You may have heard recently that DeFi is taking over crypto. But if you’re new to crypto you may be asking yourself “What exactly is DeFi?”, “How does DeFi work?”, and “Why is DeFi so important?”. There are so many different elements of DeFi that it can sometimes be difficult to define. Knowing where to start can be a nightmare! Fear not. We’ve got you covered. Firstly, let’s look at what is driving the DeFi phenomenon.
A New Alternative
Understandably, stability and confidence in traditional finance are dwindling, and DeFi is at the forefront of a shifting economic landscape. DeFi has expedited the financial overhaul that is long overdue. Having once posed a threat to the traditional financial system, it seems that now, central banks and governments are more eager than ever to adopt blockchain technology. Also, we see DeFi blurring the lines between the traditional financial world and the crypto space. But what exactly is DeFi, and how does DeFi Work?
Beginners Crypto Guide is going to help you explore the world of decentralized finance. Also, we’ll take a look at some of the most prominent DeFi protocols in the space and how they operate. By the end of this article, you’ll have gained a wealth of new knowledge and answers surrounding the question “what exactly is DeFi?”. DeFi is one of the hottest trends in crypto currently, with many believing DeFi is taking over crypto. If you haven’t learned about it already, then now is the time to start!
DeFi Is Taking Over Crypto
Since Bitcoin came into our lives over a decade ago, a great deal has changed in the blockchain industry. As the global economy looks to be crumbling around us, it appears that DeFi is taking over crypto by providing an alternative to the traditional financial system. However, before we can understand how this is happening, we must ask, what exactly is DeFi, and how does DeFi work?
What Exactly Is DeFi?
DeFi, short for decentralized finance, is an umbrella term used to describe decentralized applications (dApps) on the blockchain. As opposed to centralized applications, wallets, and exchanges, DeFi applications have no central authority or single point of failure.
However, “DeFi” is somewhat of a loose term. Perhaps a more fitting title would be “open finance”. This is because not all “DeFi” protocols are completely decentralized.
It is widely accepted that Ethereum is responsible for what we today call DeFi. Although it could be said that Bitcoin is decentralized finance, DeFi generally refers to protocols built on top of the Ethereum blockchain. DeFi Pulse is a popular website for DeFi rankings and analytics. The overwhelming majority of projects that feature on DeFi Pulse are built on Ethereum.
However, DeFi is certainly not restricted to Ethereum. The Lightning Network is a DeFi project built on the Bitcoin blockchain that aims to add additional capabilities to Bitcoin. Also, several other blockchains are emerging with innovative DeFi solutions that could eventually become as popular as Ethereum. Projects such as Cardano, Polkadot, Cosmos, and Tron are working tirelessly to provide healthy competition to the Ethereum-dominated DeFi space.
It is the popularity of Ethereum that makes it the go-to DeFi platform for developers. However, new DeFi platforms are not setting out to kill Ethereum. Network congestion, transaction fees, and scaling are the main hurdles faced by DeFi on Ethereum. Nevertheless, developers are often more inclined to build on Ethereum instead of other blockchains because the network effect makes it easy to do so. Ethereum DeFi is plug-and-play. There are hundreds of templates available to build dApps on dApps on dApps using Ethereum-based protocols.
Understandably, interoperability is a crucial part of the future of DeFi. Also, for the industry to move forward, the interaction between blockchains must be seamless, for developers and users alike. Seemingly, this is the main objective of competing DeFi blockchains. Rather than becoming an “Ethereum Killer”, as so many have tried and failed to do, many DeFi projects are instead seeking to work with Ethereum, helping to develop the decentralized finance space as a whole.
Ethereum created smart contracts in 2013. This was an absolute game-changer for cryptocurrency! Smart contracts are pieces of code that exist on the blockchain. They enable immutable transactions to be automated upon a specific set of events occurring. There is no chance DeFi is taking over crypto without the use of smart contracts! If you haven’t already, make sure to check out our article on smart contracts where we explore the endless possibilities of this innovation!
So, what is a DeFi protocol doing under the hood? Generally, most lending and borrowing platforms are a series of protocols that rely on smart contracts to generate liquidity. Usually, when funds are staked in DeFi, they are staked into a smart contract.
How Does DeFi Work?
You can think of DeFi as a sort of “money Lego”. Decentralized applications are built to be interoperable. For example, you can take out an over-collateralized loan on a platform such as Aave. This is done by locking up your crypto assets and borrowing against them. From here, you could take your newly generated capital and provide liquidity to another lending platform such as Compound and earn COMP tokens as a form of passive income.
These loans are usually over-collateralized to prevent liquidation. Providing that users can avoid liquidation, it is possible to combine several DeFi protocols and use them together to participate in what is known as “yield farming”. This recent trend led many to believe DeFi is taking over crypto, with new protocols popping up almost daily!
Yield farming is the process of capitalizing on the highest annual percentage yield (APY) for different digital assets across different DeFi protocols. By jumping from one platform to another, users can maximize returns from borrowing and lending. Not only does this create the chance to earn interest from lending, but many platforms also reward participants with governance tokens.
By having a keen eye for the ever-fluctuating interest rates and token prices, a savvy yield farmer can maximize returns by allocating crypto assets into different DeFi protocols that offer the best returns. However, yield farming can be incredibly risky. There are many risk factors to consider when yield farming and it is not recommended for people that are new to crypto.
That being said, if you’d like to learn how to make your money work for you safely in DeFi, be sure to check out Ivan on Tech Academy. The number one blockchain education platform has the most in-depth and comprehensive guides for crypto and DeFi that can be found online. Also, if you’d like to learn how to program your own flash loan, check out the DeFi 101 and DeFi 201 courses at Ivan on Tech Academy.
Centralized exchanges act as crypto custodians by holding your funds within their own cold storage facilities. Although crypto regulation is ramping up, the key issue presented by CEXs is that there is a single point of failure. Even though Binance has an emergency fund to cover losses from any potential hacks, the exchange has been hacked on numerous occasions. Also, if regulators were to shut down a centralized exchange as we have seen recently with OKEx, funds can be locked up for months, or even lost completely.
However, this is where decentralized exchanges (DEXs) come into play. DEXs such as Uniswap facilitate peer-to-peer transactions without the need for intermediaries. Rather than using an in-app wallet, DEXs can connect directly to a self-hosted Web3 browser wallet like MetaMask or a cold storage device like a Trezor. This means you have full control of your private keys, and therefore, full custody of your crypto assets.
1inch Exchange is a DEX aggregator that finds the best conversion rates for token swaps in DeFi. It works by searching all decentralized exchanges and finding the most cost-effective conversion path, ensuring you don’t pay too much for your tokens or transaction fees.
Why Is DeFi So Important?
So, what exactly is DeFi doing to help people? DeFi is important because it empowers people to generate wealth without the restrictions of the traditional financial system. Also, DeFi promotes financial inclusion by offering the same services to everyone. Whether you’re a farmer in Africa or a lawyer in the US, DeFi is open to everyone. DeFi is borderless and permissionless. DeFi does not discriminate.
The importance of DeFi cannot be understated in times of global economic instability. Fiat currencies are being devalued with quantitative easing, bail-outs, bail-ins, and stimulus cheques. While Bitcoin is the greatest store of wealth, DeFi is becoming a tool for wealth creation.
Banks simply cannot compete with DeFi. Also, negative interest rates are encouraging people to spend their money as it is devalued. However, DeFi is taking over crypto and the traditional finance sector by providing interest rates that banks can’t come close to competing with.
Not only has DeFi posed a major threat to the legacy financial system, but it has also forced the hand of centralized exchanges such as Coinbase and Binance to offer services similar to those of DeFi.
What Exactly Is DeFi Being Used For?
One important feature of DeFi is derivatives. The ability to mint synthetic assets on the blockchain gives investors indirect exposure to stocks, commodities, and precious metals. Also, this is achieved without the need for a third-party broker or large amounts of initial capital.
On a broader level, decentralized finance is empowering individuals by providing a permissionless, censorship-resistant alternative to the traditional banking system. However, DeFi is indiscriminate. You don’t need any paperwork to sign up, all you need is a crypto wallet!
How Does DeFi Work: Popular DeFi Platforms
Though there are hundreds of platforms out there, below we’ve listed some of the most highly regarded and popular DeFi protocols available.
If you were to consider Ethereum the Father of DeFi, then Maker would be its first son. Maker popularized the decentralized autonomous organization (DAO) and is a foundational layer for many other DeFi protocols. The DAO has played a crucial role in the governance of many DeFi platforms. If you’re asking yourself “how does DeFi work?”, After studying Ethereum, Maker should be your next point of reference.
The protocol was a pioneering project in DeFi and is still considered to be an essential part of the decentralized finance ecosystem.
Maker allows users to mint DAI, an ERC-20 stablecoin. DAI has become one of the most popular stablecoins in DeFi and makes up a large portion of liquidity across many platforms. Furthermore, DAI has been integrated by over 400 crypto applications and wallets.
The Compound DeFi platform is an autonomous, algorithmic lending platform and interest rate protocol. Furthermore, Compound makes it easy for developers to build dApps and other open financial applications on the blockchain.
Users can provide liquidity to the platform to earn interest, or take out a loan using their crypto holdings as collateral.
Also, the native COMP governance token was a catalyst for the summer of DeFi. The proliferation of yield farming made the COMP token reach above $336 per token, before returning to around $150 at the time of writing.
The COMP token was the ultimate prize for early adopters of the protocol, as both borrowing from and lending to the platform rewarded users with the COMP token, on top of any interest earned from liquidity provision. If you would have asked someone the question “how does DeFi work?” a year ago, the answer would have been quite different from what you might hear today. The industry is evolving rapidly, and so too is the way it operates.
Released in March 2020, Balancer is often referred to as a self-balancing crypto-ETF. Balancer is a programmable liquidity protocol. Users can create and oversee bespoke index fund-like liquidity pools, or invest in an existing pool. Furthermore, funds in these pools are self-balancing. This means that currencies within a pool can be exchanged without exiting the pool.
Balancer is an automated market maker (AMM) built on Ethereum. Users can earn fees by providing liquidity to the protocol using a variety of crypto assets. The platform works as a second layer built on top of the decentralized exchange Uniswap. Using Balancer, AMMs can create pools using unevenly-weighted assets.
This differs from many DeFi protocols that require an equally balanced asset allocation. Automated Market Makers (AMMs) facilitate market-making without the need for intermediaries. Accordingly, AMMs rely on algorithms to set the parameters of trades.
Finnish for the word “ghost”, Aave is an Ethereum-based non-custodial liquidity protocol that facilitates lending and borrowing. Aave enables users to earn interest from crypto deposits using liquidity pools.
Also, Aave created Flash Loans – the first uncollateralized loan on the blockchain. Flash Loans enable users to simultaneously borrow a digital asset, lend it out on another platform to earn interest, and repay it within a single transaction. This is thanks to Aave’s advanced understanding of smart contracts.
Synthetix is an Ethereum-based decentralized derivatives liquidity platform. The Synthetix platform is at the heart of derivatives trading in DeFi. The platform gives users exposure to a wide range of real-world assets that are tokenized and put on the blockchain.
Also, the platform allows “Synths” to be minted. Synths are price-pegged to real-world assets like shares and commodities. Also, users can earn SNX tokens by providing liquidity to the platform.
Synthetix recently launched its staking dApp. The staking dApp allows users to secure the network by locking up SNX tokens. Since the announcement, the price of the SNX token reached an all-time high of $8.61 at the time of writing.
Developed single-handedly by blockchain aficionado Andre Cronje, Yearn Finance is an all-in-one suite of DeFi products built on Ethereum. The platform facilitates lending aggregation, yield generation, and insurance. Additionally, the platform is governed by holders of the native YFI token.
One of the most innovative features of Yearn Finance is the protocol’s Vaults. This feature allows users to allocate funds to Vaults that follow automated strategies to maximize yield. Users can also move funds between different lending protocols to maximize yield using the Yearn Finance protocol.
Yearn Finance is a one-stop-shop for automated DeFi applications. The platform took the crypto world by storm in late 2020 as the YFI token price shot up to over $43,000. The reason for this is the tokenomic model adopted by Yearn Finance. Thanks to mathematically verifiable scarcity, the YFI token is the best performing DeFi governance token to date.
What Exactly Is DeFi & How Does DeFi Work? Summary
So, what exactly is DeFi, how does DeFi work, and why is DeFi so important? To some, the answer is simple. The legacy financial system excludes many people from accessing the most basic financial services. Fiat currency is losing purchasing power and people are seeking alternatives.
However, it’s important to remember that many DeFi protocols are still in their infancy. Technical problems can occur and protocols can be hacked. This is a new technology and some of the kinks are yet to be ironed out. Despite this, DeFi has come a long way in a very short period in terms of security and stability. Regardless, DeFi is taking over crypto and shaking up the traditional financial system.
Smart contract failure is an inherent risk of DeFi, but the major players in the DeFi space have worked tirelessly to safeguard these protocols. There are many high-risk DeFi protocols and scams around. However, with the correct risk management, DeFi can be extremely profitable. Remember, always do your own research and never invest what you can’t afford to lose!
See our top trading mistakes article to avoid getting rekt!
Defi Is Taking Over Crypto Conclusion
Hopefully now, when someone asks you “How does DeFi work?”, or “What exactly is DeFi?” you can provide a thorough and comprehensive overview of the vast expanse that is decentralized finance. Also, you’ll be able to explain exactly how DeFi is taking over crypto.
Many DeFi applications are now evolving to incorporate more functions and utility. Resultantly, many centralized exchanges are beginning to branch out into DeFi services. Most notably, Binance has created a suite of services that include several features of DeFi, plus a Launchpad for new crypto projects. If you haven’t heard about crypto launchpads, be sure to check out our latest article on the Top 5 Crypto Launchpads!
Disclaimer: This is NOT financial advice. Beginners Crypto Guide does NOT OFFER formal nor informal financial advice and accepts no liability for such service. You should always do your own research before making any financial decisions.