DeFi 101: A Beginner’s Guide to Decentralized Finance
Did you know there is a growing movement in the cryptocurrency industry that enables you to lend, borrow, or access insurance, in a matter of minutes, in a decentralized way? That is true. Decentralized Finance (DeFi) is one of the hottest topics in the digital currency industry for quite some time now. DeFi is a powerful blockchain application that perfectly fulfills the initial goal of Bitcoin – creating a decentralized peer-to-peer (P2P) payment system.
DeFi market has recorded a remarkable over 2,100% market surge since January 1, 2018. However, what is this new financial concept? Why is it a hot topic in the crypto and finance space? How can you join the DiFi movement and earn from it? This article will answer all these questions and give you a beginner guide to DeFi. By the time you will finish reading the last sentence, you will be ready to start earning with DeFi.
What is DeFi?
For a better understanding of DeFi, and the change it is bringing to the financial space, we should first consider how the traditional finance operates.
It may feel like money has been around all along. However, that is not the case.
People originally used the barter system of trade. They would exchange goods and services with other goods and services of ‘roughly equal value’ depending on the need. However, as our societies kept developing, so did the economy. We invented currency at some point. This made the exchange of goods and services easier. Currencies facilitated innovations and higher levels of economic productivity. However, this development did not come without a cost.
Over the years, central authorities, especially governments have issued the currencies that are the foundation of our economy. Members of the society expected these central institutions to manage the supply of these currencies in circulation to maintain a stable and fair economy. As our economies continue to develop and getting more complex, the central authorities keep gaining power as more people put more trust in them.
Currently, you trust your government to maintain the cash flow in the economy and not printing more money overnight. You also trust your bank to keep your money safe. Additionally, when it comes to investing, you trust your assets to a financial adviser. You expect to earn a profit by handing control of your money over to others. However, in most cases, the power that comes along with this trust is not always rewarded.
Instead, we have very little say in how the central authorities and corporates handle our money and investments. We even have little say in how the government is running our economy. Ultimately, it turns out that the investors only receive a fraction of returns generated from the risks that these central authorities take.
DeFi is Creating Something Different
Decentralized Finance (DeFi) aims to create an open financial ecosystem that minimizes the users’ need to trust and rely on central authorities. Technologies such as the internet, blockchain, and cryptography provide tools that enable us to build and control a decentral financial system where there is no need for central authorities.
DeFi includes digital assets, smart contracts, protocols, and dApps that are built on a blockchain. You can think of DeFi as an open financial ecosystem that allows you to build various small financial tools and services in a decentralized manner. You can modify, combine, or integrate these applications to suit your needs since they are built on a particular blockchain that offers flexibility.
Take Charge of your Financial Wellbeing
Most DeFi applications are built on the Ethereum blockchain, which is the world’s most popular programmable blockchain. This blockchain maintains a shared ledger of digital value. In this network, the participants control the issuance of Ether (ETH) – the network’s native cryptocurrency – in a decentralized manner.
Ethereum network allows the developers to build a DeFi network that can create, store, and manage digital assets (tokens) on the blockchain network. Such applications are called Smart contracts or decentralized applications (dApps). These are contracts that are enforced by the decentralized blockchain. These applications run only as programmed on the blockchain network. Ethereum network will allow you to build complex irreversible agreements without the need for an intermediary.
Anyone, Anywhere, Anytime
DeFi has become popular because it has the opportunity to bring about a financial system with a high level of transparency. As long as you have an internet connection, you can access and interact with smart contracts built on the Ethereum blockchain. Most of the smart contracts are open source and interoperable with the existing smart contracts. Therefore, as a user, you can choose which service works best for you by verifying the smart contracts’ code.
You can store, trade, and invest your assets in this decentralized financial ecosystem and earn higher returns compared to when dealing with the traditional financial system. Here. You have complete control of your investment when dealing with dApp’s since there are no intermediaries.
What are the Products of the DeFi Ecosystem?
Various products are involved in DeFi. Such products are collectively referred to as open finance since DeFi is an open ecosystem. You may find some of these products and services familiar to existing financial services but with some decentralized twists. The popular applications include:
- Lending and borrowing
- Decentralized exchanges (DEXs)
- Payment Services
- Automated market makers (AMMs)
- DeFi Tracking Services
Decentralized Lending and Borrowing
Borrowing and lending is arguably the most popular and fastest-growing sector of DeFi. Like in the bank set-up, users can deposit funds and earn interest from other users who are borrowing such funds. However, the difference is, in the DeFi setup, the lenders and the borrowers are connected by a smart contract instead of a third party. Such smart contracts enforce the terms of the loans and distribute the interest. All the activities take place without the need for a third party like banks. By eliminating the intermediaries, decentralized lending and borrowing offer the users the opportunity to earn higher interests. Users also have a more clear understanding of the risks due to the transparency of the blockchain network.
While there are many ways to lend crypto assets to others, the most popular way to lend in DeFi is through decentralized lending pools. The lending pool brings together lenders for a given market, who deposit their funds into a smart contract. Borrowers can take loans from these pools of assets, instead of an individual lender. The interest generated from the borrowers is shared amongst all the lenders based on the amount they contributed to the pool. The interest rates are typically algorithmic and depend on supply and demand – the higher the demand the higher the interest rate, while more supply results to lower interest rates.
MarkerDAO and Compound Finance are the two largest DeFi dApps, by market cap, with a 77.5% combined market share. These two platforms allow users to use their cryptocurrency as collateral in borrowing funds or earn interest by lending out their digital assets to other users. The leading lending and borrowing platforms such as marker and compound features other products within their dApps such as Stablecoin and access to other DeFi services.
The following are examples of lending and borrowing DeFi products:
- MakerDAO, a decentralized credit platform.
- InstadApp, an intuitive interface built on top of MakerDAO to help the new users without technical and financial experience.
- Compound Finance, an algorithmic money-market protocol.
Other lending products currently in use include Compound, dydx, and Fulcrum.
Decentralized Exchanges and Open Market Places
Decentralized Exchange (DEX) is another popular DeFi application. These cryptocurrency exchanges use smart contracts. Smart contracts control activities such as enforcing the trading rules, executing trades, and handling funds whenever necessary. Trading on a DEX does not require any exchange operator, sign-ups, identity verification, or withdrawal fees.
Just like central exchanges, DEXs also employ highly innovative methods such as atomic swap to achieve minimal settlement time or risk. DEXs are a cheaper and secure trading ecosystem. However, it is important to understand that not all DEXs are decentralized and non-custodial as they may claim. It is important to research before using them.
Examples of DEXs are:
- IDEX – a dApp on Ethereum blockchain that features real-time token exchange.
- Bancor – a decentralized liquidity platform.
- Atomex – a multicurrency wallet that features a built-in swap exchange.
- Binance DEX
- Radar Relay
- Kyber Network
Other types of open markets majorly deal with non-fungible tokens (NFTs) exchange. Such tokens are sometimes referred to as crypto-collectibles. Examples of such markets are OpenSea and Rarebits, which helps in exploration, discovery, and trading such crypto-assets. Other market places such as District0X will even let you create your marketplaces and vote on governance procedures. P2P marketplaces built-in Ethereum have long-term potential. Such markets may cover markets for native digital assets. They may also tokenize real-world assets soon.
In an insurance service, the insurer guarantees compensation for different events such as death, damages, theft, loss, damage, illness, to the client in exchange for payment of a premium. We can also see innovation in the insurance space. DeFi is revolutionizing the insurance industry. Many DiFi loans are over-collateralized the loan seems safe because of the large pool of assets held in a reserve. However, the Achilles heel could be a smart contract vulnerability. If a hacker manages to identify and exploit a bug in the open-source code for a dApp, millions of money could be drained in a matter of seconds.
Tech institutions such as Nexus Mutual are now building decentralized insurance systems that would make users whole in the event of smart contract hacks. In the DeFi insurance setup, the dApp’s community is the service host. It features a decentralized protocol to provide blockchain-powered insurance products. Eherisc, for example, is an insurance platform built on Ethereum that features multiple decentralized, community-built insurance products such as flight delay and hurricane protection insurance. Users can purchase. The following are other examples of DeFi insurance service:
- VouchForMe; a DeFi blockchain service that users can save money by sharing risk.
- Nexus Mutual: a blockchain service that enables users to secure risks and bugs in smart contract codes.
Blockchain networks that utilized the Proof-of-Stake (PoS) consensus algorithm need validators to stake part of their digital coins to propose, create, and vote on blocks in the network. In return, PoS validators are rewarded for staking their digital assets.
Developers have created DeFi dApps that enables decentralization of products such as staking pools and staking-as-a-service. These dApps helps these users to secure a passive income just like with the savings accounts with banks. The following are examples of DeFi staking apps:
- StakeWithUs: a Staking-as-a-service for PoS protocols
- Staked.us: Staked’s non-custodial staking and DeFi lending infrastructure enable investors to earn a yield on the widest variety of crypto assets.
- Dokia Capital: a professional institutional staking service.
Decentralized payments provide solutions to the unbanked, financial institutions, and crypto enthusiasts. Decentralized payments attract low transaction fees while eliminating bank charges. It is also highly accessible. The following are examples of payment services:
- Lightning Network: a network built on top of bitcoin that features smart contracts, and low-cost and fast-off-chain payments.
- Whisp: a decentralized payroll solution that features crypto payments.
- Request Network: a decentralized blockchain network where users can request, validate, and execute payments.
Automated Market Makers
Automated market makers (AMMs) are a class of decentralized exchanges with a permissionless liquidity pool run by algorithms. AMM’s are smart contracts that create a pool of ERC20 tokens which are automatically traded by an algorithm rather than an order book.
- Uniswap – Uniswap is a fully decentralized on-chain protocol for token exchange on Ethereum that uses liquidity pools instead of order books. Anyone can quickly swap between ETH and any ERC20 token or earn fees by supplying any amount of liquidity. And anyone can create a market (i.e., liquidity pool) by supplying an equal value of ETH and an ERC20 token. Uniswap allows only one market per ERC20 token.
The market creator sets the exchange rate, which shifts through trading due to Uniswap’s “constant product market maker” mechanism. When trading reduces one side of the pair’s liquidity relative to the other, the price changes. This creates arbitrage opportunities, encouraging more trading. (Source: https://defipulse.com/)
Uniswap recently introduced its native governance tokens called UNI governance token.
- Balancer – Balancer is a n-dimensional automated market-maker built on Ethereum. It allows anyone to create or add liquidity to customizable pools and earn trading fees. Instead of the traditional constant product AMM model, Balancer’s formula is a generalization that allows any number of tokens in any weights or trading fees. Another way to view Balancer is as an inverse ETF: instead of paying fees to portfolio managers to rebalance your portfolio, you collect fees from traders, who continuously rebalance your portfolio by following arbitrage opportunities.
Balancer protocol is designed to be composable and has a few types of pools:
1) Private Pools where the only owner can contribute liquidity and has full permissions over the pool, being able to update any of its parameters.
2) Shared Pools where the pool’s tokens, weights, and fees are permanently set and the pool creator has no special privileges. Anyone may add liquidity to shared pools and ownership of the pool’s liquidity is tracked with a specific token called BPT – Balancer Pool Token.
3) Smart Pools which are a variation of a private pool where the controller is a smart contract, allowing for any arbitrary logic/restrictions on how pool parameters can be changed. Smart pools may also accept liquidity from anyone and issue BPTs to track ownership. Balancer was launched in March 2020 and has been audited by Trail of Bits. Balancer recently introduced its native governance tokens called BAL which are distributed to liquidity providers through a process called liquidity mining. (Source: https://defipulse.com/)
- Curve – Curve is a decentralized exchange liquidity pool on Ethereum designed for extremely efficient stablecoin trading. Launched in January 2020, Curve allows users to trade between stablecoins with low slippage, low fee algorithm designed specifically for stablecoins and earning fees. Behind the scenes, the tokens held by liquidity pools are also supplied to the Compound protocol or iearn.finance where to generate more income for liquidity providers. (Source: https://defipulse.com/)
DeFi Tracking Services
- Defipulse.com – DeFi Pulse is a site where you can find the latest analytics and rankings of DeFi protocols.
- CoinMarketAlert.com – Free DeFi price alerts and portfolio tracking where you never miss a market move.
- CoinGecko.com – CoinGecko provides a fundamental analysis of the crypto market and DeFi markets.
Sushi, YAM, Yearn – the Rise of Meme Coins
DeFi began by imitating the regular financial world. However, the freedom that this network offers the developers to mix and match pieces enables the developers to create unique applications on this network. As DeFi continues to boom, there is a growing hunger for this potentially revolutionary way to finance the future. Developers have created several protocols recently – all named after food. These protocols have shown little robustness or the ability to push on and make great positive changes in the space. However, these protocols have managed to lock in millions of dollars.
It all begun with Yam protocol, but now it has extended to more protocols such as Sushi, Spaghetti, and Kimchi. These protocols have locked in a total of $5oo million within hours – as was the case with KIMCHI (the DeFi farming token). Yield farming is the primary reason behind this phenomenon, people are still skeptical about it since it looks like a get-rich-quick scheme that profits off the potential of DeFi.
Yam started the era of “liquidity first, purpose later.” In actual sense, it is “liquidity first, copied, explode, and then resolve to carry on” – the purpose comes eventually. So what do these “memecoins” do? Here is a highlight of what they are.
Yam is a protocol built as a monetary experiment that combined some of the most interesting innovations in programmable money and governance. These innovations include elastic supply, a governable treasury, on-chain governance, and a fair distribution mechanism.
Yam protocol was designed to work like Ampleforth – reacting to market conditions by expanding or contracting the supply of YAM. The arrangement targeted $1 per YAM. One of the major differences, however, is that each time YAM expands the supply; it automatically buys revenue-generating coin, yCRV. YAM is distributed by users putting funds into different liquidity pools. After attracting $600 million within 24 hours, the holders were unable to decide how to use the funds for future development. The holders changed to the protocol entirely on-chain through community voting.
ShushiSwap started as a fork of UniSwap that added a token (SUSHI) to provide a reward for liquidity providers. SushiSwap took the DiFi protocol market with a storm and within a short time; more than $1 billion was locked into the protocol. After a few days, a pseudonymous project lead, Chef Nomi decided to swap his Shushi LP tokens for 37,499 ETH (About $13 million). This move led to an immediate crash in price by 73%. The experience that the investors had with this protocol showed how rapidly fortunes could be made or lost when dealing with Meme Coins.
Yearn.Finance is a portal to various DeFi products. Yearn.Finance is aspiring to be the gateway to a group of yield-generating products in the Ethereum ecosystem. The “intuitive interface to all DeFi” makes Yearn and its YFI coins stand out from the many recent meme DiFi projects. Yearn has seen a rapid ascent in August 2020, and now $650 million has been poured into this project, just one month since its launch.
The primary goal of all the Yearn products is to create a simple intuitive interface to all DeFi. Vault is the user interface that has generated a large share of conversation. Still other DeFi products from other teams that target to make life easier for active traders.
How to earn from Yearn
Yearn. Finance offers earn products. You can deposit any of several stablecoins: USDC, DAI, USDT, sUSD, wBTC, and TUSD. Yearn will then look for the DeFi platforms on which the investors can earn the highest yield.
You can also earn through vaults products. Here, users enter pools to put their existing assets to work and earn yields that they would not generate themselves. Vaults allow users to hold assets and earn a yield on it.
When you deposit your assets with yearning, it will borrow the stablecoins against the asset. It will use the stablecoin to seek yield-farming opportunities, constantly rebalancing the opportunity shifts. Yearn will then convert the gains back to the underlying assets. Therefore, if you deposited DAI, you may end up earning some yield on COMP, but ultimately you will get your gains back in DAI after the conversion.
Bitcoin is a revolutionary technology that soon, just like the internet, will be part of the foundation of the world’s economy. It is facing opposition from the conservative and skeptical institutions and individuals, but this is just a sign of revolutionary technology. When people will realize that it is here to stay, it will be late for some people, institutions, and countries to get to the position the top users of this technology.
DeFi is one of the blockchain-based technology that is revolutionizing the finance sectors. DeFi presents several ways through which an individual or institution users can earn from. You can invest your money in the decentralized Lending and borrowing and earn interest. Decentralized exchanges (DEXs) also offers you the opportunity to trade digital coins. Decentralized Insurance is a pool where you can invest in and earn interest. You can stake your digital coins as a PoS validator and earn rewards. There is also an investment in Meme Coins such as Yearn where you can earn quick fortunes. You may decide on the area where you are more comfortable with investing your funds. Continue reading our guides on crypto investments as you follow the latest trends to help you in making proper investment decisions.
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