A beginner's guide to decentralized finance(DeFi)

Table of Contents

What is DeFi?

DeFi is decentralized finance powered by blockchain technology which allows the transfer and trade of financial assets without central authority. 

DeFi comprises all financial products and services that are accessible to anyone with just an internet connection. Users can access financial services directly to the decentralized platform without relying on any banks, financial institutions, or any other third-party company.

Centralized Financial Institutions have a time limit to operate, while the Decentralized financial market does not sleep rather, they operate 24 hours a week.

DeFi allows participants to access borrowing and lending markets, earn returns through yield farming, etc. 

DeFi allows anyone to access financial services even those who don’t have access to traditional financial services. 

There are many unbanked people in the world who don’t have access to traditional financial services. Some of these people are living in remote areas where bank houses and financial institutions are not present, they have to travel all the way to town to get bank services.

With DeFi, users need only the internet to access financial services in a decentralized environment or without involving any third-party firm or any central authority or without any physical interaction with either a cashier, customer care, accountants, or any individual help. 

Various blockchains offer DeFi services. Blockchain networks ensure peer-to-peer transactions and communication. DeFi protocols use distributed ledger technology and smart contracts to make the system more decentralized and independent from middlemen.

DeFi provides services without intermediaries by utilizing cryptocurrencies and smart contracts.

What is the difference between DeFi and Bitcoin?

Bitcoin is a decentralized digital currency that runs on its own blockchain and is used as a store of value. 

DeFi involves all the financial services that are built on public blockchains like Ethereum and allows users to trade, lend, and borrow using their cryptocurrency holdings as collateral. Bitcoin is like a normal fiat currency while DeFi is similar to traditional financial institutions like banks. 

Difference between Traditional finance vs DeFi

Traditional Finance	Decentralized Finance(DeFi)
Users must share personal data	No need or must  to share personal data as users connect themselves  directly to the digital wallets
The unbanked or underbanked cannot access traditional financial services	Users manage their own funds as they are banks.
Transactions are seen and can be intercepted at any time	Transactions are anonymous and can not be manipulated or canceled by anyone after issued.
Has limited working hours	It is 24/7/24

 

What makes up decentralized finance(DeFi)?

 1. Decentralized exchange(DEXs)

DEXs allow users to buy and sell cryptocurrencies in a noncustodial way without the need for any intermediary or third-party firm.

In DEXs, users trade digital currency without having to create an account on an exchange. 

DEXs allow users to trade cryptocurrencies directly from their wallets connected to the blockchain instead of centralized wallets which are built on exchange.

 DEXs involve the use of smart contracts and liquidity pools to facilitate the purchase and sale of digital assets.

 DEXs are built on top of distinct blockchains, which makes them compatible with the technology in which they are developed. For example, DEXs built on Ethereum’s blockchain, allow the trading of cryptocurrencies built on Ethereum only such as ERC-20 tokens. To start using DEXs, you must have wallets compatible with the blockchain in which DEXs are built.

The problem with DEXs is compatibility. Cross-compatibility is required to enable people to trade digital assets that are built on different blockchains in one DEX.

Also, liquidity is low compared to Centralized exchange. This is due to fewer participants caused by less adoption of DEXs. 

As DEXs become more scalable, transaction volume will increase which will add more liquidity to the pool and many people will be able to buy and sell their digital assets in a fast and efficient way while retaining their personal information and transactions privately more securely.

2. Aggregators and Wallets

Aggregators are interfaces by which users interact with the DeFi markets. They are decentralized asset management platforms that automatically move users’ crypto assets between various yield-farming platforms to generate the highest return.

Wallets are locations for storing and transacting digital assets.

 3. Decentralized marketplaces

These are places where users interact in a peer-to-peer network and transact with one another without the need for any intermediary to facilitate transactions. This is enabled by smart contract which is the self-execution code that executes automatically when a certain condition has been triggered.

 4. Oracles and prediction markets

Oracles help to connect off-chain data to the blockchain via a third-party provider. Oracles has enabled prediction markets to be done on DeFi crypto platforms, users can place bets on the outcome of an event.

5.  Layer 1

Layer 1 represents the blockchain that the developers choose to build on.DeFi applications and protocols are deployed on the layer 1 blockchain. Ethereum is the main layer-1 solution in decentralized finance. Other rivals are Solana(SOL), polkadot(DOT), Tezos(XTZ), etc. These aim to ensure scalability by allowing cross-compatibility between different blockchains. This interaction between blockchains will increase transaction speed and lower transaction costs.

Defi Use Cases

Lending platforms lending platforms allow users to borrow funds while using their cryptocurrency as collateral

•  Payments and stablecoins
  

Stablecoins are digital currencies that are pegged to fiat currency such as the U.S. dollar. These stablecoins do not fluctuate like other digital currencies such as Bitcoin(BTC).

 

• Margin and Leverage

Margin and leverage allow users to borrow cryptocurrencies on margin using other cryptocurrencies as collateral.

 

How can you make money with DeFi?

• Liquidity pools in DeFi

Liquidity pools provide trading liquidity for buyers and sellers who pay fees for their transactions. Liquidity providers need to send specific funds to a smart contract and receive pool tokens in return. The return earned is passive income pool providers earn after traders pay transaction fees when interacting with the pool.

• Yield farming (liquidity mining) in DeFi

This involves profiting from various DeFi projects by participating in liquidity pools. In yield farming, users lend out their crypto to other users and earn interest that is paid in crypto or governance tokens. This is the way investors earn passive income by making their crypto work for them. Yield farming allows investors to stake crypto assets in a smart contract-based liquidity pool. The pool reuses the cryptocurrency invested to provide liquidity in DeFi protocols. You can earn passive income in DeFi by depositing your cryptocurrency to a liquidity pool that pays an annual percentage yield(APY).

What is APY?

An APY Is a unit representation to measure the yearly returns earned on investments, including the compounding interest.

• By Staking

Staking is the process of locking your tokens into a smart contract for a fixed amount of time in exchange for more of the same token.

• Defi lending

This is a peer-to-peer(p2p) service that allows borrowers to loan crypto directly from other investors in exchange for fixed-interest payments. In DeFi lending investors interact directly with borrowers. Investors deposit their digital assets to the lending platform with a fixed maturity interest rate in return. The deposited crypto tokens are then loaned to the borrowers and repaid within a set duration with interest.

Distinct properties between centralized finance(CeFi) and decentralized fiance(DeFi) 

Public verifiability

For DeFi to be classified as non-custodial, its application code and bytecode must be verified publicly on the blockchain. This is because most of the DeFi application code are not open-source (not accessed by the public), so, to ensure that is bug-free and its security is strong, it should first be publicly verified.

Atomicity

Defi has a programmable atomicity feature that allows actions to be performed sequentially.

CeFi does not have a programmable atomicity attribute.

Anonymous development and deployment

DeFi projects are developed and deployed by anonymous teams while CeFi teams are known.

Custody

DeFi allows customers to access services 24 hours from Monday to Sunday without delay while CeFi has a limit on their working hours. For example, all banks do not offer services during the weekend.

Exchanges

CEX order books are managed and controlled by a middleman who matches buyers' orders with sellers’ orders. These middlemen tend to manipulate the market by increasing spreads and changing quotes in the pairs being traded.

DEXs on the other hand use automated market-maker(AMM) protocol to match orders placed on the exchanges. Automated market makers use mathematical algorithms to execute trade depending on transaction volumes. This removes middlemen who manipulate the market and change the market direction in the direction they want causing traders to lose their money.

Transaction costs

In DeFi and other blockchains, transaction fees are critical to avoid spam.

CeFi can decide to add transaction fees to their services or to offer services free without users to pay transaction fees.

Execution order malleability

Blockchains offer peer-to-peer transactions between users. This allows users to assign transaction fees they want when trading. In CeFi transaction fees and execution are assigned and implemented by the government or financial institutions.

Non-stop working hours

DeFi markets are open 24 hours a day, seven days a week while CeFi markets do not operate during weekends and public holidays.

Privacy

Blockchain which powers DeFi markets ensures users' privacy regarding their personal information and transactions. CeFi markets are controlled by middlemen or third-party firms. These centralized firms are more prone to cyber-attack and sometimes tend to disclose user’s personal information.

Arbitrage risks

Arbitrage should operate automatically to avoid the risk of price swings. Arbitrage on centralized and hybrid exchanges is inherent to market price swings. When transaction fees are ignored, arbitrage between two decentralized exchanges on the same blockchain can be deemed risk-free. This is due to the blockchain atomicity feature that allows traders to write smart contracts that perform that performs the arbitrage and revert if the arbitrage does not return a profit. When two DEXs on separate blockchains are arbitraged, the arbitrage risk is comparable to a CEX and hybrid exchange.

Inflation

Inflation is the loss of a currency's purchasing power. This results in the depreciation of an existing currency supply caused by adding a new supply.

In CeFi, only central banks have the power to produce fiat money, and inflation is measured against the values of a representative number of consumer products using an instrument called the consumer price index.

In DeFi, the supply of digital assets is subject to change and differs from blockchain to blockchain.

Cross-chain services

Some cryptocurrencies such as Bitcoin(BTC) are developed on independent blockchains. This makes it difficult for the DeFi markets to support and use them on their services due to the complexity and delay of completing atomic cross-chain exchanges.

CeFi stores funds from several chains while decentralized financial services require tokes to follow a common standard such as ERC-20 Ethereum tokens to ensure interoperability.

Fiat conversion flexibility

Centralized services are easier and more flexible than decentralized exchanges to convert money from digital currencies such as Bitcoin(BTC) to fiat currencies such as the US dollar(USD). This is because fiat currency conversion requires a centralized institution,

Defi has limited capability to convert digital assets into fiat currency

Advantages of DeFi 

1. No or less human error

DeFi platforms are audited publicly to ensure that their smart contracts are error-free. The use of smart contracts makes DeFi ecosystems error-free from humans because there is no third-party firm involved in managing and controlling processes and activities occurring in the DeFi system, instead, everything executes according to the automated set of instructions written on the smart contract.

2. Transactions are permissionless

DeFi projects are peer-to-peer, distributed, and decentralized meaning anyone can join and access decentralized financial services without any limitation from central authority or a third-party firm. DeFi projects are not controlled and managed by any third-party firm, they are maintained and managed by clients and anyone with a computer can join the DeFi without the need for any document registrations or KYC compliance.

3. Immutability

The use of cryptography and consensus algorithms in blockchain makes DeFi immutable.

4. Unlimited accessibility  

Users can access DeFi services and products at any time without delay. Services are available 24 hours a day, 7 days a week.

5. Easy Lending and Borrowing Applications 

Users can lend their digital assets and earn higher interest rates than traditional financial services such as banks do not provide. Lending and borrowing is a peer-to-peer service without involving any bank, borrower and lender can transact directly without any problem.

6. Transparency 

Blockchain is a distributed ledger, meaning that, the nodes who participate in validating transactions occurring in the DeFi protocols have a copy of all the transactions and activities occurring in the system. The ability of every validator to see what is happening or going on in the system while not manipulating anything increases trust in the users. This is quite different from traditional banks as transactions are visible and managed by banks only and other users cannot see and understand what is going on.

7. No single point of failure

 There is no central server located somewhere where people need to connect and send their requests to access DeFi services. DeFi platforms are deployed on public blockchains such as Ethereum, this public blockchain is decentralized and distributed. Being distributed allows anyone to participate in validating transactions occurring in the system. Because nodes are distributed in different geographical locations, if one node(validator) goes down, no effect on the system because others will continue to run the network, and is impossible for all nodes to go down be if they were located in the same place and owned by 1 person. This makes DeFi ecosystems sustainable to failure and cyber-attack.

8. They are more resistant to cyber-attack

Always hackers before doing any hacking activities, gather information about a target first, this information will be used together with their attacking tools to exploit and penetrate the target system. DeFi uses blockchain, and blockchain has no central server (physical device) where hackers can target, send their request to shut down the system, and conduct hacking activities. DeFi become more resistant to hackers due to peer-to-peer transactions without requiring any middleman and distributed nodes in different locations to validate transactions making the DeFi systems more secure and resistant to hackers.

 

Disadvantages of DeFi

1. Scalability

DeFi suffers from scalability problems, and because DeFi projects are deployed on top of the existing blockchain such as Ethereum. They suffer from higher transaction fees and low transaction speed caused by traffic congestion of transactions waiting to be validated by validators.

2. Interoperability

Most DeFi projects are not interoperable with each other. DeFi projects are built on independent blockchain, which makes it difficult for them to interact with each other. To facilitate interactions, they need cross-compatibility of their blockchain so that they can share attributes and features. This will help developer even to move their DeFi ecosystem from one blockchain to another without any problem.

3. Liquidity

DeFi ecosystems are more decentralized than centralized systems. This makes it difficult for the user to adapt to a system that is not centralized. For example, Decentralized exchanges (DEXs) have limited features in trading digital currencies to centralized exchanges(CEXs), also no fiat currency is used to buy and sell digital assets in DEXs, only digital assets are used and user need to connect their wallets without entering their personal information to the system. This creates a difficult environment for beginners, novices, and less experienced individuals with computer skills to interact with DEXs like the way they interact with the centralized exchange.

4. Instability

DeFi is not stable because of the problems facing the blockchain on which they are deployed. For example, Ethereum wants to shift from proof-of-work(POW) to proof-of-stake(POS). These changes will affect the Ethereum network and can make it unstable for some time.

5.    Smart contract problems

DeFi smart contracts are more vulnerable to attack. If an Audit is not well done on the smart contracts to ensure they are bug-free, can result in serious problems for DeFi projects.

Top Most Popular DeFi Projects

1. Terra(LUNA)

2. Avalanche(AVAX)

3. Dai(DAI)

4. Lido Staked Ether(STETH)

5. Chainlink(LINK)

6. Uniswap(UNI)

7. Aaave(AAVE)

8. Fantom(FTM)

9. Compound(COMP)

10. Tezos(XTZ)

11. Yearn. Finance(YFI)

12. Wrapped Bitcoin(WBTC)

13. Pancake Swap(CAKE)

14. SushiSwap(SUSHI)

15. Loopring(LRC)

16. Wrapped Bitcoin(WBTC)