Learn Cryptocurrency
14 Jan 2021

Beginner’s Guide to (DeFi) Decentralized Finance

CoinSwitch Kuber

DeFi is an accessible international banking system designed for the internet era as an alternative to an invisible, tightly regulated system held together by decades-old technology and practices. It allows you to have control and visibility over your money. It also exposes you to global markets and provides alternatives to your national currency or banks. 

DeFi enables access to financial services to anyone with an Internet connection and is generally owned and operated by the users. So far, tens of billions of dollars in cryptocurrency have passed through DeFi apps, and the amount is rising by the day.

Let us attempt to understand DeFi, its components, applications, and the risks and rewards associated with it.

Key takeaways:

  • DeFi is an abbreviation for “decentralized finance.”
  • DeFi works based on smart contracts
  • A smart contract is a kind of program that is self-executed. In simple words, it’s an automated contract that executes itself based on the conditions given.
  • DeFi architecture has four layers, namely, settlement, protocol, application, and aggregation layers
  • Transactions through DeFi can be more efficient, flexible, secure, and automated.

What is DeFi crypto?

DeFi is an abbreviation for “decentralized finance,” an umbrella term for a range of financial apps based on blockchain.

For the uninitiated, it is inspired by blockchain. And this allows many entities to retain a copy of transaction history, preventing centralized control. Moreover, this is essential because centralized systems and human controllers slow down transactions and give consumers less control over their money. Decentralized Finance makes blockchains unique with its applications (discussed further).

Similarly, large corporations also take care of financial applications including loans, insurance, crowdfunding, derivatives, and more. So, one of the ultimate benefits of Decentralized Finance crypto is removing intermediaries from all transactions, unlike the traditional banks.

How does DeFi work?

DeFi works based on smart contracts. A smart contract plays the role of a traditional bank. A smart contract is a kind of program that is self-executed. In simple words, it’s an automated contract that executes itself based on the conditions given. When a smart contract is live, it’s designed to never change and always operate as planned.

DeFi Benefits

For example, if a smart contract is designed to transfer funds from Account A to Account B every Tuesday, it will not do unless Account A has the necessary cash; similarly, no one has the authority to modify the contract by any means.

Components of DeFi

DeFi requires stable currencies and a wide range of use cases, just as existing financial ecosystems. Stablecoins, crypto exchanges, and lending services are DeFi components. Smart contracts enable DeFi apps to function by encoding the conditions and actions required to run these services.

A smart contract code, for example, contains a particular code that defines the exact terms and circumstances of an individual loan. Assets may be liquidated if specific terms or circumstances are not met. All of this is accomplished through a particular code, rather than by a bank or other organization manually.

These smart contracts lay the basic foundation for DeFi. These contracts can simply change the way we deal with finance. These smart contracts operate on four layers, which are as follows:

Settlement layer

The settlement layer is the foundation for all Decentralized Finance transactions. It has a public blockchain and its own digital money. Transactions on DeFi applications use this money, which may or may not be exchanged publicly. Ethereum and its native token (ETH) are examples of the settlement layer. 

Protocol layer

DeFi protocols are interoperable, which means they may be utilized by various companies to develop a service or app at the same time. The protocol layer is responsible for the liquidity (High volume of assets) of the DeFi ecosystem. Synthetix is an example of a DeFi protocol. It’s utilized to make simulated copies of real-world items.

 Application layer

The application layer is where a consumer uses the DeFi app. These apps turn protocols into easy consumer services. This layer contains the most popular cryptocurrency applications including decentralized cryptocurrency exchanges and lending services.

 Aggregation layer

This layer enables smooth money transfers between financial assets to enhance profits. Physically, such a trade would involve a lot of paperwork and organization. But here, a tech-based structure is used to invest and let traders swap services easily. This involves lending and borrowing of DeFi crypto. 

Relationship between DeFi and Ethereum 

Most “DeFi” applications are based on Ethereum, the world’s second-largest cryptocurrency platform. And Ethereum is easier to use than Bitcoin to develop decentralized applications.

Since Ethereum’s smart contract architecture is more flexible to execute transactions, these smart contracts are created using Ethereum programming languages like Solidity.

For example, a user wants money transferred to his friend next Tuesday, but only if the temperature exceeds 90 degrees Fahrenheit. A smart contract can contain such rules. Dozens of apps run on Ethereum, some of which are discussed here. The upcoming Ethereum 2.0 network update may help these apps by addressing scalability concerns.

How to invest in DeFi?

  • Decentralized exchanges (DEXs): DEXs are exchanges that allow users to trade cryptocurrencies directly without having to trust an intermediary.
  • Stablecoins: You can invest in a stablecoin: a cryptocurrency that is linked to a real asset (like USD) to steady its price.
  • Lending platforms: These platforms employ smart contracts to replace middlemen, like banks, in the lending process.
  • “Wrapped” bitcoins (WBTC): A method of delivering bitcoin to the Ethereum network that allows direct utilization in Ethereum’s Decentralized Finance mechanism.
  • Yield farming: You can also invest in DeFi through Yield farming. Yield farming is a strategy for educated traders who are prepared to take on risks, in which they search through numerous DeFi tokens for possibilities of higher returns.
  • Liquidity mining: Another great way to invest in DeFi crypto, liquidity mining is when  DeFi apps attract users to their network by offering them free tokens. For example, if you deposit money in a bank, you will receive interest. Similarly, if you lend your crypto to a new crypto platform, they will pay you interest. The main distinction between a bank and liquidity mining is that liquidity mining has the potential to generate more interest than banks.

Potential Rewards of DeFi

Transactions through DeFi can be more efficient, flexible, secure, and automated, unlike traditional finance.

DeFi also bridges the gap between ordinary customers and wealthy persons or organizations. Anyone may join a DeFi lending pool and lend money. The risk is higher than a Certificate of Deposit, but the potential payoff is larger. (Easy access and large payoff)

That’s not it. Since DeFi services are open-source software, they may be easily incorporated and modified. They can, for example, automatically transfer your assets across various collateral pools based on your investing profile. 

Potential risks of Decentralized Finance

It is critical to recognize that investing in DeFi is extremely risky.

There are three primary categories of risk to consider, which are as follows:

1. The dangers of technology

Smart contracts pose a risk of flaws in a DeFi protocol if there’s even a slight inconsistency in the developer’s code. 

 2. Asset risks

When borrowing on a DeFi program, you generally provide collateral in the form of other crypto assets that you possess. DeFi protocol Maker, for example, demands borrowers to collateralize their loan for at least 150 percent of the loan amount.

Since cryptocurrencies are volatile, their value swings often. If there is a downturn, the value of the crypto assets collateral may fall. And this might force some investors sell their positions. This could create huge losses for investors.

3. Product risk

It’s also worth noting that, unlike with a regular bank, no regulation or insurance is protecting your money when you use Decentralized Finance. And most importantly, DeFi loans are collateralized with other crypto assets. This means, borrowers who use these protocols aren’t liable if they are unable to repay a loan efficiently.

Is it safe to invest in DeFi?

Since Decentralized Finance is relatively new, it is both dangerous and promising. The ecosystem still has some serious challenges, ranging from security risks such as smart contract weaknesses to technological dangers such as being locked out of your wallet. Aside from the risks, DeFi can be extremely beneficial. The business is young and vibrant, with various new ventures that outperform what traditional financial intermediaries have to offer.

FAQs What Is Decentralized Finance:

Q1. How decentralized finance works?

Decentralized finance is a blockchain-based type of finance. And it uses smart contracts instead of central financial intermediaries like brokerages, exchanges, or banks to supply traditional financial products.

Q2. What is Decentralized Finance?

Decentralized finance is a system that eliminates intermediaries while making transactions.

Q3. Is decentralized finance safe?

Defi continues to be subject to dangers like market fluctuations, smart-contract hacking, and a lack of advancement.

Q4. Which is better; centralized or decentralized?

Well, it depends on the needs of the organization or the individual, in my opinion.

Final thoughts

DeFi claims that anybody with an internet connection anywhere in the world would be able to access any global currency, earn interest on deposits, and obtain loans instantaneously. 

Even getting access to a solid USD-backed currency is revolutionary in certain emerging nations. This could ultimately revolutionize finance.

 

Disclaimer : Crypto products and NFTs are unregulated and can be highly risky. There may be no regulatory recourse for any loss from such transactions. The information provided in this post is not to be considered as investment/financial advice from CoinSwitch. Any action taken upon the information shall be at user's own risk.

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CoinSwitch Kuber

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