Decentralised Finance or DeFi is an umbrella term used for a wide range of innovative crypto offerings that have the potential to disrupt the traditional financial industry. DeFi eliminates the need for middlemen as the transactions are managed and executed using smart contracts. Smart contracts are computer codes that have certain predefined logic embedded in them. The transactions are executed automatically once these conditions are met.
There are many use cases of DeFi ranging from yield farming, and open lending platforms to staking and decentralised exchanges (DEXs). DeFi offers a range of innovative ways to make money, even offering higher interest rates for lending in comparison to traditional banks with fewer barriers to entry. This is a guide to decentralized finance which explains decentralized finance for beginners.
How does Decentralized Finance work?
When compared to traditional financial applications that use core banking systems for recording transactions, DeFi uses blockchain as the underlying ledger for recording and maintaining transactions.
Blockchain handles all the core accounting functions such as matching inputs and outputs and no external systems are needed to reconcile balances as the blockchain nodes are used to validate transactions. Unlike traditional systems, no separate processes are needed for settling and clearing transactions in DeFi. Once the transaction is broadcasted on the blockchain, transaction clearing, processing, and settlement are undertaken at the same time.
There are no banks or intermediaries to authorise transactions within DeFi. Also, the code is open source and open to scrutiny so anyone can get the code audited, creating a sense of transparency in DeFi protocols. The most prominent blockchains that are used to build DeFi apps include Ethereum, and Binance Chain. These underlying blockchains are used to store the content of the apps, the content of the smart contracts, and the ledger status of all the deposits, withdrawals, and other transactions.
Read more: Decentralised Finance vs Traditional Finance
Decentralised applications (dApps)
A decentralised app or dApp is like a digital application that is downloaded on a computer or a phone, but unlike traditional apps, it is run on blockchain technology. A dApp is a software application that runs on a distributed network and unlike traditional apps that are hosted on a centralized server, dApps are built on a peer-to-peer decentralised network.
The most popular types of DeFi applications include:
Decentralized exchanges (DEXs)
Decentralised Exchanges or DEXs are used to trade digital assets where users can interact directly with each other without an intermediary. DEXs allow you to hold your assets in a non-custodial way which means that you retain complete ownership of your assets by managing your private keys. DEXs are built on different blockchains and Ethereum is one of the prominent blockchains used with its ERC-20 tokens.
DEXs form an integral part of the DeFi system and continue to grow in popularity and usage. They are automated using smart contacts and as they become more scalable, their trading volumes are expected to increase further over time.
Read more: Decentralized exchanges vs Centralised exchanges
Aggregators and wallets
Aggregators are the interfaces used by users for interacting with the DeFi market. One can think of them as asset management platforms that are decentralised in nature, used for automatically moving the user’s crypto across various yield farming protocols for generating the highest returns.
To conduct any DeFi activity, a DeFi wallet is essential as it is used to own, manage, and transfer the user’s assets. With a DeFi wallet, users remain in control of their funds at all times as they are the access points to their DeFi wallets, and maintain complete ownership. Wallets can store different assets and come in several different forms including software, hardware, and exchange wallets.
Read more: How to choose a DeFi wallet?
Lending and borrowing in the DeFi ecosystem
Another use case that has emerged from crypto is lending and borrowing in DeFi. These platforms allow users to lock their crypto assets via a smart contract and borrow against their position. Users can also lend to borrowers and earn yields by locking their positions. Usually, the yields in the DeFi ecosystem are higher than the ones offered in the traditional financial system as there are operational efficiencies generated through smart contracts.
One such example of a DeFi project is MakerDAO, created in 2015 on top of the Ethereum blockchain. MakerDAO enables users to lock ether and generate Dai, a stablecoin pegged to the U.S. through smart contracts. The saving platform of MakerDAO called Oasis uses Dai, offering a lending and borrowing platform for its users.
Another such lending and borrowing project is the compound protocol which has created a new credit market for users to earn interest on crypto assets or borrow against the asset by providing collateral. Compound functions 24/7 from anywhere in the world and so do all the other DeFi platforms, unlike traditional banking. Its native token is COMP and the platform functions based on the token and adjusts interest rates depending on its demand and supply.
Yield farming in DeFi
Yield farming is the process of deploying DeFi to maximize the user’s returns by depositing crypto assets into a pool with other users. With the DeFi platforms, users can borrow, lend crypto assets, and earn other crypto assets in return. Smart contracts are used to automatically facilitate yield farming, requiring minimum human intervention while conducting transactions efficiently.
Yield farming involves a liquidity provider (LP) and a liquidity pool (which is a smart contract filled with tokens). Think of a liquidity provider as an investor who deposits tokens into a smart contract to fuel liquidity. Yield farming works on the automated market maker (AMM) model which eliminates the need for the conventional order book and instead creates liquidity pools using smart contracts.
Read more: Yield Farming vs Staking in DeFi
How is DeFi different from crypto?
Centralised exchanges or CeFi are online trading platforms that allow you to trade crypto assets via an intermediary. The exchanges act as a middleman between a buyer and seller to facilitate transactions. An account on a crypto exchange is more like your online brokerage account to trade crypto. There are many crypto exchanges across the world such as Binance, Coinbase, Kraken, CoinDCX, etc and one can easily create an online account on their websites or mobile apps and commence trading.
Decentralized exchange (DEX) is the next stage in the evolution of trading digital assets that allow users to trade and execute transactions without an intermediary. A DEX is a marketplace that facilitates peer-to-peer exchange of crypto assets where the users can directly trade with each other without transferring the management of their funds to an intermediary.
Source: Appinventiv
Importance of DeFi
With the advent of technological growth and the emergence of new digital technologies such as the blockchain, DeFi is redefining the way banking and financial transactions are conducted globally. DeFi can be thought of as conducting transactions using digital fiat whereas, unlike physical money that is deposited and stored in banks, crypto in DeFi is stored and transacted using blockchain technology without the need for an intermediary such as a bank.
With continued development in the blockchain space, many innovative products have emerged through the advent of DEXs. DeFi products such as Staking, Lending, Swap, Liquidity farming, etc., provide novice ways for investors to explore various opportunities and earn high yields. Moreover, DeFi provides an ecosystem for developers to innovate as it allows easy integration of smart contracts and DApps that are essential for the development of new financial products. For example, with Okto wallet, one can access thousands of assets via cross-chain and multi-chain interactions between protocols, providing high-yield earning opportunities to investors.
CeFi vs DeFi
Advantages and disadvantages of DeFi
Ease of Use
The interface of CEXs is simple and easy to use and thus, the majority of the crypto volume is currently on centralized exchanges. Only a simple email and password are needed to start trading on CEXs and hence, users find it easier to trade on CEXs as compared to DEXs. Some of the CEXs are regulated entities that custody the funds of the users, and also provide insurance on deposited assets, making it easier for users to trust a CEX. However, emerging DeFi platforms such as Okto are designed for users to explore and navigate Web3 opportunities as seamlessly and efficiently as Web2.
DeFi lowers costs and reduces transaction time
In both traditional and DeFi transactions, most of the functions can be performed such as the deposit and withdrawal of money, sending money to someone else, and online shopping. But what differentiates DeFi from traditional financing is that since DeFi is digital in nature and uses blockchain technology, DeFi transactions are processed faster and at lower costs. Elimination of intermediaries or third-party in financial transactions also brings in efficiencies in DeFi. It is especially beneficial when sending money across borders as one can access their funds at any time as the DeFi system operates 24/7.
Trust Source
Since DeFi is built on the blockchain, a public blockchain acts as the trust source that governs all the operations in the financial sector and creates transparency in tracing and tracking all transactions. On the contrary, public governance acts as the trust source in traditional financing which entails laws and licensed financial institutions, governing all the operations.
Innovative Product offerings
DeFi provides numerous opportunities to innovate and provide a range of unique financial services such as staking and yield farming. The DeFi ecosystem uses open-source code and developer tools that allow developers to experiment and innovate and provide innovative financial instruments. Developers can work around the clock without restrictions, upgrading financial products and instruments in the financial sector.
Security
Security is considered more robust for DEXs in comparison to CEXs as they are decentralized. Data on CEXs is stored online and hackers can target such platforms to gain access to the central database, compromising users’ private keys and withdrawing their funds. On the contrary, as most of the DEXs do not hold any private keys that are required to gain access to the user’s account, it is difficult for hackers to gain control of a user’s crypto wallet. However, users of DEXs are required to manage and safeguard their private keys.
Use Cases of DeFi
Some of the most prominent use cases of DeFi include:
Asset Management
With various DeFi developments, users have an array of platforms to choose from for managing their crypto assets. They can conduct financial activities such as buying, selling, and transferring digital assets while maintaining complete control and privacy of their digital assets within DeFi. Moreover, they can earn passive income on their holdings by using DeFi services.
Decentralized Autonomous Organizations (DAOs)
A Decentralized autonomous organization (DAO) is a type of legal structure within DeFi with no central governing body that works with a specific mission in coordination with other stakeholders according to a set of rules encoded on the blockchain. They are used to making decisions in the working and management of blockchain projects.
DAOs have become popular as they provide transparency in the functioning of organizations as compared to traditional companies. Any stakeholder can easily view and validate the actions and decisions undertaken for the running of the company. As a result, DAOs are less prone to the risks of censorship and corruption.
Metaverse and NFTs
Metaverse has the potential to revolutionise and fuel a new immersive economy powered by social tokens. These social tokens can be leveraged by celebrities, and communities to monetize their brands, creating direct interactions between artists and customers with higher profits for the parties involved as the middlemen are eliminated.
Metaverse functions alongside the growth of NFTs that has given birth to the new digital economy as content creators, service providers, and merchants have started trading on NFT marketplaces more frequently. NFTs drive further adoption of the Metaverse as they can record the digital rights of the users for sorting, tracking and enforcing their rights.
Real-World Assets on the Blockchain
Real-world assets (RWAs) on the blockchain are an important emerging use case as the technology significantly helps unlock large sums of liquidity and utility. Proposals to invest in the US corporate bonds and treasuries were passed by the large DeFi lending players such as MakerDAO in partnerships with traditional banks for providing loans using RWAs as collateral. RWAs provide numerous opportunities to traditional institutions by injecting DeFi liquidity and making the RWAs more tradable. Moreover, the transparency provided by recording deals on the blockchain makes the whole process more efficient with faster and cheaper deals in comparison to traditional markets.
Lending and Borrowing in DeFi
Lending and borrowing have also become core concepts of the crypto ecosystem, especially with the emergence of DeFi which is built on the blockchain.
Lending and borrowing in the blockchain ecosystem are conducted in a decentralized system where the concerned parties deal with each other directly without an intermediary using smart contracts. These smart contracts form an integral part of the DeFi system with rules or policies that could be in the form of the terms of a loan, interest payments, contract expiry dates, collateral, loan amount, etc. These smart contracts are self-executed upon meeting certain requirements that are embedded in them, for example, repaying interest and loan installments at pre-agreed intervals.
Read more on: Lending and Borrowing in Decentralized Finance
Asset Tokenization
One innovation in the DeFi space is the tokenization of assets where tokenization of loans, collaterals, debt obligations, etc. is becoming a stark reality. The transparency provided by the blockchain, makes the issuance of loans, repayments, and loan terms easily readable by machines and humans.
Digital identity
Blockchain-based digital identity is an important use case of the technology. When combined with the DeFi protocols., it provides easy access to the global financial system, banking the unbanked. This empowers the financial system as people in remote areas can access financial services using DeFi while creating a digital identity for such users.
Web3 gaming
2022 encountered large numbers of gaming projects with DeFi integrations ramping up developments and trying out commercial viability. In the future, these projects will further develop and find themselves growing as DeFi continues to grow and become mainstream.
Read more: Top Web3 Play-To-Earn Games
Loan origination in dApps
In DeFi if one wishes to secure a loan, a dApp can be used to enter the loan requirements, and an algorithm is used to match up with peers that meet the requirements. Once the lender's terms are agreed upon, the loan origination process begins.
Once the consensus mechanism verifies the transaction, it is recorded on the blockchain and the borrower receives the loan. Smart contracts are encoded for timely payments at agreed-upon intervals as well as for interest payments. The same process is followed on the blockchain at the time of repayment using the dApp and the funds are then transferred to the lender.
How to start your journey in the world of Decentralized Finance?
Step 1: Setting Up Your DeFi Wallet
The first and foremost thing required to begin your DeFi journey includes setting up a DeFi wallet.
Why is a DeFi wallet needed?
A DeFi wallet is needed to access, store or transact virtual assets. DeFi wallet is the key to accessing any kind of DeFi service and as they are non-custodial, users maintain control and privacy of their funds at all times. This is in contrast to traditional crypto exchange wallets where the owners of the exchanges could have a certain degree of access and control over the user’s funds.
Okto is a mobile wallet for all DeFi offerings which is designed to provide a seamless customer experience for easy access even if you haven’t used DeFi before. Okto is a multichain DeFi wallet, providing interchain operability with multi-chain swaps, with access to 1000s of tokens from a single wallet.
Read more: Custodial vs Non Custodial Wallets
Step 2: Funding Your Wallet and Buying Tokens
After setting up your wallet, you need to fund your DeFi wallet. Users can do this either by linking their credit/debit cards supported by a DeFi app or directly transferring crypto from other wallets.
Step 3: Learn the “How-to” of investing in DeFi
The next step is to learn how to use different DeFi services. These include:
Yield Farming: Yield farming allows investors to deposit money in a DeFi platform or protocol, just like a savings account where you deposit your money with a bank, and earn interest in return for the funds deposited. However, unlike the banking system, DeFi utilises smart contracts where the deposited crypto is invested automatically and the user starts earning interest.
Lending and Borrowing in DeFi: Users can lend their tokens or crypto assets to borrowers via dApps such as a DEX which is facilitated by a smart contract and in return, can earn yields from the interest paid on the loans. Yield farmers can borrow a token of their choice by providing another token in return as collateral. Users can then use the borrowed coins to farm and earn yield. Throughout this process, the user can keep their initial holding, as the token could increase in value over time, while still earning interest on the borrowed tokens.
Liquidity Mining: Liquidity Mining is a part of yield farming and is used for adding functionality to the crypto ecosystem. Liquidity is essential for successful trading and by lending assets to a DEX, users provide liquidity and receive rewards in return.
Liquidity Pools: Yield farming involves a liquidity provider (LP) and a liquidity pool (which is a smart contract filled with tokens). Think of a liquidity provider as an investor who deposits tokens into a smart contract to fuel liquidity. Yield farming works on the automated market maker (AMM) model which eliminates the need for the conventional order book and instead creates liquidity pools using smart contracts.
Staking: Staking is usually of two kinds in the DeFi world. One is in the form of proof-of-stake blockchains in which the user provides their tokens for consensus and network validation. In the second form, the user stakes LP tokens that are earned while injecting liquidity into the DEXs. As a result, the users can earn yield twice, once for supplying liquidity in LP tokens which can then be staked further to earn more yield.
Read more: What are Liquidity Pools in DeFi?
Step 4: Exploring DeFi Projects
After setting up a wallet, loading your wallet with the coins of your choice, and learning how to use different DeFi services, the next step is to explore different project dApps. These dApps run on top of a blockchain network. They are also called DeFi protocols and you can choose from a range of protocols depending on your interests and requirements. . DEXs, lending platforms, and yield farming platforms are three good starting points to begin your DeFi journey.
Read more: Top DeFi Projects
Future of DeFi
DeFi recorded one of the highest growth rates within Web3, with a total value of the assets locked within DeFi protocols (also known as the total value locked (TVL)) surpassing $200 billion at the peak of the bull market in 2021.
DeFi provides numerous opportunities to innovate and provide a range of unique financial services. One can simply borrow, lend, swap assets, save, and earn interest on their crypto holdings on their mobile phones with little or no barriers to entry.
The growth and development of DeFi projects have made it easier for developers to provide innovative financial solutions and experiment with dApps. Use cases such as NFTs and GameFi have also seen tremendous developments due to the growth of DeFi. Hence, the future of decentralized finance is promising with myriads of developments to come that will benefit the crypto ecosystem and financial industry at large.
FAQs
1. Is DeFi Investing safe?
DeFi is constantly evolving with new developments emerging frequently. Although it offers innovative financial products, DeFi comes with its own risks and challenges just like any other financial service. Currently, it is unregulated and is prone to hacks and attacks. Hence, investors must carry out their own research and due diligence before investing in DeFi.
2. Is Bitcoin a Decentralized Finance?
Bitcoin is the first cryptocurrency based on blockchain technology. DeFi is designed in a way that it uses crypto as a part of its ecosystem, and hence Bitcoin is not DeFi.
3. What Is the Total Value Locked in DeFi?
TVL or total value locked is one of the most common metrics used in the DeFi space. TVL is a measure of the total value of assets that are locked up in a protocol. It is an important indicator as it projects the amount of liquidity available in different DeFi platforms to conduct activities such as lending, borrowing, staking, etc. This indicator demonstrates the overall growth of the DeFi industry. The total value locked in Decentralised Finance currently stands at $49 billion as of 27th Feb 2023.
4. How to earn passive income in DeFi?
One can earn passive income in DeFi by investing their idle crypto assets on DeFi platforms such as Okto. Okto DeFi wallet is a one-stop solution to all things DeFi where users can easily explore vetted DeFi investment opportunities with varied returns and invest seamlessly.
