What Is Decentralized Finance

(DeFi) and How Does It Work?

Beginner’s Guide

Decentralized Finance, or DeFi, is a revolutionary financial system that operates on a decentralized network using blockchain technology. DeFi enables financial transactions without the need for intermediaries such as banks or other financial institutions. This guide will introduce you to the basics of DeFi and how it works.

What is Decentralized Finance (DeFi)?

Decentralized Finance (DeFi) is a financial system that allows financial transactions to be conducted without intermediaries. It operates on a decentralized network using blockchain technology. DeFi applications use smart contracts to execute financial transactions automatically, without the need for a centralized authority to oversee them. This means that anyone can participate in DeFi transactions, regardless of their geographic location or financial status.

How does Decentralized Finance (DeFi) work?

DeFi works by using blockchain technology to create decentralized applications that allow for financial transactions to occur without intermediaries. Transactions are executed automatically using smart contracts that are programmed to carry out specific actions when certain conditions are met.

For example, a DeFi application could be programmed to automatically execute a loan payment when certain conditions are met, such as the borrower making a payment on time. The loan payment would be executed automatically, without the need for a bank or other financial institution to oversee the transaction.

What are the benefits of Decentralized Finance (DeFi)?

Decentralized Finance (DeFi) has several benefits, including:

No intermediaries: DeFi allows financial transactions to occur without intermediaries, reducing transaction costs and increasing financial inclusivity.
Decentralization: DeFi operates on a decentralized network, reducing the risk of a single point of failure.
Transparency: All transactions on the blockchain are transparent and can be audited by anyone, increasing trust in the financial system.
Programmability: DeFi applications can be programmed to automatically execute transactions based on certain conditions, increasing efficiency and reducing the potential for error.
Accessibility: DeFi allows anyone to participate in financial transactions, regardless of their geographic location or financial status.

What are some examples of Decentralized Finance (DeFi) applications?

There are several types of DeFi applications, including:

Decentralized exchanges (DEXs): DEXs are platforms that allow users to trade cryptocurrencies without the need for intermediaries.
Lending platforms: DeFi lending platforms allow users to borrow and lend cryptocurrencies without the need for intermediaries.
Stablecoins: Stablecoins are cryptocurrencies that are pegged to the value of a fiat currency or commodity, providing a stable store of value.
Prediction markets: Prediction markets allow users to bet on the outcome of events, providing a way to hedge against future outcomes.
Insurance: DeFi insurance platforms allow users to purchase insurance against certain risks, such as smart contract failures.

Conclusion

Decentralized Finance (DeFi) is a revolutionary financial system that operates on a decentralized network using blockchain technology. DeFi applications allow financial transactions to occur without intermediaries, reducing transaction costs and increasing financial inclusivity. With its many benefits, DeFi has the potential to transform the financial industry and create a more inclusive and transparent financial system.

What is DeFi?

DeFi stands for “Decentralized Finance”. It refers to a financial system that operates on a decentralized, distributed network using blockchain technology, without the need for intermediaries such as banks or other financial institutions. DeFi applications allow financial transactions to occur automatically using smart contracts, without the need for a centralized authority to oversee them. This enables anyone to participate in financial transactions, regardless of their geographic location or financial status. DeFi has the potential to transform the financial industry and create a more inclusive and transparent financial system.

Ethereum applications

Most decentralized finance applications are built on top of Ethereum, the world’s second-largest cryptocurrency platform, which sets itself apart from the Bitcoin platform in that it’s easier to use to build other types of decentralized applications beyond simple transactions. These more complex financial use cases were even highlighted by Ethereum creator Vitalik Buterin back in 2013 in the original Ethereum white paper.

That’s because of Ethereum’s platform for smart contracts – which automatically execute transactions if certain conditions are met – offers much more flexibility. Ethereum programming languages, such as Solidity, are specifically designed for creating and deploying such smart contracts.

For example, say a user wants his or her money to be sent to a friend next Tuesday, but only if the temperature climbs above 90 degrees Fahrenheit according to weather.com. Such rules can be written in a smart contract.

With smart contracts at the core, dozens of DeFi applications are operating on Ethereum, some of which are explored below. Ethereum 2.0, a coming upgrade to Ethereum’s underlying network, could give these apps a boost by chipping away at Ethereum’s scalability issues.

The most popular types of DeFi applications include:

Decentralized exchanges (DEXs): Online exchanges help users exchange currencies for other currencies, whether U.S. dollars for bitcoin or ether for DAI. DEXs are a hot type of exchange, which connects users directly so they can trade cryptocurrencies with one another without trusting an intermediary with their money.
Stablecoins: A cryptocurrency that’s tied to an asset outside of cryptocurrency (the dollar or euro, for example) to stabilize the price.
Lending platforms: These platforms use smart contracts to replace intermediaries such as banks that manage lending in the middle.
“Wrapped” bitcoins (WBTC): A way of sending bitcoin to the Ethereum network so the bitcoin can be used directly in Ethereum’s DeFi system. WBTCs allow users to earn interest on the bitcoin they lend out via the decentralized lending platforms described above.
Prediction markets: Markets for betting on the outcome of future events, such as elections. The goal of DeFi versions of prediction markets is to offer the same functionality but without intermediaries.

In addition to these apps, new DeFi concepts have sprung up around them:

Yield farming: For knowledgeable traders who are willing to take on risk, there’s yield farming, where users scan through various DeFi tokens in search of opportunities for larger returns.
Liquidity mining: When DeFi applications entice users to their platform by giving them free tokens. This has been the buzziest form of yield farming yet.
Composability: DeFi apps are open source, meaning the code behind them is public for anyone to view. As such, these apps can be used to “compose” new apps with the code as building blocks.
Money legos: Putting the concept “composability” another way, DeFi apps are like Legos, the toy blocks children click together to construct buildings, vehicles and so on. DeFi apps can be similarly snapped together like “money legos” to build new financial products.

Lending platforms

Lending markets are one popular form of decentralized finance, which connects borrowers to lenders of cryptocurrencies. One popular platform, Compound, allows users to borrow cryptocurrencies or offer their own loans. Users can make money off of interest for lending out their money. Compound sets the interest rates algorithmically, so if there’s higher demand to borrow a cryptocurrency, the interest rates will be pushed higher.

DeFi lending is collateral-based, meaning in order to take out a loan, a user needs to put up collateral – often ether, the token that powers Ethereum. That means users don’t give out their identity or associated credit score to take out a loan, which is how normal, non-DeFi loans operate.

Stablecoins

Another form of DeFi is the stablecoin. Cryptocurrencies often experience sharper price fluctuations than fiat, which isn’t a good quality for people who want to know how much their money will be worth a week from now. Stablecoins peg cryptocurrencies to non-cryptocurrencies, such as the U.S. dollar, in order to keep the price under control. As the name implies, stablecoins aim to bring price “stability.”

Notable stablecoins include:

Tether (USDT)
USD Coin (USDC)
Binance USD (BUSD)
Dai (DAI)

Prediction markets

One of the oldest DeFi applications living on Ethereum is a so-called “prediction market,” where users bet on the outcome of some event, such as “Will Donald Trump win the 2020 presidential election?”

The goal of the participants is, obviously, to make money, though prediction markets can sometimes better predict outcomes than conventional methods, like polling. Centralized prediction markets with good track records in this regard include Intrade and PredictIt. DeFi has the potential to boost interest in prediction markets, since they are traditionally frowned upon by governments and often shut down when run in a centralized manner.

Decentralized Finance

How do I make money with DeFi?

There are several ways to make money with DeFi:

Yield Farming: Yield farming is the process of lending or staking cryptocurrencies to earn a return on investment. DeFi platforms use smart contracts to automatically execute these transactions, providing investors with high returns on their investments.
Trading: DeFi platforms allow users to trade cryptocurrencies without the need for intermediaries, providing investors with the opportunity to make money through buying and selling cryptocurrencies at the right time.
Liquidity Provision: Liquidity providers on DeFi platforms provide liquidity to trading pools, earning a percentage of the trading fees generated by the platform.
Investing in ICOs: Initial Coin Offerings (ICOs) are a way to raise capital for new cryptocurrency projects. Investing in ICOs can be risky, but it can also provide investors with high returns if the project is successful.
Staking: Staking is the process of holding cryptocurrencies in a wallet for a specified period of time to earn rewards. DeFi platforms use staking to incentivize users to hold their tokens, which can provide investors with high returns.

It is important to note that investing in DeFi can be risky, and investors should do their own research before investing in any project. DeFi is a new and rapidly evolving industry, and there are many risks associated with investing in new and untested projects. It is important to only invest what you can afford to lose and to seek professional advice if necessary.

Is investing in DeFi safe?

Investing in DeFi can be risky, and it is important to understand the potential risks before investing.

One of the main risks associated with DeFi is the risk of smart contract bugs or vulnerabilities. Smart contracts are self-executing contracts with the terms of the agreement between buyer and seller being directly written into lines of code. If there is a bug or vulnerability in the code, it could result in the loss of funds.

Another risk is the lack of regulation in the DeFi industry. DeFi operates on a decentralized network without the need for intermediaries such as banks or other financial institutions. This means that there is no central authority to oversee transactions or protect investors.

In addition, DeFi projects are often new and untested, and there is a risk that they may fail or not deliver on their promises. It is important to do your own research before investing in any DeFi project and to only invest what you can afford to lose.

That being said, there are steps investors can take to mitigate risk, such as diversifying their investments across different DeFi projects, using reputable platforms, and keeping their private keys secure. It is also important to stay informed about the latest developments in the industry and to seek professional advice if necessary.

When will DeFi go mainstream?

It is difficult to predict exactly when DeFi will go mainstream, as it is a rapidly evolving industry that is still in its early stages of development. However, there are several factors that could contribute to the mainstream adoption of DeFi.

One factor is the growing interest in cryptocurrencies and blockchain technology. As more people become familiar with these technologies and their potential applications, there may be a greater willingness to try out DeFi platforms.

Another factor is the increasing demand for decentralized financial services that are more inclusive, transparent, and accessible to everyone. DeFi has the potential to provide financial services to people who are underserved by traditional financial institutions, such as those in developing countries or without access to bank accounts.

In addition, the development of user-friendly DeFi platforms and applications could make it easier for mainstream users to participate in DeFi without the need for technical knowledge.

However, there are also challenges that need to be addressed before DeFi can go mainstream, such as the need for greater security and regulation, and the need for interoperability between different DeFi platforms.

Overall, it is likely that DeFi will continue to grow and evolve over the coming years, and we may see greater adoption as these challenges are addressed and more people become familiar with the technology.

How will Ethereum 2.0 impact DeFi?

Ethereum 2.0 is a major upgrade to the Ethereum blockchain that is designed to improve its scalability, security, and sustainability. It is expected to have a significant impact on the DeFi ecosystem, as most DeFi applications currently run on the Ethereum network.

One of the main features of Ethereum 2.0 is the transition from a Proof of Work (PoW) consensus algorithm to a Proof of Stake (PoS) consensus algorithm. This is expected to significantly improve the scalability and energy efficiency of the network, which will enable more DeFi applications to be built and used on the platform.

Another feature of Ethereum 2.0 is the introduction of sharding, which will enable the network to process more transactions in parallel. This will further improve the scalability of the network, which is a key requirement for the continued growth of the DeFi ecosystem.

In addition, Ethereum 2.0 is expected to introduce improvements to the Ethereum Virtual Machine (EVM), which is the platform on which most DeFi applications are built. These improvements will make it easier and more efficient to build and run DeFi applications on the Ethereum network.

Overall, Ethereum 2.0 is expected to have a positive impact on the DeFi ecosystem by improving the scalability, security, and sustainability of the Ethereum network. This is expected to attract more users and developers to the platform, which will further fuel the growth of the DeFi ecosystem.

Bitcoin as DeFi

Bitcoin is often considered a store of value and a form of digital gold, but it is not typically thought of as a DeFi asset. This is because Bitcoin was not specifically designed for DeFi applications and has some limitations that make it less suitable for some DeFi use cases.

For example, Bitcoin has limited scripting capabilities, which makes it difficult to build complex financial applications on top of the Bitcoin blockchain. In addition, Bitcoin transactions can be slow and expensive, which can make it less suitable for DeFi applications that require fast and cheap transactions.

However, there are some DeFi applications that have been built on the Bitcoin blockchain or that use Bitcoin as collateral. For example, there are Bitcoin-backed stablecoins like Wrapped BTC (WBTC) and RenBTC that can be used in DeFi applications. These stablecoins are backed by Bitcoin held in custody and can be used to access DeFi protocols on other blockchains, such as Ethereum.

In addition, there are some Bitcoin-based DeFi protocols that have been developed, such as Sovryn and Rootstock (RSK). These protocols aim to provide DeFi functionality on the Bitcoin blockchain, such as decentralized lending and trading.

Overall, while Bitcoin is not typically thought of as a DeFi asset, there are some DeFi applications and protocols that have been developed on the Bitcoin blockchain or that use Bitcoin as collateral. However, Ethereum is currently the most popular platform for DeFi applications, due to its superior smart contract capabilities and scalability.

The Pros and Cons of Decentralized Finance

Up to this point in the guide of what is DeFi, we’ve discussed a lot of different aspects regarding the subject, and mentioned multiple reasons why it’s an interesting topic, in general.

With all of that being said, though, it’s probably a good idea to boil things down to some specific benefits and shortcomings. While I do acknowledge that this isn’t always a good way of viewing things, and that a sphere as intricate as DeFi can’t really be thoroughly examined in such a fashion, it’s still a good method to place things into perspective.

Right, then – first of all, let’s discuss the most prominent benefits that DeFi has to offer to all casual users of the space:

Decentralization and Anonymity. While these two features are a no-brainer when it comes to DeFi, they do still need to be mentioned, nonetheless. Yes – with participating in different DeFi services, you’ll be able to retain your anonymity, and transact in decentralized crypto coins and tokens. There are no middlemen involved, and all transactions are public and available for everyone to see.
Speed. Thanks to the blockchain technology behind all of the DeFi ventures, transactions and other processes are settled in a matter of seconds. You don’t need to wait for days on end in order to get that loan approved, or to stand in line so that you could exchange one currency for another.
Less Bureaucracy. With traditional financial institutions, you’ll often be bombarded with lots of papers that are filled with industry-specific jargon, to the very brim. With DeFi, chances are that you’ll be able to skip many of the bureaucratic processes, and will have the possibility to concentrate on the most important information.
Simpler to Get Into. DeFi often doesn’t have any form of gatekeeping. In most cases, all that you need in order to start off with some sort of a DeFi project is a cryptocurrency wallet, and some crypto coins (usually, Ether).
A Lucrative Area. While this is probably the most subjective point on this list explaining what is DeFi and what are its benefits, it’s still a huge reason why people choose to enter the space, nonetheless. There’s no denying that decentralized finance can be lucrative – if you’re looking at how to invest in DeFi, you likely think so yourself!

With the benefits and most-notable features out of the way, let’s now take a look at some of the less-ideal parts of DeFi, and what you should be keeping in mind if you do actually decide to enter the space:

A Notable Number of Scams. With all this talk about regulations and DeFi becoming increasingly more mainstream, you would think that the space has become relatively safe. This, however, is not necessarily the case. To this day, there are multiple scams and rug pulls running in the DeFi world. Some are a bit more obvious than others, but this doesn’t make them any less dangerous.
Regulatory Uncertainty. Once you learn what is DeFi, you’ll have a pretty good understanding of the place that regulations occupy (or, rather – will occupy) within the space. That being said, as of writing this guide, this place is still rather uncertain. Some DeFi enthusiasts aren’t all that excited about the lack of clarity regarding the topic, since strict new rules can surely influence the sector significantly.
A Volatile Space. The cryptocurrency market has a pretty established reputation of being extremely volatile. It still being a young and developing space, there’s a lot of uncertainty floating around, and any major news can sway prices of these assets into the double digits, percentage-wise. Well, the same extends to DeFi ventures, too – you never know if you’re using the next big project, or one that’s about to reach its peak, and then drop off, like it never existed. Thus, your investments are always prone to being swept out of your hands.

As you can probably see for yourself, both the benefits and drawbacks of the DeFi scene are intricate and notable. On top of that, do keep in mind that the list above includes only the more well-known features – that aside, there are plenty of smaller points to keep in mind, as well!

How to Get Started in DeFi?

Getting started in DeFi can seem daunting at first, but with some basic knowledge and a few simple steps, anyone can start participating in the DeFi ecosystem. Here are some steps to get started:

Learn the basics: Before diving into DeFi, it’s important to understand the basic concepts and terminology. This includes understanding what blockchain is, what cryptocurrencies are, and how DeFi works. You can find many educational resources online, such as blogs, videos, and tutorials.
Get a cryptocurrency wallet: To participate in DeFi, you’ll need to have a cryptocurrency wallet that supports the specific cryptocurrency you want to use. Some popular cryptocurrency wallets include MetaMask, Ledger, and Trezor. These wallets allow you to store, send, and receive cryptocurrencies.
Purchase cryptocurrency: Once you have a cryptocurrency wallet, you can purchase the cryptocurrency you want to use for DeFi. You can purchase cryptocurrencies on cryptocurrency exchanges such as Binance, Coinbase, or Kraken.
Connect to a DeFi platform: Once you have purchased the cryptocurrency, you can connect to a DeFi platform that supports that specific cryptocurrency. Some popular DeFi platforms include Aave, Compound, Uniswap, and Curve.
Start using DeFi protocols: Once you have connected to a DeFi platform, you can start using the DeFi protocols available on that platform. These protocols include decentralized lending and borrowing, decentralized trading, and yield farming.
Stay up to date: DeFi is a rapidly evolving ecosystem, so it’s important to stay up to date with the latest developments and trends. You can do this by following DeFi influencers on social media, reading DeFi news sites, and joining DeFi communities on forums and social media platforms.

Overall, getting started in DeFi is not difficult, but it does require some basic knowledge and a few simple steps. With time and experience, you can become more comfortable with the ecosystem and start exploring more complex DeFi protocols.