One area in cryptocurrencies attracting huge attention is DeFi or decentralized finance. The total value locked in DeFi contracts already surpasses $68 billion. It is a new financial system that operates outside of the traditional finance system with banks, brokers, and other financial institutions. Instead, it is based on blockchain technology, utilizing smart contracts to create decentralized financial instruments such as loans, bonds, trading, and other types of assets.
I'll talk about what DeFi is in detail, how it works, how to get started, and discuss the most popular applications as well as the advantages and risks associated with DeFi.
What is DeFi?
Decentralized finance, or DeFi for short, is an ecosystem of financial applications and protocols that isn't controlled by centralized financial intermediaries run by a few powerful individuals and institutions. The focus lies instead in each user having control over their finances, cutting the middleman out. It reflects the desire to disrupt traditional financial institutions by leveraging the power of blockchain technology.
The financial services offered in DeFi use smart contracts on a blockchain, making them open to anyone with internet access to use. Through these smart contracts, people can lend or borrow funds from others, speculate on price movements on a range of assets using derivatives, trade cryptocurrencies, insure against risks, and earn interest in savings-like accounts.
Where does DeFi come from?
Bitcoin could be considered the first example of DeFi, allowing users to hold and send value to anyone with an internet connection. Launched back in 2009 by Satoshi Nakamoto, Bitcoin was the start of a new asset class now worth over $1 trillion.
Ethereum, launched in 2015, made the use of smart contracts popular, kickstarting this industry now known as DeFi. In 2017, MakerDAO's stablecoin-based lending platform became the first DeFi application to receive significant use. A set of smart contracts on the Ethereum blockchain made it possible to put Ether up as collateral and borrow DAI, a stablecoin pegged to the US dollar.
And more recently, especially in the summer of 2020, DeFi saw its popularity explode. Many projects saw their valuations skyrocket well into the billions of dollars, with most of them built and deployed on the Ethereum blockchain.
How does DeFi work?
With the components of DeFi being generally no different than other financial ecosystems, DeFi requires stable currencies, so-called stablecoins, and offers a wide variety of use cases. The success of DeFi apps relies on the successful implementation of smart contracts.
These smart contracts, which have been designed with certain functions in mind for the operation of that particular DeFi app, are executed on the Ethereum blockchain. The DeFi ecosystem relies heavily on these smart contracts for smooth operation and a consistent user experience.
For example, a smart contract can be programmed to allow for the issuance of peer-to-peer loans, and it is executed when a borrower expresses interest in receiving a loan. The use cases can range from something simple like a smart contract that sends an allowance every Friday to a crypto wallet, to something complex as flash loans involving instant borrowing, trading, and repayment in a single transaction.
The applications for DeFi are growing daily, with projects constantly innovating and pushing the boundaries. Here are the most popular applications, along with the best-known projects in each case.
Decentralized exchanges, or DEXs, connect cryptocurrency traders directly so they can trade without having to trust any intermediary. Traders never give up control of their assets. And since these exchanges are based on smart contracts on the blockchain, they are open 24/7/365.
Decentralized exchanges are most often for newly issued tokens because there are almost no hurdles to list a new token on them. More popular coins and tokens are usually listed on centralized exchanges, which offer a better user experience along with lower fees.
Top DEXs include: Uniswap, PancakeSwap, MDEX, and 1inch.
Lending and borrowing
Just as with traditional finance, in DeFi it is possible to lend and borrow stablecoins and other cryptocurrencies. With lenders getting up to 30% interest in a year, it is seen as an attractive option to traditional banking, where some banks even go so far as to have a negative deposit rate.
To be eligible for a DeFi loan, borrowers need to offer assets worth more than the amount of their loan. These assets are liquidated if their value falls under a specific threshold. And as everything is done through smart contracts, a borrower doesn't have to give out their identity or credit score to take out a loan.
Top lending platforms include: Maker, Compound, and Aave.
Yield farming, also referred to as liquidity mining, is a way to generate rewards with cryptocurrency holdings. At its core, it is a process that allows cryptocurrency holders to lock up their holdings to generate the most returns possible on those assets by leveraging different DeFi protocols.
A yield farmer will look for the highest yield by moving between several liquidity pools and protocols. Yield farmers are always trying to find the best coin with which they can generate more yield than before.
Top platforms for yield farming include: Compound, Synthetix, and Curve.
Stablecoins aim to mimic traditional, stable currencies. Stablecoins are cryptocurrencies that peg to the value of other currencies, such as the U.S. dollar, or other commodities. This means their price is usually steadier than unpegged cryptocurrencies like Bitcoin or Ether. They bring stability and a way to exit the crypto volatility without having to cash out to fiat currencies.
The biggest stablecoins by market cap are: USDT, USDC, and BUSD.
Wrapped Bitcoin (WBTC) is an ERC-20 token — backed 1:1 by bitcoin — that represents Bitcoin (BTC) on the Ethereum blockchain. That enables bitcoin holders to use tokenized bitcoin in the largely Ethereum-powered DeFi market.
A prediction market allows participants to make bets on the outcomes of future events instead of bets on options or cryptocurrencies. Based on blockchain technology, these prediction markets eliminate intermediaries.
Prediction markets gained popularity during the 2020 US presidential elections, with Augur, a decentralized prediction market platform, recording a milestone volume of over $8 million.
Derivatives are one of the key elements of any mature financial system. They derive their value from underlying financial assets (like a security) or a set of assets (like an index).
Synthetix is the most popular derivatives platform on crypto, offering exposure to a vast range of fiat currencies, metals, bonds, commodities, and cryptocurrencies.
How do I get started with DeFi?
To interact with DeFi, the first step is to own Ether and other cryptocurrencies. You'll have to make your way onto a centralized exchange like Coinbase or Binance, which serve as fiat on-ramps, deposit a fiat currency like the US dollar and buy crypto Ether — this is what you’ll often use to purchase tokens throughout the ecosystem, and, most importantly, what you’ll use to pay for transactions on the network (referred to as gas fees.)
The next step is to create your crypto wallet on the Ethereum blockchain. This will act as your account for all Ethereum based tokens and will be allocated a unique address that will serve to interact with the DApps in DeFi. The most popular crypto wallet for use in DeFi is MetaMask. You can download the browser extension, create a wallet and transfer your Ether from a centralized exchange to the public key of the wallet.
Once you have your wallet with crypto assets on it, you can interact with DeFi applications and start lending, borrowing, trading, speculating, and farming.
You hold your own money. Instead of putting your money in the hands of financial institutions, you hold it and control how it is used.
Faster than traditional finance. Deposits and withdrawals from the traditional finance system can take days, whereas in DeFi it is a matter of seconds or minutes.
Open-source and permissionless. Billions of people around the world are unbanked because of insufficient identification and access to capital, geographic isolation, and government oppression. DeFi is open to anyone with an internet connection and the markets are open 24/7.
It's built on transparency. Anyone can look at the data and the smart contracts and inspect how it works.
Keep your privacy. Wallets are pseudo-anonymous, listing only public addresses. There is no need to associate personal identification with a wallet.
Higher interest rates. DeFi lending protocols typically offer much higher interest rates for deposits not seen in traditional finance.
Higher fees than centralized exchanges. Many of the DeFi services are also offered by centralized exchanges like Coinbase and Binance, with lower fees, since each transaction doesn't have to be recorded on the Ethereum blockchain.
High risk of losing funds. In DeFi, it is possible to lose funds to scammers, exploits, and vulnerabilities found in smart contracts, hackers stealing funds from wallets, and many other attacks.
Lack of insurance. While insurance is used in centralized finance as protection against fraud and other exploits, it's much rarer to find on DeFi.
Why is DeFi so popular?
Since there are no restrictions, almost everyone can take part in DeFi. With the rise of stablecoins, high interest, and the prospect to make ludicrous gains in a short period, DeFi attracted millions worldwide.
Is investing in DeFi safe?
No, it’s risky. Many believe DeFi is the future of finance and that investing in disruptive technology early could lead to massive gains. But it’s easy to fall for scams, invest in bad projects, and lose all crypto assets.
Where can I learn more about DeFi?
The best way is through experience, by buying crypto and interacting with the protocols. Twitter and Telegram are also the social hotspots for the crypto community, with many eager to share their knowledge. Lastly, websites like DeFi Pulse and Finematics are great sources to expand your knowledge of DeFi.
The bottom line
The decentralized finance ecosystem is much smaller than traditional financial markets and faces the same growth challenges as cryptocurrency as a whole. It still has plenty of room for growth and potential for innovation and massive income gains. Yet, it’s still a risky endeavor for the average investor and you need to have a solid understanding to be able to succeed and not lose all your assets.
Still, crypto is bringing money online, and we’re seeing a quantum leap in what’s possible when it comes to the functionality of money. In future years, we might see every financial service that exists today being rebuilt for the crypto ecosystem and the emergence of a more efficient financial system.
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