Beginner’s Guide to Decentralized Finance (DeFi)

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Beginner’s Guide to Decentralized Finance (DeFi)

Feb 5 2021

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DeFi, or Decentralized Finance, is undoubtedly the biggest trend of 2020. The trend came in the middle of the COVID-19 pandemic, going big around the same time as people were getting locked up in self-isolation, afraid of the virus and the way it spreads. At the same time, interest in the crypto industry surged as it promised contactless payments, as well as rising prices of coins like Bitcoin, Ethereum, and alike.

  • DeFi sector aims to bring banking features to the decentralized world.
  • Decentralized finance offers services like lending/borrowing, staking, yield farming, and more.
  • DeFi also offers services like tokenization, which has a growing use in ownership sharing.
  • Another major product of DeFi is the stablecoin market, which serves as a safe haven from crypto volatility.
  • While DeFi is largest on Ethereum, where it was invented — it is expanding to other blockchains.

So, we could say that the crypto industry offered safety, interesting new assets, a way to earn, and that was more than enough to attract most people. With fiat currencies once again in danger due to the banks’ decision to start printing money to provide momentary relief, they also emerged as highly desirable investment opportunities, especially since the stock market plummeted due to COVID-19 fears.

The DeFi sector, which has been around for years, only nobody really paid any attention to it, chose that time to emerge and attract interest, and ever since then — it has been exploding at a rapid pace.

What is DeFi, actually?

As mentioned, DeFi is short for decentralized finance, and it represents a sector of the crypto industry that provides crypto users with services similar to those that banks offer regarding traditional currencies. While banks are definitely warming up to crypto, they still mostly do not provide anything more than custody services, and even that is mostly reserved for institutional investors only.

Meanwhile, retail users turned to decentralized banking services offered by decentralized finance. Services such as decentralized exchanges (DEXes) staking, lending/borrowing, yield farming, and more all became great methods to earn a passive income by supporting networks with your coins.

So, not only did users manage to keep their coins safe and free of risk that is usually associated with trading, but they also managed to increase their wealth by helping with transactions processing, providing liquidity, and more.

The DeFi sector surged drastically since it emerged. Back in June 2020, just before the summer when it truly went off, the entire sector had $1 billion dollars in TVL (Total Value Locked), which was considered a new record at the time.

These days — a little more than half a year later — the DeFi TVL sits at $41.78 billion according to DeFi Pulse, and it continues to climb up, as the interest in these services only continues to grow alongside it.

How does DeFi work, and why is it attracting so much attention?

As the name suggests, the core principle of DeFi is decentralization. By now, most people who know of crypto understand the industry’s main purpose, which is to take the power away from the banks and return it to the community. Through decentralization, there is no single entity that controls everything, that manages the money, or one that can freeze that money and deny service to anyone.

All transactions are managed by the community, and every member is responsible for keeping their own money safe.

The DeFi sector is no different. Borrowing and lending, for example, is done between community members. Basically, if someone has extra money that they wish to store, they can either lock it up inside a wallet and wait for its price to grow, which could take years — or they can lend it and get it back within a certain time period, with interest. The second method is no different from locking the funds away, in the sense that you won’t be using the money. However, instead of simply waiting for the price to grow, you can also earn interest and increase your wealth.

Then, there is staking — a process of locking up your coins to provide liquidity and earn a reward in exchange for your contributions. The concept is similar when it comes to yield farming, which involves lending coins via the ETH network. You will also receive rewards for helping out through interest.

All in all, it is a way to make your extra money useful to the community, and receive something for doing so. Anyone can do it, and earn free money in exchange, which is likely one of the reasons why projects like these are doing so well.

Lending, however, seems to be the most popular decentralized financial service in the industry, which is understandable. Lending/borrowing works similarly to how it works in traditional finance, only there are no banks involved, as mentioned. But, if you are borrowing money, you still need to prove that you can pay back the loan by providing some kind of collateral. However, that’s the only requirement. It is faster and simpler, done through smart contracts, and there is interest that you need to pay if you are borrowing money.

The reason why we say that lending is the most popular is the fact that the top 3 DeFi projects based on Total Value Locked are all lending protocols — Maker (TVL $6.84 billion), Aave (TVL $5.62 billion), and Compound (TVL $5.11 billion).

After that, decentralized exchanges, or DEXes, are the biggest protocols around. The biggest one so far used to be Uniswap, although it was recently dethroned by another one called Curve Finance, which currently holds the 4th position in the DeFi sector. Uniswap sits right below it, with its TVL being only $30 million lower than that of Curve Finance at the time of writing.

There are other services, such as the ones that are porting Bitcoins to Ethereum network by locking away BTC and releasing Wrapped Bitcoin (wBTC), which results in using Bitcoin within dApps and smart contracts — something that would otherwise be impossible, since Bitcoin’s network is not a development platform. Some projects offer decentralized price oracles that aim to deliver accurate prices from a number of exchanges and avoid price manipulation, and more.

Basically, possibilities are endless, and the rise of DeFi truly shows that the crypto industry is maturing, as it is looking for ways to earn money without relying solely on price movement.

  • DeFi is imagined as the future of digital finance.
  • It removes expensive intermediaries like the banks, and makes loans and other ways of making money a lot more accessible.
  • DeFi is still at the beginning of its development, and a lot is likely to change in years to come.
  • In order to use DeFi tokens, special ERC-20 supporting wallets like MetaMask are necessary.
  • As of December 2020, Ethereum started Phase 1 of Ethereum 2.0, allowing users to start staking ETH as well.

How to enter the DeFi sector?

If DeFi sounds interesting to you, and you wish to try it out, then there are certain steps that you need to take. The process is not complicated by any means, but there are a few things you need to do in preparation.

The first step would be to prepare a wallet that supports Ethereum-based coins. There are several wallets that you can choose, but the common option is MetaMask. After that, you can find a platform that offers DeFi tokens, and purchase the ones you like. Of course, you would first have to do a bit of research and familiarize yourself with different DeFi projects, and figure out which one(s) you are interested in investing.

Then, and only then should you go and buy the coins for the DeFi protocol that you wish to use.

You may have noticed that this guide is talking about Ethereum-based tokens, specifically. Ethereum is not the only platform that offers DeFi projects. Many others have recognized the potential of the DeFi sector and have added support for DeFi on their platforms. However, Ethereum remains the birthplace of DeFi, and the most popular platform for developing these projects.

If you find a DeFi project that is based on another network, you will, of course, need to obtain a wallet that supports that network’s coins.

The last and final step is to put your coins to use. Let your money make more money, without you having to move a finger to earn it. That can be anything of the processes that we already mentioned, including staking, lending, yield farming, and alike. You can even go to a decentralized exchange and grant the use of your tokens to this platform. As a result, you will help it provide liquidity and become its market maker. In return, you will receive a percentage of the fees that come from the DEX’s use. We mentioned some of the biggest DEXes already, including Curve Finance, Uniswap, or its biggest rival, SushiSwap, which is the third-largest DEX at the time of writing.

Be careful when investing and trading

Whatever you decide to do, remember one thing — while using DeFi tokens to earn is less risky than trading, it is not completely risk-free. You can still invest your money in a project and then see its price drop, which would cause losses for you. Even if we exclude that — DeFi is young. It has been less than a year since the development of the sector has started, and a lot of it still remains highly experimental.

There are also common threats, such as scammers and hackers who will prey on naive traders, so do your research and think twice before you give money to someone. Try not to use ‘emerging’ services that no one has heard of. Read reviews, user impressions, projects’ white papers, and more.

The crypto industry remains quite risky, with issues like volatility, hacks, and scams still troubling the sector, mostly due to the lack of regulations and new users’ inexperience.

What are the other benefits of the DeFi sector?

So far, we have mostly focused on projects that allow you to earn passive income by using your existing money. However, that is not all that DeFi can do. As we already mentioned, there are many possibilities — most of which were not even discovered yet due to DeFi’s young age, if you believe crypto experts.

For example, there is tokenization, which also falls under the category of DeFi. Tokenization is the process where you can take a real-world asset and create its digital version through tokens. The asset in question can be anything, from stocks to real estate, art and jewelry, gold, expensive wine, and more. Anything can be tokenized, although this is mostly used for things that cannot be easily split into fractions.

By taking an asset and tokenizing it, you are creating a number of tokens, each of which represents ownership of the asset, and has a corresponding value. So, if you cannot buy an expensive painting, but you are willing to share ownership of it, you and a number of other people can purchase certain amounts of tokens that represent your partial ownership of that painting. It is easier, faster, and safer. Best of all, thanks to the immutability of the blockchain, you will have permanent proof that you are the (partial) owner of the asset.

Then, there are stablecoins — cryptocurrencies that are pegged to a real-world currency or some other asset that gives it its value. The biggest and best-known stablecoin in the crypto industry right now is Tether (USDT), which is pegged to the US dollar. That means that every USDT coin is backed by $1, and its price is stationary. 1 USDT will always be $1, as long as the company behind Tether has enough money in its accounts to back every coin with $1.

Stablecoins are, therefore, considered to be immune to price volatility that forces coins’ value to go up and down. As such, they are always the first thing that investors seek out when crypto prices start to drop.

As you can see, the DeFi sector is filled with possibilities, new products, and the ability to earn money. Best of all, it represents the next step in the evolution of the crypto industry — one that is likely to remain, and not just die out as most passing trends do. DeFi is a major step in the right direction when it comes to taking the power away from the banks.

With the crypto industry being able to offer banking services in a decentralized way, it is officially more than just digital money that can be passed around. It is an ecosystem, and it brings a new era of how funds are being managed and used. Once again, the sector is rather young, and it has yet to go through the development that will make it as big as it can be. But, once it does, and the weaker projects drop out — what remains will undoubtedly be the ones that the future of decentralized finance will be built upon.