Beginners Guide to Decentralized Finance Explained In Plain English
Decentralized Finance (DeFi) aims to correct the flaws of the present banking system. Imagine a new financial system that operates 24/7, where users control their money, and transactions cost little to nothing? Those are the promises of decentralized Finance.
Interestingly, this financial system is not just the stuff of a sci-fi movie. Decentralized Finance is already here. DeFi has grown so much in the past few years that its relevance has become impossible to ignore. This piece will help you level your DeFi game from a novice to a DeFi master. You will learn about decentralized Finance, how DeFi works, and the top Defi protocols on the Ethereum blockchain. Let’s dive into it.
What Is Decentralized Finance (DeFi)?
Decentralized Finance is coined from two terms- decentralized and Finance. Decentralization describes an open system without centralized control or authority. On the other hand, Finance involves economic activities such as lending, borrowing, saving, insurance, etc.
On that note, you can think of Decentralized Finance as an open financial system that lets users control their funds and enables them to access financial services without control from any central authority.
The key drivers of Defi are its transparency, permissionless nature, and incentive system. For example, in DeFi, anyone from anywhere can provide financial services and receive them.
How Does Decentralized Finance (DeFi ) Work?
Two entities must be present before a user can access Traditional Finance (TradFi) financial services. The first is the bank or money manager that keeps or provides funds, and the second is a legal institution that draws the term of the agreement between the bank and the user.
However, instead of intermediaries, DeFi runs on a smart contract. These are sets of blockchain codes that specify the terms of contracts between two parties. The code will execute the given instruction when the parties involved fulfill the agreement.
The circulating supply within a DeFi protocol is provided by members, known as liquid providers, for a share of the reward and participation in protocol governance.
Some unique forms of decentralized applications known as Dapps are needed to access a smart contract and use DeFI. Since Defi runs on computer codes, they tend to be more autonomous, reliable, and easy to maintain and scale.
What Are The Objectives of Decentralized Finance?
Some of the goals of DeFi include:
Privacy
DeFi keeps the users’ identities private and anonymous. It does not require users to reveal their identities before using dapps. All you need is a Web 3.0 wallet stocked with cryptocurrency.
Fast Transaction Speed
The primary requirement to obtain crypto-backed loans and premium insurance is to have enough crypto in your wallet to post as collateral. Defi services are less time-consuming and efficient as background checks and paperwork are eliminated.
Better Rewards
DeFi cuts hungry banks and profit-driven intermediaries from its services. As a result, it provides higher returns to liquidity providers and charges little interest when using it.
Transparency
Dapps run on smart contracts whose codes are often open-source. This builds trust and transparency among members as anyone can view the code to understand the system’s workings and how money is deployed.
Financial Inclusion
The permissionless nature of decentralized Finance makes it accessible to everyone regardless of their credit score and background. This enables it to provide financial inclusion to millions of unbanked individuals worldwide.
What Can You Do With Defi?
Decentralized Finance enables users to enjoy all the services banks provide. These include:
Save Money
You can deposit fiat currency, stablecoins, and digital assets in cryptocurrency savings account to earn attractive returns.
Get Loan
DeFi provides a trustless ecosystem for borrowing funds. The protocols are sustained by substantial financial incentives for both depositors and borrowers.
Trade on Decentralized Marketplace
Decentralized marketplaces are platforms that enable users to trade digital assets (crypto and NFTs) without intermediaries. They are one of the most used DApps because they give users complete control of their assets and identity and enable them to trade at a reduced cost. Decentralized Exchanges (DEX) are also the best place to find 100x tokens at their early stage since the barrier of listing tokens on such exchanges is usually low.
Get Insurance
Defi protocols provide insurance in relief funds against liquidation to investors or a stimulus that keeps a project afloat during a treasury hack.
Trade Synthetic Assets:
Synthetic exchanges on DeFi enable investors to trade assets, not on the blockchain. More on this later.
Play zero loss Games:
These are decentralized protocols such as PoolTogether, where users pool funds into risk-free savings accounts for a chance to earn a daily prize. The daily interest accrued is randomly shared among depositors. The money deposited into the savings account is routed to a liquid lending platform. Since the code is open-source, it can easily be verified relatively and securely.
Top DeFi Protocols on Ethereum Ecosystem
The following is a short list of Decentralized finance protocols to watch in the Ethereum ecosystem:
Uniswap
Uniswap is the largest decentralized exchange on the Ethereum blockchain. It enables users to trade or swap Ethereum and other ERC-20 tokens without intermediaries.
The exchange giant operates based on an automated market model where members deposit assets into different liquidity pools for a share of the trading fee. Users can swap from one coin to another by connecting their wallet to a liquidity pool of the pair they are interested in and then place a trade. Transactions are often quick and attract only a 0.3% trading fee.
Uniswap ranks among the largest protocols in the Ethereum ecosystem. It has a governance token (UMI) and posted $8 billion in value of locked assets at the time of this writing.
Synthetix
Synthetix is a decentralized marketplace for trading synthetic assets. You can think of it as a place to get exposure to the price of assets that don’t exist on-chain (e.g., stocks, gold, real estate) and profit from their price volatility.
SNX serves as the synthetix network’s native token. Users can stake SNX or ETH as collateral to mint synth. Synthetic assets are also tradeable as ERC-20 tokens on the synthetic.io exchange. SNX holders and miners get a portion of the trading fee anytime synth is exchanged.
Aave
Aave is a decentralized money market on Ethereum for lending and borrowing crypto assets. Suppose you have some cryptocurrency in your wallet. In that case, you may deposit it into the Aave lending pool to earn yield or use it as collateral to borrow loans.
Aave is famous for its slew of exciting products. For instance, it has high liquidity that enables users to withdraw their fund anytime, support flash loans, and offers a steady return of stablecoins.
There are over 20 lending pools on Aave, and it is used by over 100,000+ people worldwide.
Alpha Homora
Alpha Homora is an innovative product from the Alpha Finance Lab that enables yield farmers and liquidity providers to get up to 2.5x leverage on their liquidity mining exposure. This is a win-win for both parties since the extra liquidity increase Alpha Homora pool size while borrowers earn more rewards.
Fun fact: DyDx offers up to 25x leverage position to liquidity providers.
The most appealing feature of Alpha Homora is that farmed tokens are reinvested back in the yield farm daily. So, farmers earn more APY from compounding. Alpha Homora is not without its peculiar risks and vulnerability like other forms of leverage trading. It would help to read the fine prints and understand how leverage works before joining its liquidity pool.
Yearn.Finance
Yearn.Finance is the brainchild of Andre Cronje, a prominent South African programmer. He has acclaimed the grandfather of DeFi until he bowed out of Defi unceremoniously in April. But his legacy project still lives on.
Yearn. Finance aggregates the best yield farms on the Ethereum blockchain and invests users’ funds into them. It is a crucial DEFI tool that saves liquidity providers undue stress looking for the best high-yield farm. The protocol provides assets to a host of high-yield lending protocols on Aave, Uniswap, dydx, Compound, Fulcrum, etc.
Furthermore, yearn. Finance also enables users to earn high APY on WBTC and stablecoin deposits.
How to Get Started with Decentralized Finance (DeFi)
DeFi is like a language. Getting fluent in it requires lots of practice. Here is a pathway to advance your skill from DeFi novice to true Defi degen.
Step 1: Create a cryptocurrency wallet
The first step in your Defi odyssey is to create a wallet to store your token and move assets across various DeFi protocols. MetaMask comes highly recommended if you want to interact with dapps on the Ethereum ecosystem. However, Trust Wallet and Phantom are best suitable for Binance Smart Chain and Solana Dapps, respectively. Here is an article and video on how to use MetaMask
Step 2: Buy Ethereum on a centralized exchange
You will need Ether (ETH) to pay the utility fee on most Ethereum dapps. So try to load your wallet with as much ETH as you can afford to practice with. The best way to buy ETH as a beginner is through a centralized exchange that accepts your local currency. Here is a helpful guide on how to buy on Binance
Step 3: Swap ERC-20 tokens on a decentralized exchange
ERC-20 tokens are coins that are compatible with the Ethereum blockchain. You can use Ethereum-based decentralized exchange such as Uniswap to swap from one ERC-20 token to another. Navigate to the official Uniswap website, connect your wallet, choose the pair you want to swap, and sign the transaction in your wallet. Here is an article and video about Uniswap’s basic
Step 4: Deposit in a lending protocol
Want to make your crypto work for you? Invest it in a DeFi platform to earn yield. Decentralized lending platforms enable users to supply funds or take out loans while remaining in full custody of their assets. Examples are Compound and Maker. Hover to the official compound website and familiarize yourself with the interface. Check the kind of tokens you can deposit and borrow. Follow the prompts to lend out the supported tokens for decent rewards or approve your coin as collateral to borrow another token. Here is an article and video on how to use Compound. Check out DeFi pulse to discover other DeFi lending platforms.
Step 5: Become a liquidity provider
A liquidity provider provides liquidity to a decentralized exchange liquidity pool to earn a fraction of transaction fees. This is the stuff of a DeFi intermediate. To continue this step, you must learn about impermanent loss and decide on the pool you want to belong to. Here is an article and explainer video on adding liquidity to Uniswap pools.
Step 6: Automated yield farming
Maximize your return by moving your liquidity pool token into a yield farming DeFi protocol to earn reward tokens. Coingecko is an excellent place to find yield farming opportunities. But you will soon discover that rewards constantly change, and keeping up with the rate may be an extreme sport. Instead, liquidity aggregators like to yearn.finance finds the most lucrative pool for you automatically.
Step 6: Buy synthetic assets from synthetix to diversify your investment portfolio.
Step 7: Earn yield on yield with liquid staking on Lido
Step 8: Once you gain proper mastery of how DeFi works, you may decide to build a Dapp or participate in community governance by drafting proposals.
Challenges of Using DeFi
The present Defi ecosystem has some challenges it must first overcome to become the core element of our financial system. These include:
Technology risk
Smart contract bug is a severe issue in DeFi. It will likely incur a massive loss if a protocol ceases operation or loses its treasury. Defi protocols must review their code for potential loopholes and backdoors before launch. Similarly, investors must thoroughly vet projects they want to invest in before depositing their hard-earned funds.
Cluttered ecosystem
The Defi ecosystem is scattered. You’ll hardly find a Dapp that offers all the services you need. As a result, users move their assets across protocols more often than they like. To make DeFi more user-friendly, developers need to build more on-ramp protocols where users can access all their financial needs in one place.
Poor User experience
The lack of customer support on most fully decentralized financial protocols means users have to figure out how the ecosystem works by themselves.
Fluctuating asset prices
The relative volatility of crypto assets poses a problem to the mass adoption of Defi. There are several cases where the price drops have put users in lousy debt and made them lose their share of a 50/50 liquidity pool.
Conclusion.
The motive of decentralized Finance is to weaken the stronghold of centralized financial institutions by giving users full ownership and control of their funds.
While this may sound unrealistic, data suggest that millions worldwide now save money, obtain loans, earn interest, and carry out different financial services on Dapp without relying on mediators.
However, it would help to note that decentralized applications have risks and limitations. This makes sense because the technology is still new and developing.
As more blockchain support smart contracts, decentralized products that give users more complete and cheaper access to financial services will develop.
Nevertheless, the DeFi ecosystem is worth paying attention to. Hopefully, this post streamlines your entry into the crazy world of Open Finance.
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