Everything You Need to Know About DeFi and How DeFi Works!

Everything You Need to Know About DeFi and How DeFi Works!

You would like to get into DeFi because you have read and heard so much about it. But you don’t know where to begin? If you answer yes, you have come to the right place because our “Everything You Need to Know About DeFi and How DeFi Works” guide will give you the information you need.

A Brief History of DeFi

Remember when humans traded goods and services. They still do, but their economies went under modifications as they advanced. Slowly and gradually, we invented currency to make exchanging goods and services more accessible. And even the progress was gradual, yet it came at a cost.

Historically, central governments have issued currencies that underpin our economies. Ultimately giving them more power as more people came to trust them. However, people have lost confidence and trust, thus questioning the centralized authorities that manage their assets.

Then DeFi came along intending to create a financial system that is open to all. Moreover, its main aim was to minimize relying on a central authority. When all of these things were going on, DeFi emerged in 2009.

In the same year, Bitcoin was launched and was considered one of the first peer-to-peer digital currencies built on top of the Blockchain network. This concept revolved around transforming the traditional financial world through Blockchains. However, it was just the beginning of the decentralization of financial systems.

The 2015 launch of Ethereum and other smart contracts fueled the decentralization further. Ethereum network is a second-generation Blockchain that was the first to use this technology in the financial industry. Moreover, it encouraged businesses and enterprises to create and apply DeFi-related projects—giving rise to the proper DeFi ecosystem.

Since then, DeFi has provided hundreds of opportunities to create a transparent and robust financial system. However, DeFi is still a work in progress, and since 2020 it has seen a significant inflow of equity.

What is DeFi?

Decentralized Finance, commonly known as DeFi, refers to financial apps based on blockchain technology that allows multiple parties to conduct digital transactions.

Over the past few years, DeFi has grown in popularity due to the possibility of earning significant interest in various cryptocurrencies. Moreover, it provides numerous mainstream financial world services controlled by the masses rather than a central entity.

Initially, lending was the main reason behind DeFi.Today, DeFi applications help participants save, invest, trade, market-making, and much more. The ultimate goal of DeFi is to challenge and replace traditional financial service providers

DeFi comes from 2 different words. One is De, which means Decentralized, whereas the second is Fi, which means finance. Now “Finance” is simple to grasp. We all know what financing is and how it works.

So, what exactly is decentralization? In simple words, decentralization means that the control isn’t in the hands of a single person or entity. On the other hand, banks and other financial institutions have complete control over your funds thus can freeze your assets whenever they want.

In addition, banking services might not be available to everyone globally, and the services banks offer are expensive and slow.

If we look at decentralization, it is just the opposite of centralization. Unique goods, a faster speed of innovation, more transparency, more efficiency, and lower-cost cross-border payments are among the fundamental differences and advantages of DeFi.

DeFi is not perfect. That is to say; there has been news about hacks, scams, and bugs found with various DeFi. Therefore, it is imperative that you research and adequately vet the DeFi before connecting your wallet to it

In the world of Crypto, DeFi is a Blockchain-based form of finance. Instead of relying on a central financial institution, it uses smart contracts, including self-executing computer programs built on Blockchain to perform peer-to-peer transactions.

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How Does DeFi Work?

DeFi provides services without the use of intermediaries by utilizing cryptocurrencies and smart contracts on the blockchain technology. On the other hand, financial institutions operate as transaction guarantors in today’s financial world. Because your money passes through them, this gives these institutions enormous influence. Furthermore, many individuals around the world lack access to a banking system.

As said earlier, cryptocurrencies and decentralized finance use blockchain technology which is a database or ledger that offers transparency and security. Dapps are the applications that conduct transactions and run using the blockchain technology.

‎On a public blockchain, the decision to add a transaction to the chain is made by consensus. This means that the transaction must be valid if the majority of validators agree. If the validators agree on a transaction, then the block is closed and encrypted, and a new block is created with the previous block’s information.

You can usually use DeFi through software known as Dapps, also known as decentralized apps. As we discussed earlier, most of them are now running on the Ethereum Blockchain.

In contrast to a traditional bank, there is no application to complete or account to open. As a result, by designing your own Dapps, you can mix and match protocols to uncover new combinations of opportunities.

DeFi is not something that is based on a single principle. DeFi has many types. So, keep on reading to know some ‎of the crucial components of the DeFi world.  ‎

6 Main Components of DeFi

The main goal of DeFi is to build a new financial ecosystem that is open to all and doesn’t rely on third-party trust. That goal was only possible when the below six components acted together. So, let’s have a look at these six components one by one.

1. Stable Coins

Cryptocurrencies connected to a stable reserve asset, such as the US dollar, are known as stable coins.. While Bitcoin, Ethereum, and other cryptocurrencies are highly volatile, stable coins provide a better substitute to ease price swings.

Now you can use stable currencies for various things—from trading goods and services, making international transactions faster and cost-effective, and smart contracts to borrowing and lending assets.

If a country’s economy falls and its currency runs down, many individuals turn to stable coins. It is trading fiat money for coins tied to a different country’s currency to sustain their wealth.

There are two types of stable coins: algorithmic stable coins and non-algorithmic stable coins. DAI is an example of a stable algorithmic coin, whereas, Tether is an example of a stable coin not based on an algorithm.

Of course, many people would argue that non-algorithmic stable coins contradict decentralized currencies. However, it’s interesting to see DeFi apps using both types of stables coins.. 

2. Lending and Borrowing

Lending and borrowing are the basic components on which DeFi works. DeFi lending allows investors to deposit money and earn interest using a decentralized application. So, you can borrow money from the network and repay it with interest within a specific deadline.

A coin holder uses a smart contract to send the tokens they want to lend into a pool. Smart contracts eliminate the need for a middleman and additional expenses associated with taking out a loan.

Moreover, this also eliminates the lengthy documentation processing period. In the end, it allows DeFi to process loans considerably more quickly than a typical banking institution.

Compound, MakerDAO, and AAVE are a few examples of DeFi initiatives that allow users to lend and borrow. With over $10 Billion in assets locked in the protocol, Compound is now the largest DeFi lending as well as borrowing application available.

3. Derivatives

The value of Derivatives contracts depends on the performance of an underlying financial asset. Generally, stocks, commodities, currencies, market indexes, and other assets form an underlying asset.

As we know, in the DeFi derivative markets, anybody can make a contract tied to an asset. As a result, DeFi derivatives are more accessible because users don’t need to submit confirmation of identification or eligibility. Synthetix is the major DeFi program in this field. 

4. Decentralized Exchanges (DEX)

.Decentralized exchanges (DEX) are cryptocurrency exchanges that allow buyers and sellers to collaborate directly. It enables users to conduct transactions over a peer-to-peer network.

Additionally, it will enable you to exchange multiple cryptocurrencies. But remember one thing: you can’t buy digital assets with fiat money from your bank account using decentralized exchanges.

The elimination of intermediaries, the prevention of market manipulation, and anonymity are advantages of DEXs. They also provide faster and less expensive transactions compared to centralized exchanges.

DEXs use smart contracts, which self-execute under predefined conditions and log each transaction to the Blockchain. These secure transactions are indeed a great addition to the digital finance industry..

Moreover, there are four crucial types of DEXs: DEX aggregators, order book DEXs, automated market makers (AMM), and liquidity pool-based. Here, the thing to consider is that each type of decentralized exchange allows seamless trading opportunities between end-to-end users via smart contracts 

5. Insurance

Insurance is a centralized finance feature that can be duplicated in a decentralized environment. It refers to buying coverage or getting compensation against losses caused within the DeFi industry 

For instance, insurance is utilized in the DeFi space to cover deposits and against any uncertain event, including exchange hack, attack on DeFi protocols, smart-contract failure, and more. Nexus Mutual and Open are two popular initiatives in this category. 

6. Margin Trading

DeFi crypto margin trading, like traditional finance, refers to using borrowed cash to increase shares in a specific asset. You can take it as a method to amplify trading results or to maximize profits from trading. The traded financial asset serves as security for the loan. 

In addition, Leverage and shorting are the two main components of margin trading. Leveraging occurs when you, as a trader, borrow assets to enhance the number of assets traded. 

On the other hand, Shorting is when you borrow an asset to sell with the expectation that the asset’s value will fall. Fulcrum and dYdX are examples of Crypto margin trading platforms. 

DeFi: A New Way for Financing!

DeFi is paving paths towards a brand-new financing system in the future. However, we think that this isn’t way too far as it opposes the centralized financial system by discarding typical controllers and empowering ordinary people with the help of peer-to-peer trades.

Decentralized finance is opening up the folds of traditional finance into much more simplified finance. DeFi uses essential key points of the conventional financial system and insurers to make lending, borrowing, and trading easy to access for ordinary people.

So, you can now put your money in an online savings account and get 0.50 percent interest on it. Then, the bank lends that money to another customer at a 3 percent interest rate, pocketing the 2.5 percent profit.

Similarly, traders use DeFi to lend their funds to others without third-party interaction, avoiding the 2.5 percent profit loss. Thus instead of saving your funds in a bank, you can lend them directly to another person for 3 percent.

You must be thinking that it is just how I send money to my friends through traditional financing, then how is it so different.

Well, to send dollars to your friend, you must still have a debit card or bank account linked to those banking apps. In brief, these peer-to-peer payments are still relying on centralized financial intermediaries. The following section will explain the benefits of using a DeFi.

What Are the Benefits of DeFi?

At this point, you might have already pointed out the pros about DeFi. To give you a brief outline of these benefits, have a look at the following points.

• You aren’t required to disclose any personal data. Therefore, there is no breaching of personal space. Instead, you get access by creating a wallet
• You can relocate your assets anywhere, at any time, without requesting permission.
• Interest rates and prices are frequently updated in real-time and much higher than on traditional Wall Street.
• Everyone engaged has access to the complete collection of transactions.
• You are the sole controller of where your transactions are and how to use them.
• No third-party involvement. 
• Loans and insurance without a credit score may be more accessible.
• Higher interest rates may be available.

Some Probable Odds of DeFi!

Every process has both its advantages and drawbacks. In the same way, DeFi itself is an incredible financial system, yet it has limitations. So let’s get through them!

Technology Risk

Collections of codes known as smart contracts are required to execute a set of instructions for DeFi apps to function. However, if there is a problem with a developer’s code, then you’re going to land in a faulty DeFi protocol.

In short, if correctly coded, then the DeFi will perform well. Unfortunately, most of the time, users might commit unforeseen mistakes in the code that governs these protocols, which eventually results in future complications in the system. 

Product Risk

A new pool or some new yielding method that has not been might have higher yields because they haven’t been evaluated. However, how your product or investment is generated involves a substantial level of risk.

In addition, unlike typical banks, there’s no insurance or protection for safeguarding your assets when you use DeFi because DeFi loans are secured with other crypto assets.

Therefore, the borrowers using DeFi protocols can’t be held liable if they can’t repay a loan. These risk considerations are one of the reasons why experts advise investing just what you can afford to lose. Plus, performing comprehensive research beforehand investing is a must

Asset Risk

Let’s assume you are borrowing assets on a DeFi program. So, you often provide security in the form of other crypto assets you already own. DeFi protocol Maker, in this case, will demand borrowers to lend their loan for at least 150 percent of the loan value. As we know, cryptocurrencies are volatile; thus, their value changes regularly.

If there is a downturn, the value of the crypto assets used as security may fall, thus forcing investors to close their position at a loss. Hence the reason some people utilize Stablecoins, which are supposed to be secured and, therefore, less volatile.. 

How is DeFi Different from Bitcoin

Both of these terms are a bit confusing, and as a beginner, you might not be able to tell them apart. But they both have a slight difference that makes them different from one another.

So, Bitcoin is a decentralized digital currency that operates on its Blockchain. It works without an administrator or central bank, and users can buy and sell it via any peer-to-peer network without any middlemen. 

In comparison, DeFi refers to financial services built on public Blockchains such as Bitcoin and Ethereum. For instance, it allows users to earn money by either borrowing, lending, or staking against their cryptocurrency holdings.

Moreover, it comprises several applications that revolve around financial services, including buying and selling, lending and borrowing, and more.

Okay, let us make it to the point: Bitcoin is a type of cryptocurrency, and DeFi is built to acquire cryptocurrencies in its ecosystem

How Do People Make Money in DeFi?

People are attempting to make money while working on DeFi in various ways. Besides other ways, using Ethereum-based lending apps to generate passive income is one of the best options.

What happens is that users lend their money and earn interest on the loans. But that’s not the only way. Another approach is yield farming. However, this approach is a bit riskier and is usually suitable for expert traders.

DeFi involves risk, especially when you’re employing new technology. Besides, it’s even riskier if you are a newcomer tempted by the potential profits of yield farming and passive income. But you need to understand patience is the only key! 

What Can You Actually Do with DeFi?

Like you do with your traditional financing, you can do the same with DeFi. You can make transactions, lend or loan assets, transfer money, buy the insurance and invest for the future—all is possible with DeFi.

However, one advantage that makes DeFi stand out is that the transactions are quicker. Plus, you don’t need to carry out any documentation or permissions. The process is just simple and available to all.

How to Get Started with DeFi as a Beginner?

So, now as you are all aware of DeFi, it’s time you learn the proper process to get started with it. Below is the step-by-step guide on how you can begin with DeFi, even if you are a beginner.

Step 1: Set Up Your Wallet

The first step to begin is setting up your wallet. For this, all you need is to have a cryptocurrency wallet loaded on your browser. A preferable one is your personal choice and the one that supports Ethereum. Besides, make sure that you can connect it to several DeFi protocols. Click here to learn more about wallets.

MetaMask is one of the most widely used wallets. But this is not the only crypto wallet available. There are many other wallets available that you can use to connect and interact with DeFi. 

Let’s make it simpler using the MetaMask:

1. Install the MetaMask add-on on your desktop or whatever gadget you are using. However, using a desktop computer with a responsive browser that supports extensions like Chrome or Brave is better.
2. As soon you are done installing the extension, you will be directed to create a new wallet. Now, select the “Create a Wallet” option.
3. Agree to the terms and conditions, and then set a unique password. Remember that if you ever misplace your device, you will be unable to access your account using this password. So, make sure to secure your MetaMask wallet on your device.
4. You will be assigned a seed phrase at this stage. It is a sort of secret key composed of 12 random words. Note it down and keep it safe because it is the only way to recover your account if your device is ever misplaced.

You can also set up popular physical wallets such as Ledger, Trezor and KeepKey.

Step 2: Invest in Your Relevant Coins

Coming towards step 2, it involves purchasing your relevant coins. Purchase the appropriate currency for the DeFi protocol that you intend to use. As we said earlier, in terms of DeFi, Ethereum is a popular choice.

This is all because of the value it delivers through its smart contracts. So, this concludes that most DeFi protocols are based on Ethereum. Hence, you will most likely need to purchase ETH in order to use them in DeFi.

You can purchase Ethereum from a cryptocurrency exchange such as Binance. You can also acquire cryptocurrency with money in a peer-to-peer exchange. Beware! Sign up for reliable websites only, as the bitcoin sector is riddled with scams and frauds. Binance also has a peer-to-peer exchange.

Step 3: Get to Know DeFi

Everything is done: you have created a wallet, purchased Ethereum, and you are all set to step into the world of DeFi. And this brings us towards the 3rd step, which is to get to know DeFi. 

Honestly, there are various ways to make yourself familiar with the world of DeFi. Some of these ways were explained in the beginning as well. However, we have made a brief review here for you.

• You can try your hands over lending crypto. This way, you will become a yield farmer. This also includes earning governance tokens if you ever lend out your coins.
• You can also put your money on a decentralized exchange like Uniswap. You earn fees by becoming a market maker on the DeFi exchange.
• Lastly, you can invest in DeFi ventures like AAVE or Yearn Finance. However, keep in mind that these assets are unstable.

In the end, always keep in mind that the crypto world is packed with dangers. Whatever you do, never share your credentials or even devices with an unauthorized person(s). As there are a lot of scammers on the run, so be careful! 

Some Handy Tricks for Stepping into DeFi

Below are some of the quick tips and tricks that you can use to have the most from DeFi.

• Make sure you aren’t going for everything you see
• Expect to face loss the way you expect to profit
• Try to be accurate at data collection
• Get yourself familiar with decentralized exchanges
• Research thoroughly about whatever you invest in

Was Centralized Finance Not Enough?

With the world moving towards new innovations each day, finance is also undergoing a lot of modifications. Decentralized finance or DeFi is one of the most advanced financial technologies that are faster and easier than traditional financing.

Because the world has become a hectic place to live in, we are always looking for shortcuts. Centralized financing needs more time, plus it comes at the expense of sharing your personal information. Therefore, not everyone is fond of it anymore.

DeFi Vs. Traditional Finance

Until now, you will be aware of DeFi and its distinction from traditional finance to some extent. To compare the two points, we have devised a simple example here.

Take commercial banks as an example. In the traditional world, financial institutions can be used to keep your money, take a loan, earn interest, send transactions, and so on. As you know, commercial banks have a long track of success. Also, these commercial banks might offer insurance and security measures in case of theft.

Obviously, such institutions hold and control our assets to some extent. The bank processing and transactions might be time-consuming at times. On top of that, commercial banks require exact information and identification of the user in order to participate. This process itself is way too time-consuming!

On the other hand, DeFi constitutes financial products and services. These services can operate without the help of banks or other third-party corporations. You can access these services anywhere—you just have to own a device, some capital, and an internet connection.

Unlike banks or traditional financing systems, the decentralized financial market doesn’t sleep. Basically, the transactions occur literally every time, 24 hours a day, 7 days a week, and almost 365 days a year, with no intermediary having the capacity to stop them. 

Thanks to these assets’ underlying Blockchain technology, Bitcoin and most other cryptocurrencies offer amazing features. To sum it up, transactions are done faster, cheaper, and, in certain situations, more securely.

DeFi	Traditional
No need to share any personal details.	Users have to share personal credentials.
No eligibility.	Specific requirements to open an account.
The user is responsible for all of his funds.	Bank can withhold a user’s account at any time.
Speedy transactions.	It might take days to process transactions.
It operates 24/7	Operation hours are limited to weekdays.

Probable Future of DeFi

DeFi is in active competition with the traditional financial system. Even though it has faced many challenges in the beginning yet, the world of decentralized finance is on the rise.

Because of DeFi’s flexibility, it is basically permissionless and can more easily support third-party integrations. Another advantage of DeFi is that everything is more transparent because it uses Blockchain. This could aid in the improvement of due diligence and the reduction of financial scams and bad business practices.

It’s just unpredictable how this space will evolve over time. We are expecting some of the greatest rises in the status of DeFi as building financial services becomes autonomous. Hopefully, these services will be quick, safe, accessible, and independent. 

Final Thoughts

This guide is a go-to place to start with DeFi. With our guide, you will be able to dig deep into DeFi and be a pro at it.

On a side note, it is important to realize that DeFi involves risks. Because of this, do complete research before interacting with related applications. Hopefully, this guide has helped lay the basis for you to make the most of Crypto in terms of future finance. 

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