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What Is Decentralized Finance (DeFi)? A Beginner’s Guide
Introduction
There are many concepts every crypto beginner needs to know, and one of them is Decentralized Finance (DeFi). The Decentralized Finance system is growing so fast because of its effects on our regular banking systems.
Today, it is normal for people to go into banks to deposit their cash. Also, people go to banks to get loans for various reasons. The bank loan borrowers the cash deposit that other customers make. They attach interest to the loans, get the loan back and keep the interest. After that, they pay the depositors the actual money the customers deposited. Also, they charge the depositor for using their services.
So, the bank makes money off us by borrowing our monies. After taking the profits, they still charge us from our monies for using their service. Simply put, the banks rip others with your money and still rip you on your deposit. Moreover, if you save in the banks for a long time, you will get very little interest accumulation.
Many people know what banks do, so they do not even try banking. Currently, there are over a 1.7billion grownups in the world today who are unbanked. Even those who have bank accounts do not have control over their monies. Truly, they depend on the bank for any transaction they want to initiate.
These things are the financial problems we face with our financial institutions today. So, how do we tackle these issues? How will people get full control of their money and stop the banks from ripping them? The answer is Decentralized Finance.
DeFi, also known as Decentralized Finance, is the growing alternative to this inadequate traditional banking. Indeed, it is the connection between the banked and the unbanked. Primarily, anyone with a smartphone and internet access can access financial services. Also, they can put their money to work through DeFi and get lots of interest.
Hence, this article will discuss DeFi, its various components, terminologies, applications, and how to make passive income with it. Truly, by the time you finish reading, you will be smarter regarding DeFi and its uses.
What Is Decentralized Finance (DeFi)?
DeFi is a parent name for a set of blockchain finance tools. The idea allows people to carry out banking activities without the banks. So, people using these tools can borrow, lend, and save money for interest. All of these will happen in and through their phones and internet connections.
Decentralized Finance (DeFi) vs. Centralized Finance (CeFi)
What Is Centralized Finance (CeFi)?
Before now, CeFi was the standard for crypto trading. DeFi crypto only just came into the scene recently. So, what happened in CeFi? Well, it was just like DeFi with little control by central authorities. In CeFi, all cryptocurrency transactions happen through a central exchange. Also, the management of the central exchange is in charge of the funds belonging to crypto traders.
Therefore, as a Cefi crypto trader, you will not have a private key to access your exchange wallet. In addition, the exchange takes on the responsibility of listing coins you can trade. Again, the exchange determines the transaction fees you pay for trading on the platform.
Finally, crypto traders in Cefi do not own their crypto assets. Moreover, the traders are subject to the rules governing the transactions in the exchanges. So, as a Cefi crypto trader, you do not have total control over your money and how you transact with it.
Decentralized Finance vs. Centralized Finance
| Attributes | DeFi | CeFi |
| Control of funds | DeFi crypto traders are in charge of their money. | Crypto traders do not have control over their money. |
| Services | Users can Trade, Lend, and Borrow funds. | Users can carry fiat to crypto swaps, Borrow, Lending, Trade, and Pay for items. |
| Personal Details | Proof of Work | Framework with plugs |
| Security | They do not take the blame for your funds. | There can be security issues in the exchanges. |
| Total Market Cap | $16 billion* | $324 billion* |
| Customer Reps | There are no customer reps. | The exchanges provide customer reps for crypto traders. |
| Risks | Security rests on technology at work. | The exchanges take care of security. |
Why is DeFi so Important?
Here are some of the positive features that make Decentralized Finance so important:
- DeFi removes our traditional finance institutions’ fees for using their platforms.
- You will be responsible for controlling your money fully.
- It allows you to save your funds in safe digital wallets rather than keeping them in banks,
- As long as you have an internet connection, you do not need consent to use it.
How Does the DeFi Work?
Decentralized finance makes use of smart contracts. These contracts remove the need for banks to confirm transfers. So, DeFi crypto traders can send funds to one another directly. This method is called a peer-to-peer method of transfer. Also, DeFi transactions get their security via the blockchain.
What are DeFi Products?
Decentralized finance products are platforms where users borrow and lend funds to each other. Also, they allow u to use derivatives to predict digital assets’ price actions. DeFi crypto traders can also use crypto to earn yields as you will in a normal savings account and insure risks.
DeFi Currencies
In the world of crypto, DeFi currencies are also called coins or crypto. A DeFi crypto or coin is almost like a digital twin of fiat money. So, traders use DeFi coins to transfer value. DeFi coins are native tokens of certain blockchains, for example, Ethereum and Uniswap.
Components of Decentralized Finance
Decentralized Exchanges (DEX)
DEX are crypto exchanges that link crypto sellers and buyers. On the DEX, buyers and sellers can make P2P transfers.
Wallets
A Decentralized Finance wallet is a non-custodial crypto safe. They give users total control over their crypto assets. Also, their users take care of their assets and private key security.
Aggregators
In DEX, these elements are crypto finance platforms that give traders access to various trading pools. They can do all these via one dashboard, for example, Fire Salamander.
Markets
A DeFi market is a market that allows security sellers and buyers to deal with each other directly. In addition, they will need to meet in a regular exchange to transact.
Oracles
An Oracle in decentralized finance is a third-party service that enables smart contracts to access real-world, external data. Moreover, oracles empower these contracts to access data live feeds that do not exist on the blockchain. For example, prices of assets in real-time.
Prediction Markets
These markets are for trading event outcomes. In other words, they are called exchange-traded markets. In addition, the prices in the market can always be an indication of what is on the crowd’s mind.
Layer 1
This term refers to the ground architectural layer of the blockchain. In other words, it is the basic structure. For example, Bitcoin.
Decentralized Finance Terminologies
DApp (Decentralized Application)
DApps are software programs that carry out special functions. Also, no individual controls the software.
Gas Fees
A gas or gas fee is an amount of Ether that a user will need to carry out transfers. Also, the fees are for paying miners who confirm these transfers.
Impermanent Loss (IL)
IL refers to the rise and fall of cryptos after a user has sent them to a pool of liquidity.
Passive Income
Decentralized finance passive income is one way to easily earn money in DeFi. To earn money passively, you will deposit your tokens to a platform. The platform will give you an Annual Percentage Yield (APY) for your deposit.
Automatic Market Maker (AMM)?
AMM is a base protocol that DEXs use. The protocol has an automated mechanism for trading. Again, AMM removes the need for mediators like CEX and other regular financial firms. So, with AMM, users can transact with one another without the need for a middleman.
What is the Total Value Locked in DeFi (TLV)?
TLV is the amount of funds users have transferred to a Decentralized finance platform. Also, users deposit these funds for various reasons. For example, liquidity pools, lending, or staking.
Liquidity Pool
Liquidity Pools are the total funds locked up in a smart contract.
Decentralized Finance Use Cases
Lending Platforms
These are platforms that give loans in crypto without mediators. Also, on these platforms, users can list their tokens for lending to others. You can borrow from these DeFi platforms via peer-to-peer lending if you need a loan.
Stable Coins
These coins are digital currencies that allow DeFi crypto investors to gain yields on their assets in the market. Also, these investors use these coins to hedge against crypto volatility.
Margin and Leverage
The sum of money a person invests plus the total pool is known as margins. However, the practice gives DeFi crypto traders the power to trade, known as leverage. Moreover, traders use margins to produce high leverage. In return, the high leverage can heighten profits as well as losses.
DeFi-native Activities
This concept refers to being part of a liquidity pool. Majorly, as a liquidity provider, you can deposit a certain amount of money to a smart contract. In return, the decentralized finance platform will reward you with its native coins. The rewards are from profits that come in from transfers and trading fees on the platforms.
Decentralized Finance Risks
There are about five major risks in decentralized finance.
- Smart Contract Risks: It means that cyber thieves can attack smart contracts.
- Oracle Risk: These third-party services can fail due to network disruptions.
- Custodial Risk: People can lose access to their wallets and funds if they lose their private keys.
- Regulator Risks: Governmental authorities cannot control this tech. Hence they might have issues vetting it.
- Scalability Risk: Transaction processing speeds can be slow. For example, while Ethereum can process only 15 transactions per second, Visa can process 65,000.
How to Make Money (Passive Income) with Decentralized Finance?
There are four basic ways to make money through passive income in DeFi, and they are:
Staking
This method refers to DeFi crypto traders locking up their funds in a protocol for a long time. As a result, they get ROI on the tokens that they stake.
Providing to Liquidity
This method involves sending funds to decentralized finance and a DeFi crypto trader. The platforms will use the funds together with that of others for operations. As the platform uses your funds, you will get rewards in the protocols’ native decentralized fiance crypto.
Yield farming
This concept refers to using decentralized finance to maximize returns. In this process, DeFi crypto traders can borrow and lend money and earn returns in crypto for their services.
Lending
This method involves lending individuals your crypto directly without an intermediary. As a DeFi crypto trader, you will receive interest on the payback of the crypto you loaned.
Is it safe to Invest in Decentralized Finance?
Although you may not believe it, Decentralized finance has flaws. Indeed, it can remove regular mediators. However, it might not give users the safety these mediators provide. For example, in 2021, the total amount people lost to Decentralized finance scams was $1.3 billion.
Also, here are some popular decentralized finance scams that exist today:
- Pump and dump scam: This scam is also called the rug pull scam. For this type of scam, a team of developers will launch a coin and use social media to hype the coin. Once many DeFi crypto investors buy their coins, the price will pump. Then, the developers will sell their holding at the pump’s peak, thereby crashing the price. An example of this DeFi crypto scam is the Terra rug pull scam.
- The Honey Pot Scam: This scam is easy. Developers produce a DeFi crypto, and investors buy, and the coin will peak to an ATH. Then the developers will restrict access from investors to sell their holdings.
- Wallet Dusting: In this type of scam, scammers send obscure coins to a DeFi crypto trader’s hot wallet. Once the person makes a transaction with the coin, the scammers trace other transactions to the trader’s cold wallets. Then launch a targeted phishing attack and clear the DeFi crypto trader’s holdings.
- Phishing Scams: These scams involve hackers creating fake websites that sell products. Then, they promise DeFi crypto traders services in exchange for their coins. When you pay, your money is gone. Another method is by posing to be a legit exchange asking you to verify your account. They will send you a link that will warrant using your private keys to access it. When you do, they will access your funds and steal everything from you.
The Future of Decentralized Finance
Defi is still in its early stages. For people who are just starting, the system is not regulated. So, for them, decentralized finance has many scams and hacks.
Also, many central bodies are trying to add rules to Decentralized finance. However, it is not easy because of its nature. Till now, some questions are still unanswered. For example, who will enforce these rules, and how will the people enforce them?
Other future concerns affecting Defi are carbon footprints, hardware failure, software maintenance, energy, and stability.
As long as some of these questions remain unanswered, there will be no safe use for Defi in the future. Also, financial institutions will find a way to get into the system if it succeeds. They are not going to let decentralized finance take their means of making profits. So, if they cannot control your money, they will find a way to make money from Defi.
Conclusion
You have seen Defi’s components, terminologies, risks, investment opportunities, risks, and future in this article. Decentralized finance is the fastest-growing arm of the blockchain. Currently, a lot of companies and individuals are getting into the system. So, knowing all there is in decentralized finance positions you for the future of finance and fintech.
References
A Beginner’s Guide to Cryptocurrency
Role of DEX Aggregators in DeFi
Decentralized Prediction Markets
Blockchain Layer 1 vs. Layer 2 Scaling Solutions
