Decentralized Finance (DeFi): All You Need to Know as a Beginner

10 min read

Are you tired of relying on banks and other financial institutions for your financial transactions? Decentralized Finance (DeFi) could be the solution you’ve been looking for! 

In this article, we’ll cover everything you need to know as a beginner, including the history of DeFi, how it works, its benefits, and potential challenges. So, let’s dive in!

What is Decentralized Finance (DeFi)?

Decentralized Finance (DeFi) represents an ecosystem or a cluster of financial applications and initiatives built on blockchain networks that typically use smart contracts and are not controlled by a central authority, challenging the conventional finance industry.

So, DeFi aims to create an open-source, permissionless, and transparent financial service ecosystem that is available to everyone and operates without any central authority. 

Using DeFi, the users would maintain complete control over their assets and interact with this ecosystem through decentralized peer-to-peer applications (DApps).

The History of DeFi

The term was first used in 2018 by a group of entrepreneurs and developers who wanted to build an open-source financial application on the Ethereum blockchain. The goal was to create a financial system without the need for central authorities or intermediaries.

The first DeFi application, MakerDAO, was launched in 2017. It allowed users to lend DAI against Ether as collateral, which opened the door for borrowing and lending without a central entity. From there, the DeFi ecosystem grew rapidly, with many protocols focusing on borrowing and lending being launched.

In 2020, DeFi exploded in popularity, with Uniswap, Curve, and Yearn Finance being among the biggest DeFi applications. However, competition from other blockchain networks and tokens such as Metaverses, Memecoins, and NFTs caused some DeFi tokens to lose up to 95% of their value in 2022.

Despite the price drops, DeFi’s core functionality has worked as intended, and many enthusiasts believe that a second DeFi summer, or DeFi 2.0, is on the way.

How Does DeFi Work?

DeFi is like traditional finance, but instead of relying on banks and other centralized institutions to handle transactions, it uses blockchain technology and smart contracts to enable direct transactions between individuals.

Blockchain technology is like a big ledger that tracks all transactions on a given financial platform. Every transaction is time-stamped and permanently recorded on the ledger.

Smart contracts are like self-executing computer programs that automatically execute transactions among participants when specific conditions are fulfilled. They can be used for everything from payments to investments and lending.

In DeFi, cryptocurrency is the currency for transactions and records. With DeFi, people can access financial services like loans and interest on deposits without relying on traditional financial institutions.

What are the Benefits of DeFi?

Greater Financial Inclusivity

Greater financial inclusivity refers to the ability of DeFi to provide access to financial services to people who are excluded or underserved by traditional financial institutions. Many people worldwide do not have access to traditional financial services like banks or credit cards due to factors like their geographic location, socioeconomic status, or lack of credit history.

DeFi enables people to access financial services like loans, savings accounts, and investments using only an internet connection and a cryptocurrency wallet. This means that people excluded or underserved by traditional financial institutions can participate more fully in the economy.

For example, someone in a remote area with limited access to traditional financial services could use DeFi to access a loan for their small business. They could even use DeFi to save money and earn interest on their savings, which could help them achieve their financial goals.

Also, DeFi is permissionless because it helps people excluded from traditional financial services due to their credit history or lack of collateral. DeFi lending platforms use collateral in the form of cryptocurrency, which means that people who do not have traditional forms of collateral can still access loans.

Transparency and Security

DeFi is built on blockchain technology, which provides a high level of transparency and security. Transactions are recorded on a public ledger that cannot be altered. This means that once a transaction is recorded on the blockchain, it is there permanently and cannot be changed, making it easy for anyone to view and verify them. This reduces the risk of fraud and ensures that transactions are secure.

Also, DeFi transactions are secured by cryptography, meaning they are virtually impossible to hack or tamper with. This makes DeFi a much more secure option than traditional financial services, which are vulnerable to cyberattacks and data breaches.

More Control Over Finances

DeFi enables users to manage their finances directly without the need for intermediaries like banks or financial institutions. This gives users greater control over their funds and reduces the fees associated with traditional financial services. For example, if you want to transfer money to a friend using traditional financial services, you may need to pay a fee to your bank. With DeFi, you can send money directly to your friend without any intermediaries, saving you money.

DeFi Challenges

Although DeFi has many advantages, it also faces several potential challenges, including the following:

  • Complexity: DeFi can be complex and challenging to understand, especially for those new to the field. The technology uses peer-to-peer models, smart contracts, and advanced algorithms, which can lead to confusion and make it difficult for users to know how a service or application works.
  • Customer service: Unlike traditional finance systems, DeFi has no central authority or customer service center to contact for help. This can make it challenging for users to get support or assistance when they need it.
  • Volatility: DeFi is inherently more volatile than traditional finance systems because no centralized authority controls or limits transactions or market momentum. This can lead to sudden price swings and make it challenging to predict the value of assets.
  • Security: DeFi platforms have become targets for cyber attackers in recent years. Hackers have stolen over $1 billion in assets in just three months, according to a Federal Bureau of Investigation alert issued in August 2022. Smart contract security issues also pose a significant risk, making it essential to take measures to protect against potential attacks.

Stablecoins

Stablecoins are cryptocurrencies designed to have a stable value, often pegged to the value of a fiat currency like the US dollar. This makes them more suitable for everyday transactions since their value is less volatile than other cryptocurrencies like Bitcoin. Stablecoins are often used as a store of value or as a way to transfer value across borders quickly and cheaply. In addition to DAI and USDC, other popular stablecoins include Tether (USDT) and Binance USD (BUSD).

Decentralized Exchanges (DEX)

Decentralized exchanges (DEXs) are built on blockchain technology and operate without intermediaries or central authorities. They allow users to trade cryptocurrencies directly with each other rather than through a centralized exchange. By eliminating intermediaries, DEXs are more secure and less prone to hacking or theft. They also offer more privacy, as users do not need to provide personal information or register for an account. However, DEXs can have higher fees and may be less user-friendly than centralized exchanges.

Borrowing and Lending

DeFi borrowing and lending platforms allow users to lend and borrow cryptocurrencies without the need for a bank or other financial intermediary. This can provide greater access to credit for users who might not be able to access traditional financial services. Borrowers can use their cryptocurrency holdings as collateral to secure loans, while lenders can earn interest on their holdings by lending them out. Interest rates on DeFi lending platforms are determined by supply and demand and are often higher than traditional savings accounts. However, there is also a greater risk of default or loss of funds since there is no government-backed insurance or deposit protection.

Prediction Markets

Prediction markets allow users to bet on the outcome of real-world events, such as election results or the price of a commodity. They use blockchain technology to provide a transparent, decentralized platform for betting, with payouts automatically distributed based on the event’s outcome. Prediction markets can be more accurate than traditional polls or surveys, as they incentivize participants to make accurate predictions in order to win money. They also allow for a broader range of betting options and are more resistant to censorship or government intervention.

Comparison between DeFi and Traditional Finance

To truly understand the potential of DeFi, it’s essential to recognize the issues that exist with traditional finance:

  • Limited access to financial services for some people;
  • Lack of financial access affecting employability;
  • Potential for financial services to block payments;
  • Personal data being used as a hidden charge;
  • Markets being closed down by centralized institutions;
  • Trading hours are limited to business hours and time zones;
  • Slow money transfers due to internal human processes;
  • The premium cost of intermediary institutions.
DeFiTraditional Finance
You hold your money and assets.Your money and assets are held and managed by financial institutions.
You have control over your funds and can decide where to allocate them.You need to trust financial institutions to manage your funds responsibly and allocate them according to your preferences.
Transfers of funds and assets happen almost instantly, with no need for intermediaries.Payments and transactions can take days to process due to manual processes and intermediaries.
Transactions are pseudonymous, preserving your privacy.Financial activity is tightly linked to your identity, which can compromise your privacy.
DeFi is open to anyone with an internet connection and a compatible device.To access traditional financial services, you usually need to meet certain requirements and go through a rigorous application process.
DeFi markets are open 24/7, enabling continuous trading and investing.Traditional financial markets have opening and closing hours, and trading may be suspended during certain periods.
DeFi platforms are transparent and open-source, allowing anyone to review the code and the data.Traditional financial institutions tend to be opaque, and it can be difficult to obtain detailed information on their operations, fees, and performance.

The Risks of DeFi?

DeFi can be a tempting way to earn money, but knowing that it also comes with some risks is essential. Here are some of the risks to keep in mind:

  • Counterparty Risk: When you lend or borrow money through DeFi, there’s a risk that the other party won’t pay you back. This is called counterparty risk.
  • Regulatory Risk: Some DeFi services may not be legal in your country or may be shut down by regulators. If this happens, your funds could be at risk.
  • Token Risk: The assets you hold in DeFi can have different levels of risk, depending on factors like their liquidity, security, and the team behind them. Some tokens may be riskier than others.
  • Software Risk: DeFi relies on smart contracts, which are computer programs that automatically execute transactions. If there’s a vulnerability in the code, your funds could be at risk. You must also be careful when connecting your wallet to DeFi apps, as this could expose you to hacks.
  • Impermanent Loss: If you provide liquidity to a DeFi pool, you may experience impermanent loss if the value of the tokens in the pool changes. This means you could lose some of your deposited tokens if you withdraw.

The Future of DeFi

While it may have some ups and downs in the short term, many believe that DeFi has a future as a sustainable financial system.

However, some challenges still need to be addressed for DeFi to become a long-term success. One of the main concerns is security. Smart contract bugs can lead to the loss of assets, and while smart contract insurance DApps can help, they are not yet widely used.

Another issue is regulatory concerns. There is currently little regulation in the DeFi sphere, which makes it vulnerable to potential changes in the legal landscape. Some industry-wide regulations could increase confidence in the system.

Despite these challenges, stablecoins have enormous potential to expand in usage in the coming years. Countries with hyperinflation, such as Venezuela, have already begun adopting stablecoins, which is expected to continue.

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