Beginners Guide to Understanding Decentralized Finance (DeFi)

Beginners Guide to Understanding Decentralized Finance (DeFi)

Exchanges \ Wallets General Information Research Tutorials
April 22, 2021 by DanCurranJr
751
What is DeFi and How Does it Work? In practice, DeFi is a network of DApps (decentralized applications) and smart contracts built on Ethereum blockchain that focuses on financial applications such as loans, derivatives, exchanges, trading, and more. DeFi focuses on the concept of “Lego” money. That is, the idea is for anyone to be able
Defi

What is DeFi and How Does it Work?

In practice, DeFi is a network of DApps (decentralized applications) and smart contracts built on Ethereum blockchain that focuses on financial applications such as loans, derivatives, exchanges, trading, and more. DeFi focuses on the concept of “Lego” money. That is, the idea is for anyone to be able to create, modify, and match, connect, or build on top of any DeFi product permissionless.

DeFi protocols are modular, so they can interact with each other (similar to Lego constructors) to build an increasingly dense system of interacting parts. Anyone who can write a smart contract is able to create DeFi applications. For example, Insta DApp builds a DeFi product by simply building a better user interface on top of existing DeFi products. But in fact, the feature of open interdependence may also be DeFi’s biggest weakness.

If a key component like DAI (stablecoin, pegged to the USD and backed by Ether) becomes vulnerable or damaged, the entire ecosystem built around DAI may collapse.

Currently, the three biggest functionalities of DeFi are:

Creation of Monetary Banking Services

DeFi DApps allow you to create stablecoins (a cryptocurrency whose value is pegged to the US dollar). One such project for stablecoin is Maker. In it, each stablecoin (called DAI) is pegged to the US dollar and backed by collateral in the form of a cryptocurrency. Stablecoins offer the ability to program cryptocurrencies without reducing of volatility that you see with “traditional” cryptocurrencies like Bitcoin or Ethereum.

Maker is more than just a stablecoin project, as it seeks to be a decentralized reserve bank. People who hold the MKR token can vote on important decisions such as the Stability Fee (similar to how the FOMC votes on the Fed Funds rate).

Providing Peer-to-Peer Lending and Borrowing Platforms

Open Lending Protocols are a digital money lending platform built on a blockchain. Borrowing and lending platforms are probably DeFi’s most popular and fast-growing sector. Thanks to the current widespread use of DAI, other peer-to-peer protocols such as Dharma, and liquidity pool designs such as Compound Finance in recent years. 

Like a bank, consumers deposit their money, and when someone else borrows the digital assets, they earn interest. However, instead of intermediaries, here the smart contracts dictate the terms of the loan, connect lenders and borrowers, and distribute the interest. And while you may think that lending to a stranger sounds risky, most loans made in DeFi are backed by more collateral than borrowed value. This reduces the risk for lenders.

BlockFi and Voyager have become common decentralized lending protocols recently. 

Enabling Financial Instruments Such as DEX, Tokenization Platforms, Predictions Markets, and Derivatives.

Another type of popular DeFi application is the so-called decentralized exchange or abbreviated to DEX. DEXes are cryptocurrency exchanges that use the power of smart contracts to enforce the trading rules and execute trades securely. When trading on a DEX there is no exchange operator, no registration, no identity verification, or withdrawal fees.

DeFi’s derivative markets trade almost any asset on the blockchain using synthetic pricing. For example, synthetic price feeds create derivative tokens for stocks, futures, and even Bitcoin using smart contracts. Similarly, prediction markets are another popular type of derivative market in DeFi. Prediction markets essentially allow consumers to bet on the outcome of any event.

Tokenized assets and asset management is another fast-growing sector of DeFi. Asset management protocols allow investors to invest their money in the hands of the smart contract. Other asset management protocols, such as Set Protocol, employ automated strategies such as periodic rebalancing or following technical indicators.

How To Use DeFi?

Anyone can use DeFi products by going to the website of the respective application and connecting with a MetaMask wallet or something similar. You can also use most of the DApps on your desktop. Most DeFi DApps do not require users to provide any personal information or registration. But ETH is needed to pay for transactions on the Ethereum network. 

Users can take out a loan or earn interest on stablecoins using MakerDAO’s Oasis app and Compound. Tokens and cryptocurrencies can be exchanged with or without registration in Kyber, Uniswap, and others. You can even buy tokens that automatically place trades for you using Set Protocol.

On the other side, Synthetix is a platform that allows you to create and exchange synthetic versions of assets such as gold, silver, cryptos, and traditional currencies like the Euro. The synthetic assets are secured by additional collateral locked into the Synthetix contracts.

Is DeFI Secure?

Secure handling of cryptocurrencies and finance instruments requires specialized knowledge. There is a risk factor involved. It is the user’s responsibility to keep their key and holdings secret, use a hardware wallet, and multi-factor authentication.

As a DeFi user, you should know the changing terms of services between different DeFi products, wallets, exchanges, and crypto projects. Some DeFi products can add new dimensions that are paired with DAOs. These are decentralized autonomous organizations that can manage the protocol or platform.

Decentralized applications are still in an experimental phase.

Influence of DeFi on the Traditional Financial System 

DeFi has many benefits for consumers to which traditional banks will either have to adapt, accept them or lose a lot. Nowadays, even the central banks are also studying the role of digital blockchain-based currency in their economies.

One of the biggest advantages is that consumers can earn anywhere between a 7-10% interest rate on their cryptocurrency. This is an extremely attractive option, especially in the current negative interest rates on bank deposits and increased QE. Keeping your euros, dollars, or yen in a bank account will cost you a loss of money over time.

Decentralized finance brings many others benefits compared to traditional financial services. With the use of distributed systems and smart contracts, the implementation of a financial application or product becomes much easier and more secure. For example, many DApps are being developed on top of the Ethereum blockchain, which provides reduced operating costs and lower entry barriers.

A payment system in which anyone could send money to anyone else on the planet was just the beginning of the crypto revolution.

Is DeFi the Future?

The DeFi system cannot be censored or shut down by governments or large corporations. On the contrary, it improves confidentiality and security because there is no centralized single data source whose hacking would allow a security breach to occur.

Unlike traditional banks, Defi eliminates all the types of intermediaries that would usually be involved through the use of smart contracts. A decentralized system also eliminates all high costs, and these benefits are passed on to the end-user. The user has full control over their money without a reliable third party.

DeFi will have a huge impact on the traditional financial system and the way we manage our wealth in the future. Traditional finance may feel threatened at the moment, but it is also impossible to ignore these compelling technology, cost savings, and legacy system improvements. All of these advantages make DeFi an inevitable next step in the financial world.

Where Are the Risks?

There is always some risk with any high-return product, and DeFi also has its fair share. 

The Legal Environment

So far, the legal financial system has been deeply intertwined in many countries around the world. As a result, any attempt to remove the financial system away from this interconnected setup should create a number of legal challenges. And they will have to be addressed in order to achieve large-scale adoption of DeFi.

Lack of Interoperability Between Blockchains

In the world of DeFi applications, where no permissions are required, the lack of interoperability between chains can be a significant obstacle. This means that an application built on one blockchain, say, Ethereum, could not easily transact with an application built on a different blockchain, such as Bitcoin. However, there are already some bridging chains and protocols that allow it. For example, there are some sidechains and layer 2 solutions that trying to scale Ethereum off-chain. Also other blockchains like Polkadot and Cosmos building their ecosystems to be interoperable.  

Transaction Speed 

Ethereum networks can process 25 transactions per second, but these numbers pale compared to Visa’s 24 000 transactions per second. Overcoming speed will be a crucial challenge for DeFi if it wants to gain even greater use. To fill the gap between theory and practice, DeFi will have to overcome some other major obstacles such as non-intuitive user interfaces and affordability, capital inefficiency, hidden risks, and regulation to some extent. 

In Conclusion…

Decentralized finance could be the next significant disruption to the financial system. By using blockchain technology, this new wave of applications and services will help reduce transaction costs and improve financial services, security while providing consumers with a seamless experience from anywhere in the world.

People no longer have to participate in a system that doesn’t work for them. The cycle can be interrupted by removing the central participants. And that’s exactly what comes in the form of DeFi with C2C lending, high-interest accounts, and staking as a form of return.

Helpful? Useful? Enlightening?

Please consider making a small donation to CoinTutor.org. Any little bit helps the articles keep coming and the forums running. Pick a coin below, donate, and Thank You!

  • Bitcoin
  • Ethereum
  • MetaMask
  • Tether
  • Cardano
  • Xrp
  • Polkadot
  • Binance coin
  • Litecoin
  • Stellar
  • Bitcoin cash
  • Dogecoin
  • Usdcoin
  • Uniswap
  • Bitcoin sv
  • Tron
  • Cosmos
  • Monero
  • Tezos
  • Synthetix
  • Dash
  • Maker
  • Dai
  • Neo
  • Vechain
  • Ontology
Scan to Donate Bitcoin to 3GW2f1Du91uQFpVULZP4fwcLLTnfjUHDSY

Donate Bitcoin to this address

Scan the QR code or copy the address below into your wallet to send some Bitcoin

Scan to Donate Ethereum to 0x18b4388E6CE05b65F7Afd2a175ab9Da20324404D

Donate Ethereum to this address

Scan the QR code or copy the address below into your wallet to send some Ethereum

MetaMask

Donate to Coin Tutor Via Meta Mask

Scan to Donate Tether to 0x38D0d0039A238dE4e38FBf6dd53Aa81fdD90884E

Donate Tether to this address

Scan the QR code or copy the address below into your wallet to send some Tether

Scan to Donate Cardano to addr1qy3qmcf2dg4u0wytq3u33s8j8kzat60hsyrvmgftsvkhu73zphsj563tc7ugkprerrq0y0v96h5l0qgxeksjhqed0eaqq43up2

Donate Cardano to this address

Scan the QR code or copy the address below into your wallet to send some Cardano

Scan to Donate Xrp to rEbQS57RrYczvd16tLCrFrXfGufeyBUWQ

Donate Xrp to this address

Scan the QR code or copy the address below into your wallet to send some Xrp

Scan to Donate Polkadot to rEbQS57RrYczvd16tLCrFrXfGufeyBUWQ

Donate Polkadot to this address

Scan the QR code or copy the address below into your wallet to send some Polkadot

Scan to Donate Binance coin to bnb1mu5j9t5al68hrg4dwu34g2a8cn0qjegfc4fase

Donate Binance coin to this address

Scan the QR code or copy the address below into your wallet to send some Binance coin

Scan to Donate Litecoin to M8u4f6LL9APeLH5MAupK7geefMaBT7Pko6

Donate Litecoin to this address

Scan the QR code or copy the address below into your wallet to send some Litecoin

Scan to Donate Stellar to GAZUFMYP5IGQ3DUDADBBFKDLVBDM5DPDRRLTY4IZR5G7VANKGNH6NWJS

Donate Stellar to this address

Scan the QR code or copy the address below into your wallet to send some Stellar

Scan to Donate Bitcoin cash to qzm8xx7qqz6sttq4l5c44dua3ftaud9rvqdwypfd0f

Donate Bitcoin cash to this address

Scan the QR code or copy the address below into your wallet to send some Bitcoin cash

Scan to Donate Dogecoin to DAuyfeoKBtNhsjKmyvDtg1ANXvhXZpYHGE

Donate Dogecoin to this address

Scan the QR code or copy the address below into your wallet to send some Dogecoin

Scan to Donate Usdcoin to 0x38D0d0039A238dE4e38FBf6dd53Aa81fdD90884E

Donate Usdcoin to this address

Scan the QR code or copy the address below into your wallet to send some Usdcoin

Scan to Donate Uniswap to 0x38D0d0039A238dE4e38FBf6dd53Aa81fdD90884E

Donate Uniswap to this address

Scan the QR code or copy the address below into your wallet to send some Uniswap

Scan to Donate Bitcoin sv to 1EnacS3kV3d7jcHEJ8pc4hqeWcXgsidtdu

Donate Bitcoin sv to this address

Scan the QR code or copy the address below into your wallet to send some Bitcoin sv

Scan to Donate Tron to TF7TRB3sZkjYF44VVP1V5tyg8xY8UTXffY

Donate Tron to this address

Scan the QR code or copy the address below into your wallet to send some Tron

Scan to Donate Cosmos to cosmos1tws495gqqznj2l47v06adsfe4a7plqpug4txfh

Donate Cosmos to this address

Scan the QR code or copy the address below into your wallet to send some Cosmos

Scan to Donate Monero to 489Qx82MSwFAhRgXGoU9NrV3baCPB5vbm22EUkSizTSULcxqZ5ayisg5hWLYZegUxXJ6yuhCFGjxxaf1rQ4R67wuKh2Ykui

Donate Monero to this address

Scan the QR code or copy the address below into your wallet to send some Monero

Scan to Donate Tezos to tz1cRXMBHmqNx6NJywWEE8rnq4hkXtbHAjHm

Donate Tezos to this address

Scan the QR code or copy the address below into your wallet to send some Tezos

Scan to Donate Synthetix to 0x18b4388E6CE05b65F7Afd2a175ab9Da20324404D

Donate Synthetix to this address

Scan the QR code or copy the address below into your wallet to send some Synthetix

Scan to Donate Dash to XcYTxXipDksvyP2JJxxYe7YkKqxK5fBad5

Donate Dash to this address

Scan the QR code or copy the address below into your wallet to send some Dash

Scan to Donate Maker to 0x38D0d0039A238dE4e38FBf6dd53Aa81fdD90884E

Donate Maker to this address

Scan the QR code or copy the address below into your wallet to send some Maker

Scan to Donate Dai to 0x38D0d0039A238dE4e38FBf6dd53Aa81fdD90884E

Donate Dai to this address

Scan the QR code or copy the address below into your wallet to send some Dai

Scan to Donate Neo to AXqCkUcXbMGqs7JXkdCynz8AsejGTjmp3u

Donate Neo to this address

Scan the QR code or copy the address below into your wallet to send some Neo

Scan to Donate Vechain to 0x9AAD975d55684447AD7364105eb0aA91698fC4e6

Donate Vechain to this address

Scan the QR code or copy the address below into your wallet to send some Vechain

Scan to Donate Ontology to AZ3muytbGzc3D4CY33tRnRTnBxn39TYNdG

Donate Ontology to this address

Scan the QR code or copy the address below into your wallet to send some Ontology

Add a comment