The Beginner’s Guide to DeFi
DeFi has taken the cryptocurrency industry by storm with all the innovation it brings to the table. Here’s a quick guide to help you master the basics of DeFi.
1. What is DeFi?
2. How does DeFi work?
3. What is the Difference Between DeFi and CeFi?
4. What are the main advantages of DeFi?
5. What challenges does DeFi face?
6. How to get started with DeFi?
7. What are the potential use cases for DeFi?
8.1 What are Stablecoins?
8.2 What is Composability?
With that out of the way, let’s jump right into it!
What is DeFi?
DeFi (or Decentralized Finance) is a term you've seen us use multiple times on this platform. And for a good reason. After all, it is one of the biggest trends in the crypto industry as of now.
Remember how Initial Coin Offerings (ICOs) used to make rounds after rounds on crypto news portals back in 2017? DeFi is doing that right now. The $55.39 billion locked in across the different DeFi portals acts as a testimony to its popularity.
So what is it really? DeFi is a whole slew of financial applications that make use of blockchain technology to function. It has changed how people perceive financial transactions for good. At its core, DeFi is all about decentralization and improving the transparency of the financial systems.
The open financial economy that DeFi aims to create relies on financial protocols that are made keeping interoperability, ease of composing, and programmability in mind. Armed with the aforementioned, DeFi is bringing about the Open Finance Movement that is promoting alternative ways to think about finance.
The movement has shown people that they don't necessarily have to rely on conventional financial vehicles for loans, savings, trading, insurance, and a lot of other important aspects of finance.
The way it has been changing finance, as we know it, points at the possibility that someday DeFi applications would surpass the traditional financial markets. Being decentralized, it has an unprecedented scope and reach - and that makes it accessible for the masses.
The only thing stopping DeFi from taking over is the fact that people still need to educate themselves about blockchain technology. Not understanding the system well holds a lot of people back from making use of the technology. And that prevents them from reaping the benefits that it has to offer.
We're doing our bit to change that.
How does DeFi work?
Now that you know what DeFi is, one of the most important questions you must be asking yourself would be, "how does it work?".
DeFi relies on multiple smaller systems to work for it to function. As mentioned before, it is more of a collective space rather than a system in itself. A whole slew of non-custodial financial products having interoperability, ease of composing, and programmability at heart make up the DeFi space.
Now, you might be wondering what non-custodial actually means. In the context of DeFi, non-custodial means that you are the one managing your crypto. What that means for you, as an investor, is that you don't have to give your money out to anyone else to make your money earn for you.
Traditionally, you would deposit your money in a bank and the bank would trade on your money and share some profits with you. Or, if you choose to go for mutual funds, your fund manager would do the same for you.
In the case of DeFi, you are in complete control of your money. And it is you who decides what happens to your money and not some centralized body.
That said, the world of DeFi is one that is full of experimentation. And that has attracted some of the most successful venture capitalists and big companies to invest in the projects.
What is the difference between DeFi and CeFi?
Before we talk about the difference between Centralized Finance (CeFi), and Decentralized Finance (DeFi), let's talk about what each entails.
We've already talked about DeFi, so let's dig right into what CeFi is all about.
The crypto industry has been around for longer than DeFi is. So, it comes as no surprise that in the earlier days, CeFi was the standard for crypto trading. In fact, even now, most of the exchanges are largely centralized.
Take Binance, for example. As a user, you're required to use the exchange as per the rules set by the company. Moreover, all the assets you have on the platform are managed exclusively by the Binance team.
And that's just how centralized exchanges work. It is the exchanges that get to decide which coins are listed on the platform for trading as well as the fees you're required to pay for trading on the exchange.
You send your funds to the exchange and then the exchange manages them internally. They store your funds on the exchange and ensure that the funds stay safe.
Is it all bad, though? Depends on how much you trust the centralized exchanges.
While centralized exchanges have security measures in place to keep your funds safe, they can always fail. And when that happens, that leaves your funds vulnerable to threats. The Mt. Gox incident as well as the ones that followed it are still fresh in the minds of the investors.
On the other hand, large exchanges have entire customer service departments hired to help you out on every step of your journey on the platform. This gives you a sense of trust and comfort. And you get your issues fixed rather quickly.
When you want to convert your fiat currency into cryptocurrencies, you'll find centralized services to be more flexible than decentralized ones.
And while this is changing, it would be a while before decentralized services would be at par with centralized services in this regard.
One of the main differences between CeFi and DeFi is the fact that most centralized services require you to complete a KYC process before you can make use of the services that the platform has to offer.
Decentralized services, on the other hand, are trustless and require no KYC whatsoever (barring a few exceptions). You can directly access the services with the help of a wallet and you don't have to compromise on your anonymity.
More importantly, you don't need to trust the DeFi services to use them. If you've made a transaction, you can always check it up on tools like Etherscan. In fact, the level of transparency is so high that you can audit the platform's code yourself to verify its legitimacy.
And since the code is readily available, anyone can build on top of these platforms. This enables the DeFi to churn out innovative products at a rate you simply don't see in CeFi.
Those were some of the differences between CeFi and DeFi but there are a lot more that you realize over time when you use platforms built on the concepts of the two.
What are the main advantages of DeFi?
DeFi has a lot of advantages that it offers to users and investors alike. But if we get into every single one of them, the article would get painfully long to read. So we're only going to discuss the important benefits that have helped DeFi muster the popularity and support it proudly holds as of now.
1. It is permissionless
To make the best use of DeFi, it is imperative for us to take a look at the permissionless nature of transactions on the blockchain. It helps the financial products and services built on the blockchain reach out to a far greater number of people for whom access to centralized finance is not an option. And you'd be surprised at just how many people that is.
As of now, about a fifth of the entire global population does not have access to banking solutions for one reason or the other. Don't have proper documentation? You can't have access to banking solutions. Don't have a bank where you live? You can't have access to banking solutions. Don't have a good credit score? You can't have access to banking solutions.
DeFi frees you of these issues and enables you to access the financial vehicles that centralized finance can't provide you because of the geopolitical restrictions in your area.
MakerDAO is one of the best examples of how DeFi can help you overcome the restrictions that centralized finance puts on you. With the help of this decentralized application, you can leverage Ethereum (ETH) to take a loan. And the process of doing so is surprisingly easy. All you need to do is deposit ETH on the platform.
The platform would then use an automated smart contract to manage the rest of the process. This smart contract would help you create a Collateralized Debt Position (CDP) which would enable you to obtain DAI tokens.
2. It enhances earning opportunities
Being flexible, DeFi enables you to add more value to your investments in digital assets. The decentralized apps (dApps) Compound and Dharma are good examples for the same. They help you utilize digital assets such as DAI and USDC by enabling you to lend out some of your assets for others to borrow.
When you lend out some of your assets to other investors on the platform, you get better rates of interest than what conventional banking systems have to offer.
3. It makes banks redundant
There is no denying the importance of banks in the world of finance. But banks aren't always accessible to a lot of people (as we discussed earlier).
Since DeFi solutions are doing much better in terms of accessibility, they are the only viable solution for a lot of people.
By replacing banks in providing financial solutions to people, DeFi makes banks redundant.
4. It brings quick innovation
The traditional finance industry has largely been the same over the years. DeFi, on the other hand, has been providing the world with innovative products and services on a consistent basis. And being an open protocol with strong community support, DeFi has the power to bring in innovation quickly.
As more and more people lend their support to the system, the ecosystem is changing rapidly and providing support for an entirely new generation of services in the financial world. It has brought innovation that was largely thought of to be the domain of centralized financial systems.
5. It is transparent
Transparency is one of the main highlights of the DeFi space. Giving everyone access to the source code makes it easier for people to trust the system better. It also eases the process of trying and testing the applications built for the DeFi ecosystem. And it does it all while maintaining the trustless nature of blockchain technology.
6. It puts you in control
One of the defining features of the application built for the DeFi ecosystem is that it puts customers in control of their finances. Unlike banks wherein the bank or the government sets the rules and largely takes care of your investments, DeFi provides you the flexibility to make decisions about the investments you make with your money.
What challenges does DeFi face?
While DeFi has a lot of great things to offer, much like any other technology, it has its own drawbacks. Let's take a look at them:
1. It is slow
Blockchain technology is one of the safest technologies out there due to its complex, encrypted, and distributed nature. Unfortunately, this safety comes at a cost—speed. Transactions made on the blockchain are a lot slower than their traditional counterparts.
And while that is acceptable for a lot of us, it might be something that would make many people want to refuse to use the technology. That said, developers of DeFi applications take the limitations into account when they work on new projects. Most, if not all, of the products and services in the DeFi ecosystem are optimized to give users the best possible experience.
2. Errors are rather common and user-driven
In centralized systems, the responsibility of error-free execution of tasks lies on a single source—the organization. However, when it comes to decentralized systems, the responsibility to ensure that there are no errors is passed on to the user. Users can (and often do) make mistakes.
The immutable nature of blockchains makes it very difficult to minimize the risk of such errors. And that makes designing the right product with minimum risks quite a daunting task for the developers.
3. You are on your own
The kind of experience you have while using a DeFi application depends largely on you.
Centralized systems usually have huge customer support teams that guide you through the applications. They ensure that you have a good time while using the applications by answering your queries promptly.
Decentralized systems find it difficult to have such teams. There's plenty of documentation available. And you have a helpful community at your disposal. But at the end of the day, if you have a problem, you need to take that extra effort to solve it. Nobody does that for you.
4. Too many choices
The DeFi ecosystem churns out new and innovative products on a regular basis. And while that is great, when you have a specific use case, you need to sift through a lot of choices to make the right one. And that is quite a daunting task for an average user who is still new to the ecosystem.
This pushes the developers to not only build applications that solve specific problems but also think about how those applications would fit into the DeFi ecosystem.
How to get started with DeFi?
Getting started with DeFi is easier than you'd imagine for it to be. To start with, you need a wallet. This might need some research and thinking over because you need a wallet that works on the blockchain of your choice.
As of now, two of the most prominent blockchains in the DeFi space are Ethereum and Binance Smart Chain (BSC). While Ethereum has been the hub of innovation in this space for a long time, things are changing.
As more and more projects are finding themselves on the Ethereum blockchain, the network is slowing down. If slow transaction speed is something that doesn't bother you, it is safe for you to go for Ethereum.
However, if the transaction speed matters to you, go for BSC. Being relatively new, BSC boasts of better transaction speeds and low fees. Both of these things are inviting traders and developers from the industry to move their projects to BSC.
If you've chosen Ethereum to be the blockchain you want to go for, MetaMask is an excellent wallet to have. It is one of the most popular choices for traders and investors throughout the industry.
If you've chosen BSC to be the blockchain you want to go for instead, I would still recommend you to use MetaMask as your crypto wallet. While the crypto wallet started off as an Ethereum-based wallet, it does support BSC. Since people are familiar with the interface of MetaMask, it is an excellent choice for most traders.
We have written a beginner's guide on how to use MetaMask. Feel free to check it out to know more about the crypto wallet.
That said, the industry has a lot of choices to offer. Based on what fits your requirements best, you can go for just about any crypto wallet.
Once you've selected the wallet, it is time for you now to buy the cryptocurrencies you want to invest in. Remember, an Ethereum-based wallet is likely to store all of your ERC-20 tokens and other Ethereum-based tokens. However, if your tokens are a part of BSC's ecosystem, you would need to use a BSC-based wallet.
Now that you've bought the relevant tokens, you are ready to indulge in DeFi—and there are many ways to do so.
To start with, you can lend out your tokens and potentially make a profit from that. Now, you can lend your tokens out to other traders and profit from the interest they pay.
Alternatively, you could lend your tokens out to the platforms and earn yield for doing so. This is called yield farming and it is all the rage in the crypto industry as of now. One of the most popular platforms for participating in yield farming is yearn.finance. We have talked about yearn.finance in detail in our beginner's guide to the platform. Feel free to go through the article to know more about it.
Additionally, if you want to know more about yield farming, I would recommend you to check out one of our articles wherein we talk about it extensively.
If that doesn't sound like something you'd be interested in, you could always go become a market maker at a decentralized exchange. One of the most popular decentralized exchanges where you could earn a profit by adding liquidity to the platform and becoming a market maker is Uniswap. We have a beginner's guide wherein we discuss the platform as well as its governance token, UNI. If you're interested in knowing more about it, you should go through the article.
What are the potential use cases for DeFi?
Where traditional, centralized finance failed, DeFi won. And it is still winning. There are a lot of use cases for DeFi in the world of finance but to discuss all of them would turn the article into a book. This is why we are only going to discuss some of the common use-cases of DeFi here.
Borrowing & Lending
One of the most popular types of services that you can find in the DeFi ecosystem are the open lending protocols. When you make the process of borrowing and lending decentralized, you get access to the many advantages that the system has over traditional financial institutions.
To start with, you gain the ability to collateralize something that the world of traditional finance finds difficult to deal with—digital assets. Next up, you remove the need for credit checks which opens up avenues for a lot more people to get involved. Moreover, transaction settlement is instant when it comes to the DeFi space. And lastly, but importantly, DeFi promises standardization (not now, but in the future).
Built on public blockchains, these lending services do not require you to trust them. And to add to the trustless nature of these services and blockchain technology, on the whole, you have methods for cryptographic verification of transactions.
This reduces the counterparty risk and makes borrowing and lending a lot more accessible, faster, and cheaper. All because these lending marketplaces are on the blockchain.
Monetary banking services
Monetary banking services being a part of DeFi is really a no-brainer. After all, it's in the definition.
Be it mortgages or insurance, DeFi has solutions for everything. And the blockchain industry is growing and maturing, an increasing number of developers are focusing on creating stablecoins. If you're wondering what a stablecoin is, it is a kind of crypto asset that is pegged to a real-world asset. What makes stablecoins so lucrative is the fact that despite being pegged to a real-world asset, it can be transferred digitally without any problem.
Cryptocurrencies are known for being really volatile. Their prices fluctuate all the time—sometimes swinging by huge numbers. Stablecoins, on the other hand, have rather stable prices and can be a viable option for use on a daily basis.
We'll talk more about it soon, so don't worry if you didn't understand what I just said about stablecoins. But for now, let's talk about how DeFi mortgage and insurance solutions work even better than their traditional alternatives.
Starting with mortgage, it is no secret that the whole process of getting one is time-consuming and expensive. But with the help of smart contracts, we can reduce the legal fees to an extent.
Moving on, blockchain dilutes risk by spreading it across participants and eliminates the requirement for intermediaries. What this means for you, as a user, is lower premiums without compromising on the quality of service.
Decentralized exchanges (DEXes) are arguably the most crucial of all the applications of DeFi. It comes as no surprise, therefore, that this is the category of applications that has the most room for innovation.
DEXes allow users to go ahead and trade their digital assets without having to rely on a trusted intermediary to take care of their funds. On these platforms, the traders directly trade amongst themselves, and the assets are transferred directly to their wallets using smart contracts.
They don't require much maintenance and that allows them to have lower trading fees when compared with centralized exchanges.
Frequently Asked Questions
What are Stablecoins?
When we try to recreate traditional financial products in the world of blockchain, one of the biggest problems we face is that of price volatility. The large intraday swings in the fiat-cryptocurrency trading pairs makes it very difficult for cryptocurrencies to be used in financial products. The USD/ETH pair, for example, often sees intraday swings of 10% or more.
To use such an instrument for something like loans is less than ideal. You don't want to take a loan of 1000 USD only to know that it is worth 1100 USD right before it's time for you to repay it. Future planning becomes really difficult when we're dealing with such volatility.
Stablecoins solve this problem by being pegged against a stable asset. There are three general ways of doing so which gives us three general categories:
1. Centralized fiat-collateralized stablecoins:
These stablecoins are backed in a 1:1 ratio by fiat. A good example of such a stablecoin is the USD Coin (USDC) which is issued by Coinbase. It is backed 1:1 by the US dollar. As long as you have faith in the authority that issues the stablecoin and the fiat it is pegged against, you're good to go.
2. Decentralized crypto-collateralized stablecoins:
These stablecoins don't have any user agreement or central operator. Anyone can use them without the permission of the government or any company. This, however, increases the complexity of maintaining stability.
3. Decentralized algorithmic stablecoins:
These stablecoins rely on algorithms to maintain stability in prices and don't have any collateral backing the system up. A problem with this type of stablecoins is that an entity with a lot of funds can attack it. And when that happens, people would lose their trust in the stability of the system causing the stablecoin to eventually die out.
More often than not, however, you would find yourself using the first two types of stablecoins.
What is composability?
DeFi applications are also called money legos since every application pertains to a specific financial service or product which can be combined with others to create a complex offering that is powerful and customized to the specific needs of the users.
More often than not, these applications are connected with each other for individual transactions. This means that the connections are made on the fly.
This is what composability is all about. It helps apps interact with each other in a meaningful way instead of working in silos.
Imagine wanting to add a feature for trading tokenized assets on a platform you're building. You can easily do so by integrating one of the decentralized exchange protocols.
Before you go…
The 21st century needs financial tools befitting the century. And that is exactly what DeFi is providing us with. In the last few years, DeFi has taken the industry by storm with all the innovation it was able to bring to the table and it looks like the future has a lot more to offer.
That said, there is still a lot that the developers in the DeFi space have to work on before it can go mainstream.