Before you download MetaMask and start your DeFi or decentralized finance journey, we would like to introduce the key terms and ideas that make decentralized finance possible.
So, you are a complete beginner and have been hearing about DeFi and crypto. You’d also love to get started. Well, you are in the right place! This article will be part of a beginner-friendly series introducing you to decentralized finance (DeFi).
If you’re asked, “What is DeFi?”
Financial applications on an open, programmable blockchain for activities like saving, lending, sending money, trading, investing, and more. If your friend asks you, “Why should I care about or use DeFi?”
DeFi provides an alternative to your financial system that offers permissionless access anytime and anywhere there is an internet connection. For the first time ever, you don’t need to be interviewed by some stodgy banker for a loan or submit significant amounts of personal information to an exchange to trade. Anyone can gain access, provided they have the necessary resources to send transactions on the network.
Alright, let’s get started with the basic terms that will guide your journey.
What is Finance?
Finance is defined as the management of money and includes activities like saving, borrowing, lending, investing, budgeting, and forecasting. Finance can be seen as a societal tool to manage resources, risk, and rewards across space and time. Today, financial services represent ~20% of global GDP.
What is DeFi?
Decentralized Finance (commonly referred to as DeFi) is a blockchain-based form of finance that does not rely on central financial intermediaries such as brokerages, exchanges, or banks to offer traditional financial instruments, and instead utilizes smart contracts on blockchains, the most common being Ethereum. These decentralized applications (Dapps) and protocols (instructions for interactions between computers) allow anyone to access them and build services on top of them without requiring permission. DeFi provides solutions and new capabilities to the same timeless economic needs: Pay, Save, Trade; most DeFi activity occurs on Ethereum.
🔐 You can think of the blockchain-based DeFi app as a vending machine that dispenses financial transactions. A coin is inserted, and a financial activity occurs.
A blockchain is a decentralized database comprised of unchangeable, digitally recorded data in packages called blocks. Each block is ‘chained’ to the next block using a cryptographic signature and secured by nodes in a network spanning the globe. The blockchain database automatically updates when new transactions are verified, and each computer that is part of the network comes to a consensus regarding the correct history of transactions.
🔥 When you think blockchains, think of a collaboration tool we use to agree on who owns what. A bunch of computers has a copy and cross-verify transactions.
Why would anyone operate these computers? Computers that are selected by the consensus mechanism receive a reward. This reward is an economic incentive that aligns all the operators with maintaining the security of the network. To use the network, users pay a fee further compensating the computers that secure the network. The process of extending the blockchain leads to the creation of the currency.
Blockchains networks allow people to model scarcity with computers and have them all agree without needing to trust middlemen. Ethereum is the most-used blockchain in the world and the basis of other applications, like DeFi.
At the heart of DeFi is the ability to create open-source, permissionless, and decentralized systems. Being open-source means anyone anywhere can inspect the code to assure its safety. It also means that people can share their knowledge and innovate new products and ideas quickly. In the same way that peers review, open access helps the progress of science, open-source help the progress of our technical infrastructure. DeFi is made possible by the existence of programmable blockchains like Ethereum.
When you think DeFi, think of services to enter relationships of owing or owning something. They are accessible by anyone. A bunch of computers has a copy and cross-verify transactions.
What makes Ethereum a programmable blockchain is the ability to store and execute programs within it. These programs are called smart contracts. Smart contracts are where the business logic of DeFi applications resides. Since anyone can call and interact with them, these financial applications are permissionless. Furthermore, all smart contracts reside on the same system, allowing data sharing to be seamless.
Why use DeFi applications?
You can access similar products at lower prices if you already have banking services by removing the middlemen. With proper research, you can find projects with amazing rates of returns similar to early-stage startups.
If you are a fintech startup, you can create products with a software stack that is interoperable, composable, permissionless, and offers a greater range of possibilities out the box. The back office for financial operation is a $USD 250 billion market that is ripe for disruption.
Suppose you do not have access to banking services. In that case, you finally have an alternative to your local institutions, which may not be reliable, may not offer low-cost services, or may exclude you for a variety of reasons. Globally, 1.7 billion people cannot access simple banking services. Billions more find it hard to access sophisticated financial services, stunting growth.
DeFi improves upon the current financial activities by extending its capacities due to its programmable nature. It improves:
- Transferring funds – instant settlement with transactions taking ~15 seconds.
- Low transfer fees – The cost to send $1 or 1 billion dollars is the same.
- Borrowing – DeFi allows anyone to borrow capital as long as they meet the preset parameters, regardless of their background
- Lending – DeFi apps usually offer higher rates of returns and streaming payments.
- Fractional ownership – DeFi allows users to own a fractional share of any digital asset represented by a token.
- Derivatives – DeFi platforms enable anyone to create synthetic exposure to any asset class. Due to its wide distribution, people outside US markets can gain exposure to US equities at a lower cost in a more straightforward manner.
- Stablecoins – Digital currencies pegged to a currency like the US Dollar allow users to hedge against their local currency’s depreciation and retain their wealth.
- Governance – Transparent, decentralized organizations allow users to manage their money directly, eliminating the moral hazard of management taking excessive fees from an underperforming investment vehicle.
- Markets – The creation of a 24/7 community-owned and managed.
Unlocking illiquid investments – DeFi presents the ability for illiquid assets like Real Estate to be tokenized and listed on exchange markets.
- Decentralized exchanges – 24/7 access to trading markets with ample competition to keep fees low. These entities allow for the easy listing of any asset represented by cryptocurrency tokens since both reside on the same system.
- Trustless escrow – DeFi significantly reduces counterparty risk by using programmable, immutable, and verifiable code to hold value and only disperse under the agreed-upon conditions. Trustless peer-to-peer swaps with efficient and easy, without having to trust a third-party entity.
What are the high-level benefits of DeFi:
DeFi provides various benefits compared to traditional financial applications:
Higher returns: although risky, accessing DeFi services could yield higher returns than traditional financial products
- Permissionless: no need to ask financial institutions to create or use services.
- Access: anyone anywhere in the world with a computer can access or create innovative financial services.
- More choice: Faster innovation in financial services.
- Interoperability: the ability for services to easily interface with one another.
- Composability: the ability for financial services to easily mix, match or extend each other. They are modular like “money legos.”
- Decentralization: allows for a more robust system that is less prone to failure or systemic collapse.
- Auditability: This allows entities to easily verify transactions so they can be more trustworthy.
- Censorship resistance: protects individual rights to participate in economic activity.
- User custody: users keep complete ownership of their assets or data.
- Peer to peer: so users can engage in direct and trade with few or no middlemen.
- Trustless: specific tools reduce counterparty risk.
- Privacy: specific projects are working to protect your privacy.
- Cheaper: Lower fees, easier to move large amounts of money with easier access to capital.
It’s not all 100% benefits without risk. DeFi applications do come with some risks that users have to take into account:
- Greater user responsibility: since users can own assets without custodians.
- New security habits: users need to learn new security habits with new technologies.
- Irreversible losses: created by user errors.
- High volatility: compared to traditional assets.
- Technical risk: incorrect code can lead to hacks and loss of funds.
- Fraud: many scam projects exist.
- Phishing: hackers tricking users into sharing confidential information.
- Poor market fit: the product flops.
- Illiquid investments: can lock up your funds and create opportunity costs.
In the meantime, you can get a head start.
MetaMask – The leading cryptocurrency wallet
MakerDAO – A leading stablecoin collateralized with cryptocurrency assets
Rariable – Create, sell or collect digital items secured with blockchain
AirSwap – Over-the-counter peer to decentralized peer exchange with zero slippage
Uniswap – A decentralized exchange
Compound.finance – a decentralized automated lending protocol
yearn.finance – decentralized asset management
ChainLink – Data provider to DeFi protocols, data feed for Value Network.