Key Points
DeFi allows users to access crypto financial services with just a wallet and some cryptocurrency balance. Decentralized applications (DApps) enable lending, liquidity provision, swaps, staking, and more across multiple 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 offered by DeFi, which include staking, investing, lending, harvesting and more.
DeFi allows people to optimize income, participate in decentralized markets, access banking services, and quickly request or offer loans. However, the DeFi sector is not risk-free; you should always do careful research before taking risks.
Introduction
Entering the world of decentralized finance (DeFi) can be exciting, but also confusing. After HODLing for some time, it is common to wonder how you can obtain additional gains from your portfolio. However, when it comes to DeFi, there is a lot to be explored.
When used responsibly, DApps and DeFi projects are powerful tools. However, if you don't do your research properly before joining a project, you may make poor investment decisions. It is important to inform yourself about the risks and identify what is most suitable for you. With that in mind, let's explore the basics you'll need as you start your DeFi journey.
What is Decentralized Finance (DeFi)?
Decentralized finance refers to an ecosystem of financial applications built on blockchain networks. More specifically, the goal of DeFi is to create an open-source, permissionless and transparent financial services ecosystem that is available to everyone and operates without any central authority. Users maintain full control over their assets and interact with this ecosystem through peer-to-peer (P2P) networks and decentralized applications (DApps).
The main benefit of DeFi is easy access to financial services, especially for those isolated from the traditional financial system. Another advantage is the modular framework on which it is built, with interoperable DeFi applications on public blockchains. They have the potential to create entirely new financial markets, products and services.
Key Advantages of DeFi
Traditional finance relies on institutions such as banks to act as intermediaries and courts to provide arbitration. Applications in the DeFi sector do not need intermediaries or arbitration. The code specifies the resolution of all possible disputes and users maintain control over their funds at all times. This automation reduces costs and allows for a more fluid financial system.
As these new financial services are deployed on blockchains, single points of failure are eliminated. Data is recorded on the blockchain and spread across thousands of nodes, making censorship or the possible shutdown of a service a complicated task.
Another significant advantage of an open ecosystem like this is the ease of access for individuals who would not otherwise have access to any financial services. Because the traditional financial system relies on profit-driven intermediaries, their services are often unavailable in low-income communities. However, with DeFi, costs are significantly reduced and low-income individuals can also benefit from a wider range of financial services.
Potential use cases for DeFi
Loans
Open lending protocols are among the most popular application types in the DeFi ecosystem. Open and decentralized lending has many advantages over the traditional credit system, including instant settlement of transactions, no credit checks, and the ability to offer digital assets as collateral.
Because these lending services are built on public blockchains, they minimize trust requirements and provide cryptographic verification. Blockchain lending markets reduce counterparty risk and make loans cheaper, faster, and available to more people.
Monetary Banking Services
Since 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 creating stablecoins. Stablecoins are cryptoassets generally linked to real-world assets and are easily transferable digitally. Because cryptocurrency prices can fluctuate quickly, decentralized stablecoins can be adopted for everyday use as digital currencies not issued or monitored by a central authority.
With smart contracts, legal and risk analysis fees for mortgages can be significantly reduced. Blockchain insurance can eliminate intermediaries and allow risk to be distributed among many participants. This can result in lower premiums for the same quality of service.
Decentralized markets
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 maintain custody of their funds. Trades are made directly between users' wallets, with the help of smart contracts.Â
Some brokers, known as Automated Market Makers (AMMs), use liquidity pools to facilitate trades without needing a counterparty to match trades directly. Because they require less maintenance and management, decentralized exchanges typically have lower trading fees than centralized exchanges.
Blockchain technology can also be used to issue and consent to ownership of a wide range of conventional financial instruments. These applications work in a decentralized manner, eliminating custodians and single points of failure.
Yield optimization
DeFi DApps can be used to automate and optimize returns from staking, rewards pools, and other interest-bearing products. This process is also known as yield farming.
For example, you can receive regular rewards by mining Bitcoin, delegating BNB, or providing liquidity. A smart contract can receive its rewards, buy more assets and reinvest them. With this process, you can accumulate interest and often significantly increase your returns.
Using a smart contract saves time and optimizes interest income. Your funds are often pooled with those of other users, meaning gas fees are shared among all members of the yield optimization smart contract.
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 common contract uses legal terminology to specify the terms of the relationship between participants in a contract, a smart contract uses programming codes.
Because their terms are written in computer code, smart contracts can enforce them in an automated manner. This enables the 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. Because computer code is prone to bugs and vulnerabilities, the value and confidential information locked in smart contracts are at risk.
Challenges facing DeFi
Poor performance
Blockchains are inherently slower than their centralized counterparts, affecting applications built on top of them. DeFi application developers need to consider these limitations 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 shift the responsibility from intermediaries to the user. This can be a negative aspect for many. Designing products that minimize the risk of user error is challenging when products are deployed on immutable blockchains.
Poor user experience
Currently, using DeFi applications requires extra effort on the part of the user. For DeFi applications to become a core element of the global financial system, they must provide a tangible benefit that encourages users to migrate away from the traditional system. Recent improvements to user interfaces and educational resources are helping to mitigate this issue.
Disordered ecosystem
Finding the most suitable app for a specific use case can be difficult. 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.Â
DeFi Risks
Although the DeFi world offers attractive APYs, it is not without risks. Even though they are decentralized, you are essentially consuming financial services and some of the risks are familiar:
Risks associated with the counterparty
If you participate in cryptocurrency lending or any other type of lending, you run the risk of the counterparty not paying your debt.
Regulatory risks
The legality of certain services and projects can be difficult to determine. If you invest in a smart contract that is later terminated due to regulatory issues, your funds may be at risk. Recent actions and guidelines from global regulators are influencing the development and adoption of the DeFi sector.
Risks associated with the token
The assets you hold have different levels of risk affected by their liquidity, reliability, token smart contract security, and associated project and team. Because the DeFi sector has many low market capitalization tokens, the risk associated with the token can be particularly high.
Risks associated with the software
Code vulnerabilities can compromise the security of the smart contracts you invest in. Your wallet can also be compromised due to connecting to DeFi DApps and granting permissions. Security practices such as multi-signature wallets and insurance funds help address these risks.
impermanent loss
If you are staking in liquidity pools, any deviations from the initial price ratio will result in the loss of some deposited tokens if you withdraw the tokens from the pool.
Accessing DeFi projects
Ethereum has traditionally been the home of DeFi. However, there are already many blockchains with healthy DeFi ecosystems. Networks with smart contract capabilities, such as BNB Chain, Solana, Polkadot, Avalanche, and new layer-2 solutions on Ethereum, are popular choices.
Discovering DeFi projects and protocols requires research. Websites, online forums and messaging services 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 get started with DeFi DApps, you will need:
A supported wallet: a browser extension wallet like MetaMask or a mobile wallet like Trust Wallet. A custodial wallet (one where you don't own the private keys) is less likely to allow you to connect to DApps.
Cryptoassets: This seems obvious, but you may need a mix of assets. For example, if you want to use Ethereum-based DApps, you will need ETH for gas fees and another token for the service you choose.
DeFi vs. DeFi Traditional Finance (TradFi)
DeFi offers an open financial system for anyone with internet access, unlike traditional finance, which relies on centralized institutions and regulatory bodies. However, there is a growing interaction between DeFi and traditional finance. Banks and financial institutions are starting to explore DeFi protocols, creating hybrid models that combine the benefits of both systems.
DeFi vs. DeFi Centralized Finance (CeFi)
Even in the world of cryptocurrencies, 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 manages your funds.
Generally the same services offered. They likely run through the same DeFi platforms that the user can access directly. However, CeFi eliminates the often complicated nature of managing DeFi investments on your own. 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. In CeFi, although you have less control, you often receive better collateral and transfer some of the responsibility related to asset management and transaction execution.
What is the difference between DeFi and open banking?
Open banking is a banking system where third-party financial service providers have secure access to financial data through APIs. This enables a network of accounts and data including banks and non-bank financial institutions. Essentially, open banking enables new products and services within the traditional financial system.Â
DeFi, however, proposes an entirely new financial system that does not depend on current infrastructure. The DeFi system is also known as open finance.
For example, open banking can allow the management of all traditional financial instruments in a single application, obtaining data securely from multiple banks and institutions.Â
On the other hand, decentralized finance can enable the management of new financial instruments and new ways of interacting with them.
Final considerations
DeFi has quickly created a self-sustaining value ecosystem that attracts capital, developers, and new products. Although 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 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 DeFi Liquidity Pools and how do they work?
What is Yield Farming in Decentralized Finance (DeFi)?
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