What is DeFi? Decentralized Finance Explained for Beginners

Introduction

Exploring to enter the DeFi domain can be exciting and overwhelming too. Since it is a new financial space it is important to understand certain connotations and processes in DeFi before choosing to invest in any of the DeFi platforms. Understanding DeFi is more than decoding the newly evolving crypto space.

If understood correctly and used responsibly DeFi can be a lucrative way for investors to incur some gains from their crypto investments. If an investor rushes into the DeFi system without understanding the process it can lead to them incurring results that might not be up to the mark or up to their expectation. So, read along to understand what Decentralized Finance means. 

What is Decentralized Finance (DeFi)?

Decentralized Finance is a new financial terrain where investors from all around the world explore different financial solutions to check the best fit for their financial needs or goals. DeFi applications are built on open source peer to peer networks that offer  good TPS –  transaction per second speed, decentralization (for easy traceability of funds) and security. 

The very first DeFi example that one can think of is Bitcoin. Bitcoin is a crypto asset built on a decentralized peer to peer network to transfer digital payments from one person to another. It is not supported by any intermediary or central authority. The Bitcoin whitepaper is considered to be a revolution in the world of finance.   

Additional Read: How to buy Bitcoin in India

Why is DeFi important? 

As mentioned above, DeFi is built on the very fundamentals of Bitcoin which makes it a really important use case in the world of Web3 and finance. The interesting factor that makes DeFi more special is its potential to completely revolutionalise the traditional financial system.   

What Is DeFi-Based Lending?

DeFi based lending is an area that is rapidly growing. More and more crypto enthusiasts are showing interest in this particular functionality. Investors who have their crypto assets lying in a dormant wallet can actually create a channel to earn passive income by lending their crypto assets on DeFi platforms. 

What are the advantages of DeFi? 

DeFi offers plenty of advantages as compared to traditional finance.

DeFi is not controlled by a central authority. It does not involve any contributors or arbitrators. DeFi functions through blockchain technology and smart contracts to automate transactions on a decentralized network. 

The smart contract code automates the system for all transactions that take place on the DeFi platform. The code specifies all possible resolutions in case of any disputes in the DeFi network. This gives the user more control over one’s funds. 

What are the potential use cases for Decentralized Finance?

Borrowing and lending in DeFi

Open lending protocols are a popular use case in DeFi. Open lending and borrowing has many advantages like quick settlement, no KYC, zero to less collateral requirements for borrowing and no credit checks required. Lending and borrowing on DeFi protocols means that these transactions take place on a peer to peer blockchain that requires zero trust and is open source making it a safe and quick platform to trade on.     

Monetary banking services 

Monetary banking service is a commonly featured use case of DeFi as it offers easy mortgaging services, issuance of stablecoins and insurance. As the blockchain industry is improving, the need and demand for creating fiat backed stablecoins have increased. Traditional mortgaging services require intermediaries which can be expensive and time consuming. Underwriting and legal fees can be drastically reduced by using smart contracts on a public or permissioned blockchain.  

Decentralized marketplaces 

Decentralized marketplaces or exchanges are the most popular use cases of DeFi. Commonly called as DEX, traders can easily sign up on a decentralized exchange and lend, borrow or trade their crypto assets without any intermediary. Some popular DEXs are Uniswap and Pancake Swap. 

Yield optimization 

DeFi applications can be used to automate and optimize the compound of yields gained from staking, pooling, and other interest-bearing investments. Yield optimization is a process that uses data analytics and optimization techniques. In DeFi yield optimization is carried out by applying algorithmic techniques to fetch the best rates on crypto transactions. 

Yield optimization is referred to as Yield farming as well. In yield optimization a smart contract carries out the process of using your crypto rewards to re-invest in order to help you receive optimized returns.  

How Do DeFi-Based Yield Farming Applications Work? 

Decentralized Yield farming applications work on a simple logic. A user locks up his/ her  crypto holdings  to  earn interest depending on the rates and terms of the yield farming rules set within the smart contract of the platform. 

That was a lot of information on one paragraph. Let us take a simpler look at how yield farming works. Yield farming operates using multiple smart contracts and liquidity providers (LPs). LPs are users who are primarily in the system to provide crypto liquidity to the smart contract system in exchange for a reward. The rewards earned by LPs can also be reinvested into other smart contracts. Ethereum is the most popular technology for Yield Farming on Decentralized networks. The rewards which LPs receive are a type of ERC-20 token. 

LPs usually provide crypto tokens to a liquidity pool. This pool of funds are used to create a marketplace or are simply added to an existing DeFi platform where users can lend, borrow or simply exchange/ swap their crypto tokens by paying a fee. Part of this fee is then given (in the ratio of the funds provided) as rewards to the LPs. The entire Yield farming system on DeFi is operated and powered by a smart contract. 

Additional Read: Top DeFi Tokens 2022

What role do smart contracts play in DeFi?

Most of the existing applications of decentralized finance require a smart contract to automate the transactions process. The legal contract uses legal terminologies to create a process while a smart contract is written in computer code and is self executing. When all the terms are met, the smart contract generates a transaction on the decentralized blockchain network. 

Using smart contracts is faster, easier, and reduces the risk for both parties. 

What challenges does DeFi face? 

While Decentralized Finance may have its set of advantages, there are some disadvantages of DeFi as the space is fairly new and is evolving everyday. 

High Latency: Blockchains can be slow compared to the centralized platforms. DeFi developers need to note the limitations of blockchain technology and optimize and create solutions and products accordingly. 

Human Error risks: DeFi applications transfer ownership and responsibility to the user. Creating products that can minimize human error and reverse them is a tough challenge as these applications run on an immutable blockchain network. 

Ineffective user experience: Currently DeFi applications require too many steps to participate which makes it difficult for users to keep up with. For DeFi platforms to become mainstream in finance, a tangible benefit that incentivizes users to switch over from the traditional system could be applied.

What are the risks of DeFi(Decentralized Finance)? 

While DeFi does offer lucrative returns, it has some risks involved. Even though decentralized networks give control to users on their funds, users can face some risks: 

Counterparty Risk: In lending on these platforms there’s a possibility of the borrower not paying their loan amount. 

Regulatory Risk: Crypto currently lacks regulatory statutory in the decentralized network. Users technically lend or borrow through the smart contract. 

Token Risk: Crypto assets have different risk levels  are affected by liquidity, trustworthiness, token smart contract security, and risks involved directly from the project. The DeFi domain has many low market-cap tokens which makes investing risky at times. 

Software Risk:  Code loopholes and bugs can compromise the security of the smart contracts. User wallets could be compromised if they are connected and given permissions to these DeFi and DApps. 

Impermanent Loss: If a user is staking in liquidity pools, divergences from the price ratio entered by a user can cause an impermanent loss. 

Where can I find DeFi projects? 

Ethereum blockchain is the primary platform for DeFi. There are many other popular blockchains like Solana, Polygon, Binance chain and Avalanche. 

Online forums, messengers, and websites can help users find and learn about new DeFi opportunities. It is important to be cautious before investing in any DeFi platform. 

What do I need to access DeFi projects? 

To access DeFi projects a compatible crypto wallet and crypto tokens are required.

Compatible crypto wallet: To access DeFi platforms and explore different categories on it an individual needs to create a non custodial crypto wallet like Metamask to connect on DeFi platforms. There are different crypto wallets for different blockchain decentralized finance platforms. 

Crypto tokens: To trade, lend, borrow or swap crypto, a user needs to invest in crypto in order to explore DeFi opportunities. To be able to invest in diverse crypto assets on DeFi platforms a user will have to create native wallets of the crypto tokens they are investing in.

For beginners it is best to invest in crypto and lend, swap or borrow through a centralized exchange to explore the concept of crypto finance in a more effective way. 

What is the difference between DeFi & Traditional Finance? 

Accessibility is one of the major differences between traditional finance and decentralized finance platforms. Anyone can get access to crypto investing by simply creating a wallet without any credit check or Know Your Customer KYC verification. Once a wallet is created all one has to do is fund it with crypto tokens. In traditional finance, KYC checks and other personal documents need to be shared with a centralized authority. These steps make traditional finance time consuming and  additional work for the customer. 

DeFi also offers financial services that aren’t available in the traditional finance domain. By layering different DeFi services (sometimes known as DeFi legos), it’s possible to create brand new products that utilize multiple platforms.

What is the difference between DeFi & Centralized Finance (CeFi)? 

The crypto landscape has both decentralized and centralized finance networks. For example, on a centralized exchange that holds custody of your tokens are centralized crypto finance platforms while platforms that run on a decentralized network powered by smart contracts to automate activities on the dex can be categorized as decentralized finance.  

Both CeFi and DeFi have more or less the same products and solutions. The key difference in both is that CeFi takes away the responsibility of managing DeFi investments. CeFi platforms offer better security for novice crypto investors. Crypto Investment app like CoinDCX is the best example of a CeFi. The platform is insured by BitGo – a digital asset and trust firm. 

What is the difference between DeFi and Open Banking? 

Open banking is a financial partnership where a third-party financial service provider is given secure access to financial data through APIs of the data repository. This enables the networking of data of accounts between banks and non-bank financial institutions. Open banking helps banks to offer more financial services to their customers.

DeFi offers a different infrastructure and works autonomously irrespective of the current infrastructure of the market. DeFi is also referred to as ‘open finance’.

Decentralized finance, on the other hand, could allow the management of entirely new financial instruments and new ways of interacting with them. Decentralized Finance can apply AI and Oracles to fetch user behaviors and investing patterns. 

What Is The Future Of DeFi? 

DeFi is a relatively new segment in the crypto and web3 domain. As of today, the total value locked in DeFi is $69.38 billion. The market cap of DeFi is $ 50 billion. DeFi has been on a winning streak because of its intrinsic characteristics like transparency, accessibility and self custody of an individual’s finances.      

The bottom line

Decentralized finance is a stream that is razor focused on building an inclusive financial system that is distributed and decentralized. A financial landscape like this can potentially prevent censorship, financial surveillance and offer a channel of passive income. While a tempting idea, not everything benefits from decentralization. 

If DeFi wins at offering financial solutions that are safe and lucrative, it could potentially surpass traditional finance. 

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