defi
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What is DeFi (Decentralized Finance)?

DeFi, short for decentralized finance, is a new way that banking services can be performed without the need for banks. Activities like savings, lending, and borrowing can be done using DeFi. DeFi aims to replace traditional banking services through blockchain technology and cryptocurrencies by eliminating the intermediaries the hold our money.

Currently, banks handle all our account balances and transactions. With DeFi, a blockchain does the heavy lifting. A blockchain is a database that tracks the flow of balances and transactions. However, these records are not kept on a central server. Records in a blockchain database are instead distributed across many nodes made up of computers or servers, a technology called distributed ledger technology. Each of these nodes keeps an identical copy of all the transactions that occur on the blockchain. 

With DeFi, smart contracts have enabled the ability to create decentralized banking on top of a blockchain. A smart contract consists of lines of code and protocols that interact with the blockchain to perform actions, like earning interest, automatically.

“DeFi” currently refers to all the financial applications that are being built on blockchain technology that provide traditional banking services without a bank or central authority. Web platforms have been developed that connect users to smart contract protocols that let them earn interest on Bitcoin, stablecoins, and other cryptocurrencies.

Note: DeFi is still in its infancy and comes with risks. People have lost funds due to scams and bugs on DeFi applications. Never deposit more money than you are willing to lose, and always do your research!

What can DeFi Do?

DeFi lets you earn interest and borrow against your cryptocurrencies all without an intermediary. Applications include decentralized exchanges, lending and borrowing platforms, liquidity mining, and yield farming.

Decentralized Exchanges

Decentralized exchanges, or “DEXs” for short, are applications that allow users to trade cryptocurrencies for other cryptocurrencies without a middleman. These exchanges are created on top of a blockchain network like the Ethereum blockchain, the second largest blockchain network right behind Bitcoin. The exchange of crypto is completely done through smart contracts that swap and process coins protocols without any intermediary.

Popular decentralized exchanges include Uniswap and Sushiswap which are web applications developed on the Ethereum blockchain. Both DEXs let users connect directly to the platform with a digital wallet to “swap” cryptocurrencies.

uniswap defi dex
Source: Uniswap.org

Lending and Borrowing

DeFi applications also allow users to lend and borrow cryptocurrencies. Applications like Aave and Compound enable lenders to earn interest by depositing crypto into a liquidity pool. A liquidity pool is a group of tokens locked into a smart contract. The pool provides supply for those that borrow the cryptocurrencies.

Borrowers of these platforms can also use their existing crypto as collateral to borrow additional crypto. Smart contracts set the rules where users must maintain a certain loan-to-value (LTV) ratio so their assets always cover what they borrow.

aave defi
Source: aave.com

Because there are no intermediaries involved, favourable rates are possible when compared to traditional banking services. Depositing USDC coin (USDC), a stablecoin that is pegged 1:1 with the US dollar, can earn an interest rate of 2.01% (at the time of writing).

Liquidity Mining

Dexes and lending and borrowing platforms are just some of the simpler forms of DeFi that resemble the services of the traditional financial industry. Because of blockchain and decentralization, the ability to do banking through code has also opened up a many new opportunities.

One of those opportunities is “liquidity mining”. Liquidity mining refers to users who supply two different cryptocurrencies (called a pair) into a liquidity pool. Users can then earn interest from the transactions that occur within that pool for providing supply and creating a liquid market. When a user of the platform makes a trade, they will pay a transaction fee. This fee makes up the return for those that provide liquidity in each pool.

Balancer, for example, lets users deposit wrapped BTC and ETH (WBTC & WETH) into a pool to earn interest. Wrapped tokens are just a new token that is created to represent 1:1 of the underlying cryptocurrency so that the original token can be compatible with another platform or blockchain.

balancer pools
Source: app.balancer.fi

Yield Farming

Although not an application, another concept of DeFi is “yield farming”. Yield farming refers to maximizing your rate of return by using multiple DeFi applications to search for a strategy that provides the highest yield.

Yield farming combines lending, borrowing, and liquidity mining to generate a higher rate of return. However, with more processes comes more risk so you should always do your own research before putting your hard earned money into any DeFi platform!

How do I Get Started with DeFi?

To start using a DeFi application or platform, three things are required:

  1. A digital wallet where you control your private keys and hold some cryptocurrencies
  2. A DeFi platform like Aave or Compound
  3. The browser extension MetaMask that connects your digital wallet to the platform

Metamask has been the most popular method to connect your wallet to a DeFi platform. The browser extension will ask for your private keys in order to work. Always make sure you are downloading Metamask directly from the official website: metamask.io.

After your wallet is added to Metamask, visit the DeFi platform to connect the wallet. Also make sure that these platforms are official websites and have the correct URL!

defi

After connecting your account, you can deposit crypto to earn interest, use them as collateral to borrow other crypto, or perform other DeFi protocols.

What are the Risks of Defi?

Of course, with new technology comes new risks. Numerous platforms have been shut down due to buggy code, developers shutting down the project, and even fraudulent scams. User error may also occur such as losing or misplacing private keys, sending crypto to incompatible blockchains, and lack of knowledge.

We highly recommend researching each DeFi project you are interested in and deposit money you are willing to lose. Because DeFi is still new, choose platforms that:

  • Have a high market cap (top 100)
  • Have a large Total Value Locked (TVL), preferably in the billions
  • Have their code audited by blockchain security companies like CertiK, Quantstamp, or Hacken
  • Are active on social media and have large followings on platforms like Twitter or Reddit

Is Defi the Future?

Blockchain and cryptocurrencies will change the way of traditional finance. The best way to learn about DeFi is to do your own research! If you are brand new to the cryptocurrency space, we recommend reading more about What is Bitcoin and How Wallets Work.

If you are comfortable to dive head on to learn about DeFi, purchase your first cryptocurrencies through an exchange and start experimenting! You will be surprised to see what DeFi can do. =)

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