What is Decentralised Finance? DeFi Explained

Publish Date 08 Nov 2021
Blockchain / 6 Min Read
Alex Lielacher / Last Update 23 Jun 2022

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Decentralised Finance (DeFi) is a booming sub-sector in the global crypto markets that enables anyone with an internet connection to access open financial protocols that mimic many of the products and services found in the traditional financial industry.

Continue reading to learn more about decentralised finance, how it works, and what it can offer traders and investors.

What is DeFi (Decentralised Finance)?

Decentralised Finance (DeFi) is a broad term that refers to financial applications built on top of blockchains that don’t require intermediaries or central authorities to operate. 

The goal of DeFi is to create an open, decentralised, and transparent financial ecosystem that is accessible to everyone across the globe. 

Users access DeFi products through decentralised applications (DApps), which are web-based applications powered by smart contracts and secured by blockchain technology. A smart contract is a self-executing programme with predetermined conditions written in code that enable DApps to run autonomously. 

Ethereum and Binance Smart Chain are currently the most popular blockchains for DeFi. Some of the financial services that traders can access on DeFi applications are lending, borrowing, staking, trading, hedging and investing.

How does DeFi work?

Normally, we interact with financial institutions when we need to deal with financial matters such as processing payments, making investments, or securing a loan. In DeFi, however, smart contracts replace these institutions, and cryptocurrencies act as the payment rail. 

Smart contracts are self-executing and contain predetermined conditions. No one can change a smart contract once it’s live. For example, if a developer has designed a smart contract to send a specified amount of funds from one party to another on a certain day, that is exactly what it will do as long as the funds are available for transfer. 

Smart contracts running on open blockchains, like Ethereum, are accessible to anyone. That means that anyone can scrutinise and audit a smart contract. Reading code is nevertheless a more technical task, and the public has to trust those with the skill to do the inspections. 

That said, using DeFi applications is as easy as visiting a website and connecting the required cryptocurrency wallet. For instance, to use Uniswap, users simply have to open the Uniswap website on a browser and connect the Ethereum wallet (containing some ETH).

Traditiona finance vs decentralised finance

Source: appinventiv

What are the components of DeFi?

To better understand how decentralised finance works, we can breakdown its components as follows:

The blockchain

This is the network where DeFi projects build the applications. DeFi needs decentralised infrastructure to work. Hence, blockchain networks like Ethereum and Binance Smart Chain play a crucial role in DeFi. Also, the blockchain stores the transaction history of these projects and the state of accounts.

Digital currencies and tokens

These are assets that power the blockchain network. The blockchain’s native cryptocurrency and other tokens are examples of such assets. For instance, DeFi users pay for gas fees with Ethereum’s native token, ether (ETH).

Smart contracts

Smart contracts make DeFi functional, allowing users to utilise various financial services. For example, users cannot borrow funds and repay without the help of smart contracts.

Decentralised applications

These are the applications which will be used to access DeFi. For instance, the decentralised exchange Uniswap is an application that runs on the Ethereum network.

Types of DeFi applications

Traders have probably used a DeFi application without knowing it. That is because people expect DeFi to be complicated, yet most of its applications are surprisingly easy to use.

Here are the different types of DeFi applications: 

Decentralised exchanges (DEXs)

These are exchanges that do not hold users’ funds. That means that trades take place peer-to-peer with the help of smart contracts.

Also, DEXs do not require users to deposit funds to start trading. DEXs operate differently from centralised exchanges, which hold users’ assets. Examples of DEXs include Uniswap, PancakeSwap, dYdX, and DexGuru.

Lending platforms

Lending platforms are one of the most popular DeFi applications. Unlike traditional lenders, decentralised lending platforms don’t ask borrowers for personal information or credit history. In fact, it doesn’t matter whether borrowers have a good or bad credit history. All traders have to do is deposit collateral, which the lender will receive if traders do not repay the loan.

Moreover, borrowers can access loans faster, and geographical barriers do not apply, making loans more obtainable.

Wrapped Bitcoin

Wrapped Bitcoin (WBTC) is an ERC20 token that represents Bitcoin on the Ethereum network. The token is backed on a ratio of 1:1 with Bitcoin. WBTC enables users to earn interest from lending BTC on decentralised lending platforms. Additionally, WBTC brings Bitcoin’s liquidity to DEXs.

Prediction markets

These are markets that allow people to bet on the price of a currency or the results of a future event. In DeFi, prediction markets are intermediary-free, more accessible, and typically have lower fees compared to centralised prediction markets.

Yield farming

Yield farming involves providing liquidity to a trading or lending pool in exchange for interest or trading fees plus liquidity provider tokens that can then be staked in a yield farm to earn additional yield. Yearn Finance is an example of a DeFi platform that provides yield farming.

What can traders do with decentralised finance?

Plenty of things. 

DeFi enables anyone across the globe to secure a loan online. It also allows users to lend crypto assets and earn interest.

Crypto traders can also conduct all sorts of trades with the advantage of having control over the assets, while crypto-savvy investors can earn an additional yield on the crypto assets by deploying yield farming strategies.

DeFi also provides faster, cheaper, automated, and more transparent insurance and the ability to hedge portfolios using decentralised crypto derivatives. 

From low-cost payments with algorithmic stablecoins and seamlessly swapping one digital asset for another to earning interest on a wide range of crypto assets and investing in a diversified portfolio of digital assets, DeFi offers a plethora of opportunities for crypto traders and investors.

What role do smart contracts have in DeFi?

We have already established that smart contracts play a significant role in DeFi, acting as alternatives to centralised authorities. Using smart contracts, applications run smoother, faster, and are typically cheaper.

Compare this to conducting a cross-border money transfer through a financial institution. Transactions will likely encounter red tape that delays the process, making it more expensive. Also, conventional finance processes are prone to risks such as human errors, transaction limits, and hidden costs. Smart contracts, on the other hand, are automated and transparent, reducing such risks.

Smart contracts are also free from alterations, which means that agreements will run as they should. That makes DeFi more reliable and potentially an essential component in the future of finance.

How to invest in decentralised finance?

With so many applications to choose from, investing in DeFi can seem overwhelming.  

However, with a bit of research and clearly defined goals, it doesn’t have to be. 

Start by exploring the DeFi space to understand it better. Read guides to increase the knowledge of the subject, establish how the various DeFi protocols work, and figure out what traders want to accomplish with DeFi.  

Then, find an application and understand how it works. For example, traders could start with an established DeFi application with the lowest risk and start there. 

Next, set a budget and add funds to a crypto wallet. Begin by spending only a small amount, then increase it as confidence in the application increases. Before getting more exposure, explore other applications while paying attention to the risk versus reward every step of the way. 

When investing in DeFi tokens, experts recommend considering the liquidity and the amount staked on a platform. More often than not, tokens with high liquidity are a less risky investment than those with low liquidity. 

How to make money with DeFi?

There are various ways traders can make money in DeFi, ranging from depositing funds in a liquidity pool to earn interest or trading fees to yield farming and taking part in no-loss lotteries. 

Different opportunities to make money come with different risk profiles. Depositing funds in an established autonomous money market pool to earn interest on stablecoins, for example, is a relatively low-risk way to make money in DeFi. 

Conversely, yield farming on a recently launched, unaudited automated market maker protocol is a highly risky affair that could lead to a complete loss of funds.

Therefore, it’s essential to weigh the risks against the rewards and conduct thorough research on tokens and protocols that traders are able to plan and interact with.

What is the difference between DeFi and traditional finance?

This is how decentralised finance compares to traditional finance.

DeFi Traditional Finance

The trader holds the money.

Financial institutions hold the money.

Traders have control over the money.

Traders have to trust intermediaries to manage the money. 

Traders transaction activity is pseudonymous.

Financial activities are tied to a traders identity.

Anyone can access DeFi services.

Traders have to apply to receive financial services.

Markets are open 24/7.

Markets close.

Money transfers take minutes.

Money transfers could take days to process.

There is transparency.

Financial institutions keep books closed. If they are publicly-listed companies, they will reveal records within the premise of the law and nothing more.

What are the benefits of decentralised finance?

Financial sovereignty is one of the advantages of decentralised finance. Users have control over assets, and they don’t have to rely on intermediaries. 

The lack of intermediaries also reduces costs and delays while the blockchain provides transparency, allowing anyone to inspect the code or the product.

DeFi makes financial services accessible to all. The barriers to entry that people face in traditional finance doesn’t apply here because location and identification documents are meaningless in DeFi. As a result, the underbanked and unbanked populations in the world can benefit greatly from DeFi.

Furthermore, decentralised finance services are available 24/7. Unlike banks, DeFi platforms never close after working hours or during holidays.

What are the risks of decentralised finance?

Despite its advantages, decentralised finance faces several risks. For instance, smart contracts are not perfect. They could become buggy and there would be a potential loss of funds.

Also, the DeFi market involves the use of volatile cryptocurrencies. Hence, sending money in a cryptocurrency where the value is constantly changing is risky. 

Blockchain doesn’t eliminate the risks of investing. As with any other investment, traders can make or lose money. There is also the risk of deploying funds on a fraudulent platform and end up losing all of them. 

Handing over all the control to the users also means there is extra responsibilities. In DeFi, users have to work harder to understand what they are investing in and figure out all the nitty-gritty technical stuff, leaving no room for error. Failure to do so could result in losses due to operational errors, like anciently overpaying for blockchain transaction fees. 

DeFi is not a full-proof market. Some of the services that DeFi protocols are offering are experimental, enhancing the risk of losing money. That means that traders should enter this market with caution and conduct proper due diligence before jumping into any DeFi projects.

 

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Alex Lielacher

Cryptocurrency Content Contributor

Alex Lielacher is a ‘banker-turned-bitcoiner’ who exchanged the bond trading desk for a laptop in a co-working space to provide engaging and educational content for leading companies in the blockchain technology space.

 

 

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