A Beginner's Guide to Decentralised Finance (DeFi)
9 mins read
1 yrs ago
Over the past year, the popularity of DeFi has been on the increase, with a lot of people curious about what it means and what it might hold for them. DeFi is the acronym for decentralized finance, which is an area of finance centred on blockchain technology. It is structured similarly to cryptocurrencies as it exists to eliminate the need for financial intermediaries. DeFi, as the name suggests, is decentralized and allows entities from across the globe to hold a copy of transactions, eliminating the need for a single control source. DeFi aims to provide users total control of their funds and expand the blockchain network to modify and improve existing financial structures.
DeFi aims to expand its reach beyond direct purchases, that is, purchases of an item or service with a currency. It seeks to actively partake in other financial functions such as betting, insurance, loans, crowdfunding, and many more functionalities. Traditionally, these financial functions necessitate the need for central control, which DeFi aims to eliminate.
What is Decentralised Finance (DeFi)?
About now, you may be thinking, "all cryptocurrencies are decentralised and eliminate the need for financial intermediaries." While that is often (but not always) true, DeFi operates on a broader horizon. The DeFi movement centres on solely decentralisation and provides its investors incentives to ensure they are committed to this sole purpose.
The DeFi Finance System is built on multiple lucrative crypto projects and financial products geared towards the same goal: providing financial services to every person in the world, even those isolated from traditional markets. It also operates on a modular framework that will drive new financial services, products, and markets.
How does DeFi Work?
DeFi encompasses numerous projects which centre on decentralised exchanges, lending protocols, investments, and more. For instance, some DeFi projects have lending pools that allow you to borrow cryptocurrencies as long as you prove you can pay back in a single transaction. This lets its lenders to earn profits by loaning out their cryptocurrencies.
Another notable project in DeFi is Uniswap, which allows individuals with an Ethereum wallet to trade without a crypto exchange. Uniswap enables investors to earn profits through liquidity pools, which allow traders to purchase and sell cryptocurrencies without worrying about the liquidity in the market. DeFi also enables the creation of synthetic assets such as Synthetic's tokenised stocks that are pegged to similar prices as their non-synthetic counterparts. Decentralised Finance projects may also be considered non-custodial; they do not help their users manage their finances on their behalf, and users maintain total control of their finances.
However, DeFi projects also operate with the use of governance tokens, which allow users to make decisions on modifications to the protocols of the network. Users can buy these tokens to enable them to play a more active role in the governance of DeFi projects.
Ethereum and DeFi
Most of the applications that are considered to be DeFi are built on the Ethereum blockchain. Ethereum, the second-largest cryptocurrency in the world, is the major digital currency used in transactions that concern DeFi. The Ethereum network operates with the use of smart contracts that offer flexibility that is necessitated for DeFi projects' operations. Some DeFi projects may also require the creation and execution of smart contracts.
Smart contracts are structured similarly to a standard contract, in that something happens only if another event cooccurs. The significant difference is that it involves using a computer code to specify the details of the contract and enforce it. Contracts are a legal document that specifies the terms and conditions for a relationship between two parties; in smart contracts, a computer automates this process without the need for manual supervision.
Smart contracts are faster and pose fewer risks to both parties, as it ensures their interests are protected. However, smart contracts are set up on computers, leaving them vulnerable to bugs or hackers, which may expose the confidential information locked in the contract. Smart contracts are still under development and modifications to safeguard them against these vulnerabilities are in progress. Examples of popular DeFi applications set up on smart contracts include:
Stablecoins are one of the most popular applications of DeFi. Stablecoins are designed to reduce the volatility of cryptocurrencies by pegging them to a real-world asset. Stablecoins pegged to an asset help to keep the price surge under control. For example, a stablecoin could be pegged to a dollar to regulate price fluctuations, meaning the stablecoin would always cost one dollar.
Lending platforms are set up on smart contracts to eliminate the need for financial intermediaries, such as banks, in the loaning process. The goal is to connect borrowers directly to lenders. For instance, Compound, one of such platforms, allows users to loan their funds at interest to other users in need of a loan. The interest rate is determined through mathematical algorithms. Higher demand for specific cryptocurrencies may result in higher interest rates. Those interested in taking a loan need to provide Ether, the token that powers the Ethereum network, as collateral. They are not required to provide their personal details, which is necessitated in a traditional banking system. They can enjoy anonymity while getting loans without financial intermediaries.
Decentralised exchanges eliminate the need for traditional, centralised crypto exchanges. They focus on allowing users to trade their currencies directly for other currencies. They concentrate on peer-to-peer exchanges (P2P) in facilitating these trades.
Another example of DeFi projects is prediction markets such as Intrade and PredictIt, which allow users to place bets on the possible outcomes of an event, such as an election or sporting event. The goal is to boost interest in prediction markets and eliminate the need for third parties.
Other applications of DeFi projects include liquidity pools, yield farming, and money Legos. These DeFi projects are geared towards enabling direct trades of financial services and goods. They provide incentives for investors, which creates a platform that allows users to trade directly.
What are the potentials of Decentralised Finance?
Traditional finance centres on the banks as intermediaries to facilitate transactions. The court is used to enforce and settle disputes that may arise based on these transactions. DeFi eliminates the need for these third parties as smart contracts cover these roles. The smart contract is programmed with a resolution strategy for any dispute that may occur; it is fortified to enforce this. This helps to reduce the cost of these transactions while allowing users to maintain their privacy. The financial services set up on the blockchain are optimised and distributed across thousands of nodes to eliminate the possibility of censorship and a takeover by an organisation or individual.
DeFi is set up to create financial inclusion for everyone in the world. Most economic systems are set up to generate profit. This means that it is focused on the high-income communities where they can make more profit. DeFi aims to provide the benefits of these financial institutions to low-income communities at reduced costs. It enables ease in participation in prediction markets, and it helps ease the process of borrowing and lending by making it available to everyone.
DeFi would reduce trading costs that using intermediaries may incur as it requires fewer maintenance charges. DeFi projects allow for the creation of several financial derivatives on the blockchain to facilitate security and provide other financial services to users.
What challenges does DeFi face?
DeFi offers several benefits that would altogether help in restructuring financial systems to suit the needs of the masses. However, despite the good intentions of many DeFi Projects, there are many challenges they face in their operations. Some of these challenges include:
Poor user experience
DeFi centres on eliminating the need for financial intermediaries and transfers the responsibilities of these intermediaries to smart contracts. The DeFi applications built on the blockchain are challenging to modify, resulting in some limitations in their functionalities. This might make it challenging to modify bugs or errors on the application. This could make it difficult to design new products that are free of user errors.
Best application use
DeFi applications may require some extra effort on the part of the user. This is why, despite the numerous benefits they offer, they may need to incentivise users to switch from the traditional system to them. It may also be difficult for users to find the best application to use that suits their needs. Therefore, developers need to broaden the scope of their applications and see how they can improve their performance in the larger financial ecosystem.
How to get started with DeFi
DeFi projects are on the path to making waves in the financial ecosystem, and it's no surprise that you may desire to be a part of this. Here is what you need to do to get started with DeFi
- Get an Ethereum wallet that can connect with multiple DeFi protocols. A popular choice is MetaMask.
- Get your wallet credited with cryptocurrency to get started: the acceptable cryptocurrencies includes ETH, ERC-20 coins, or Ethereum-wrapped BTC.
- Select the DeFi project you are interested in investing in. You may consider lending out your cryptocurrencies, investing in a liquidity pool, becoming a yield farmer, or other options. While selecting the DeFi project you wish to invest in, keep in mind that there are numerous risks involved. Several DeFi projects are still in the experimental phase, which means there are multiple risks attached as they are still under modification. Therefore, it is essential that you exercise caution as you make your way into the DeFi ecosystem.
The future of DeFi
DeFi is still in the experimental phase, which means that its potentials are yet to be fully understood. Currently, most of the DeFi projects are built on the Ethereum blockchain. Still, as developers strive to integrate DeFi into the financial ecosystem, DeFi will most likely expand to other blockchains.
The DeFi ecosystem is also under modification to make it more interoperable. At present, the accepted cryptocurrencies on DeFi projects are limited to mostly ETH and ERC-20 coins. In fact, Bitcoin, the most widespread cryptocurrencies, isn't accepted except in the form of Ethereum-wrapped BTC. Modifications are still on the way to enable cross-blockchain transactions on the DeFi ecosystem.
Bitcoin isn't left out of the DeFi ecosystem. Companies such as Suredbits, DG Labs are being founded to enable DeFi applications. Developers are on the way to create Discrete Log Contracts (DLC). This Bitcoin DeFi derivative would facilitate direct payout to users who meet specific conditions.
The expansion of DeFi would enable it to interact directly with traditional finance structures. As interest in DeFi projects increases and more investments are made in DeFi, more DeFi applications would be created to solve the limitations of financial structures.
Frequently Asked Questions on DeFi
- Are investments in DeFi safe?
DeFi projects are still experimental, which means investments are still risky. DeFi is considered by many to be the future of finance, and as such early investment might mean huge financial gains in the future. However, many DeFi projects are still being changed and created. It might be challenging to select profitable projects from those that are not yet available or finished. For example, there have been DeFi projects like the DeFi coin, YAM, which crashed in price after widespread popularity.
DeFi projects also suffer from bugs and may be difficult to modify once the smart contract is set up. However, developers believe that achieving scalability on the Ethereum blockchain would be a start to resolving the limitations of DeFi.
- Is open banking and DeFi the same?
Decentralised finance is aiming to eliminate dependence on traditional banking and enable financial inclusion. It allows for a financial system where individuals can operate without censorship and at a lower cost. Several DeFi projects are still underway, and these projects' success would invariably restructure the traditional financial structure as we know it. A lot of investments are being channelled into DeFi. However, DeFi may still be considered a highly profitable but risky business initiative.
Disclaimer: This article is meant to provide general guidance and understanding of cryptocurrency and the Blockchain network. It’s not an exhaustive list and should not be taken as financial advice. Yellow Card Academy is not responsible for your investment decisions.