
DeFi allows users to access crypto financial services with just a wallet and a few cryptocurrencies. Decentralized applications (dApps) enable lending, liquidity provision, swaps, staking, and more on many blockchains.
While Ethereum was the original home of DeFi, most blockchains with smart contract capabilities now host DeFi dApps, including Layer 2 solutions like Arbitrum and Optimism. Smart contracts are essential to the services DeFi offers, including staking, investing, lending, collecting, and more.
DeFi allows people to optimize their performance, join decentralized markets, access banking services, and participate in fast loans. However, DeFi is not without risks; You should always do careful research before participating.
Introduction
Entering the world of decentralized finance (DeFi) can be exciting, but also confusing. After a while of HODLing, it is common to wonder how you can make additional profits from your portfolio. However, there is a lot to discover when it comes to DeFi.
When used responsibly, dApps and DeFi projects can become powerful tools. But if you rush, it's easy to become overwhelmed and make unwise investment decisions. The best way to get involved is to know the risks and find what is right for you. With this in mind, let's explore the basics you'll need as you begin your DeFi journey.
What is Decentralized Finance (DeFi)?
Decentralized finance is an ecosystem of financial applications built on blockchain networks. More specifically, DeFi aims to create an open source, permissionless and transparent financial services ecosystem that is available to everyone and operates without any central authority. Users have absolute control of their assets and interact with this ecosystem through peer-to-peer (P2P) and decentralized applications (dApps).
The main benefit of DeFi is to allow easy access to financial services, especially for people who do not have access to the traditional financial system. Another advantage is the modular framework it is based on, with interoperable DeFi applications on public blockchains. These have the potential to create entirely new financial markets, products and services.
Main advantages of DeFi
Traditional finance relies on institutions, such as banks, to act as intermediaries and courts that provide arbitration. DeFi applications do not need intermediaries or arbitrageurs. The code specifies the resolution of each potential dispute, and users maintain control over their funds at all times. This automation reduces costs and enables a frictionless financial system.
As these new financial services are implemented on blockchains, single points of failure are eliminated. Data is recorded on the blockchain and distributed across thousands of nodes, making censorship or potentially shutting down a service a complicated task.
Another significant advantage of such an open ecosystem is the ease of access for people who would not otherwise have access to any financial services. Because the traditional financial system depends on intermediaries making profits, their services are often absent from low-income communities. However, with DeFi, costs are significantly reduced and low-income people can also benefit from a broader range of financial services.
Potential use cases for DeFi
Delivery and obtaining of loans
Open lending protocols are among the most popular types of applications in the DeFi ecosystem. Open and decentralized lending has many advantages over the traditional credit system, including instant transaction settlement, no credit checks, and the ability to collateralize digital assets.
Since these lending services are based on public blockchains, they minimize trust requirements and provide cryptographic verification. Blockchain lending platforms reduce counterparty risk and make loans cheaper, faster, and available to more people.
Monetary banking services
As DeFi applications are financial applications by definition, monetary banking services are an obvious use case. These may include the issuance of stablecoins, mortgages and insurance.
As the blockchain industry matures, there is an increased focus on the creation of stablecoins. These are cryptoassets generally linked to real-world assets and are easily transferable digitally. As cryptocurrency prices can fluctuate rapidly, decentralized stablecoins could be adopted for everyday use as digital currencies that are not issued or overseen by a central authority.
With smart contracts, mortgage underwriting and legal fees could be significantly reduced. The blockchain insurance industry could eliminate middlemen and allow risk sharing among many participants, which could result in lower premiums with the same quality of service.
Decentralized platforms
Some of the most popular DeFi applications are decentralized exchanges (DEXs), such as Uniswap and PancakeSwap. These platforms allow users to trade digital assets without the need for a trusted intermediary to hold their funds. Trades are made directly between users' wallets with the help of smart contracts.
Some exchanges, known as Automated Market Makers (AMM), use liquidity pools to facilitate trading without the need for a direct counterparty to match your trade with. Because they require less maintenance and management, decentralized exchanges typically have lower trading fees than centralized ones.
Blockchain technology can also be used to issue and enable ownership of a wide range of conventional financial instruments. These applications would operate in a decentralized manner, eliminating custodians and single points of failure.
Performance optimization
DeFi dApps can be used to automate and optimize the compound yield earned from staking, reward pools, and other interest-bearing products. This is sometimes known as yield farming.
For example, you can receive regular rewards from Bitcoin mining, delegate BNB, or provide liquidity. A smart contract can take your rewards, buy more of the underlying asset, and reinvest it. This process will increase your interest and often significantly increase your returns.
Using a smart contract saves time and optimizes capitalization. Your funds are usually pooled with other users, meaning gas fees are shared among all members of the smart contract optimizing performance.
The role of smart contracts in DeFi
Most existing and potential applications of decentralized finance involve the creation and execution of smart contracts. While a regular contract uses legal terminology to specify the terms of the relationship between the entities entering into the contract, a smart contract uses computer code.
Because their terms are written in computer code, smart contracts can enforce those terms in an automated manner. This enables reliable execution and automation of many business processes that currently require manual oversight.
Using smart contracts is faster, easier and reduces risk for both parties. However, smart contracts also introduce new types of risks. As computer code is prone to errors and vulnerabilities, the value and sensitive information locked in smart contracts are at risk.
Challenges Facing DeFi
Poor performance
Blockchains are inherently slower than their centralized counterparts, which impacts applications built on them. DeFi application developers must take these limitations into account and optimize their products accordingly. Layer 2 solutions like Arbitrum and Optimism are addressing these issues by offering faster and cheaper transactions.
High risk of user error
DeFi applications transfer the responsibility from the intermediaries to the user. This can be a negative aspect for many. Designing products that minimize the risk of user error is a difficult challenge when products are implemented on top of immutable blockchains.
Bad user experience
Using DeFi applications currently requires additional effort from the user. For DeFi applications to become a core element of the global financial system, they must provide a tangible benefit that incentivizes users to switch from the traditional system. Recent improvements in user interfaces and educational resources are helping to mitigate this problem.
Congested ecosystem
Finding the most suitable application for a specific use case can be daunting, and users must be able to find the best options. The challenge is not just building the applications, but also thinking about how they fit into the broader DeFi ecosystem.
DeFi Risks
While the DeFi world may offer attractive APYs, it is not without risks. Even though they are decentralized, you are basically consuming financial services, and some of the risks are familiar:
Counterparty risks
If you engage in cryptocurrency lending or any other type of lending, you run the risk that the counterparty will not pay its debt.
Regulatory risks
The legality of certain services and projects can be difficult to determine. If you invest in a smart contract that is subsequently closed due to regulatory issues, your funds may be at risk. Recent actions and guidelines from global regulators are influencing the development and adoption of DeFi.
Token Risk
The assets you hold have different levels of risk affected by their liquidity, reliability, security of the token's smart contract, and the associated project and team. As the DeFi space has many low market cap tokens, token risk can be particularly high.
Software risks
Code vulnerabilities can undermine the security of the smart contracts you are investing in. Your wallet could also be compromised due to connecting to DeFi dApps and giving them certain permissions. Security practices, such as multi-signature wallets and insurance funds, are emerging to address these risks.
Impermanent loss
If you are staking liquidity pools, divergences away from the price ratio you entered will cause you to lose some tokens deposited in the pool if you make withdrawals.
Access to DeFi projects
Ethereum has long been the traditional home of DeFi. However, many blockchains now have healthy DeFi ecosystems. Networks with smart contract capabilities like BNB Chain, Solana, Polkadot, Avalanche, and new layer 2 solutions on Ethereum are popular options.
Finding DeFi projects and protocols requires research. Online forums, messaging systems, and websites can help you discover new opportunities. However, be very careful with the information you find. Always check the security of any project you read or hear about.
What do I need to access DeFi projects?
To start using DeFi dApps, you will need to have the following:
A compatible wallet: A browser extension wallet like MetaMask or a mobile device wallet like Trust Wallet will do the job. A custodial wallet (one where you don't own the private keys) is less likely to allow you to connect to dApps.
Cryptocurrencies: This seems obvious, but you may need a mix of assets. For example, if you are looking to use Ethereum-based dApps, you will need ETH for gas fees and another token for any services you use.
DeFi vs. Traditional Finance (TradFi)
DeFi offers a financial system open to anyone with internet access, in contrast to traditional finance, which relies on centralized institutions and regulatory bodies. However, DeFi and traditional finance are increasingly interacting. Banks and financial institutions are beginning to explore DeFi protocols, creating hybrid models that combine the benefits of both systems.
DeFi vs. Centralized Finance (CeFi)
Even in the cryptocurrency space, not all financial services are decentralized. For example, staking through a centralized exchange like Binance often requires you to give up custody of your tokens. In this case, you must trust the centralized entity that takes care of your funds.
Most of the services offered will be the same. These are likely to be done through the same DeFi platforms that a user can access directly. However, CeFi eliminates the often complicated nature of managing DeFi investments yourself. You can also have additional guarantees on your deposits.
CeFi is neither worse nor better than DeFi. Its suitability depends on your wants and needs. While you can sacrifice some control in CeFi, you often receive stronger guarantees and are relieved of some degree of responsibility for asset management and transaction execution.
What is the difference between DeFi and open banking?
Open banking is a banking system in which third-party financial service providers have secure access to financial data through APIs. This enables the creation of accounts and data networks between banks and non-bank financial institutions. Essentially, it enables new products and services within the traditional financial system.
However, DeFi proposes a completely new financial system that is independent of the current infrastructure. DeFi is sometimes also known as open finance.
For example, open banking could enable the management of all traditional financial instruments in a single application by securely extracting data from multiple banks and institutions.
Decentralized finance, for its part, could allow the management of completely new financial instruments and new ways of interacting with them.
Conclusions
DeFi has rapidly created a self-sustaining value ecosystem that attracts capital, developers, and new products. While DeFi promises to revolutionize the financial sector, it is still an emerging field. The future of DeFi lies in continued technological advancements, regulatory developments, and increasing overall adoption. For sustainable growth, continuous innovation is essential to address the limitations and risks associated with DeFi.
Further reading
What is an Automated Market Maker (AMM)?
What are liquidity pools in DeFi and how do they work?
What is Yield Farming in Decentralized Finance (DeFi)?
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