Home Finance What is Decentralized Finance? Beginner’s Guide

What is Decentralized Finance? Beginner’s Guide

Decentralized finance is a term that encompasses financial services on public blockchains, creating an alternative to the traditional finance sector.

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Beginner's guide to decentralized finance
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The traditional finance space is rife with third parties, governing bodies, and gatekeepers. Consumers must deal with centralized systems and middlemen when executing financial tasks ranging from basic banking transactions to mortgages, auto loans, and stock and asset trading. Worse still, every intermediary charges a fee for its services, incurring additional costs for transactions that may still take a lot of time to process.

This jump from intermediary to intermediary for simple financial tasks has raised the need for blockchain-based decentralized systems that enable peer-to-peer (P2P) and direct interactions. That is where decentralized finance (DeFi) comes in.

Decentralized Finance Explained for Beginners

Decentralized finance is a term that encompasses financial services on public blockchains, creating an alternative to the traditional finance (TradFi) sector. One important thing to note is that DeFi is open to anyone with an internet connection anywhere in the world.

With DeFi, a consumer can do almost everything that banks and TradFi companies offer, including sending, receiving, borrowing, lending, buying insurance, and trading assets. Users can also earn interest on their holdings. Interestingly, market participants can now access scientific research through the introduction of decentralized science (DeSci).

One of the perks of DeFi is that users can protect their real identities by operating under pseudonyms. This way, their real names, email addresses, and personal information are not public, protecting them from potential harm. The DeFi space is open, transparent, permissionless, and almost free, as networks charge way less for transactions, which would still be processed faster than TradFi firms. 

So, DeFi eliminates intermediaries, high fees, unnecessary paperwork, and slow processing time associated with TradFi systems while providing better services and pseudonymity.

How to Invest In DeFi

Investing in DeFi entails using decentralized applications (dApps) and protocols built on blockchains and using cryptocurrencies as a means of exchange. These applications include decentralized exchanges (DEXs), prediction markets, borrowing, lending, and yield farming platforms. 

To gain access and utilize these dApps, you will need a cryptocurrency wallet to store your assets since they are non-custodial. A popular crypto phrase, “Not your keys, not your crypto,” depicts the importance of self-custody and being responsible for your assets by holding and safeguarding the public and private keys to your wallets.

In addition, you need to use stablecoins to protect your portfolio from the price fluctuations of cryptocurrencies. Stablecoins are pegged to traditional currencies like the U.S. dollar or the euro on a 1:1 basis to keep their prices stable and under control. You can also purchase most cryptocurrencies with stablecoins by using their pairs on DEXs.

With a crypto wallet and some assets, including stablecoins, you can choose a dApp to work with, depending on which DeFi activity you want to participate in.

The Top Ranked DeFi Protocols

A few years ago, almost all dApps could be found on the Ethereum blockchain; however, developers have recently diversified to other networks. Regardless, some applications have stood out over time and account for the bulk of total DeFi trading volume. Some of them include Uniswap, Compound, and Jupiter.

Uniswap

Uniswap is a decentralized exchange that enables the trading of cryptocurrencies through a set of smart contracts. Smart contracts are self-executing programs that automatically perform actions according to the terms of an agreement.

Although the crypto space is decentralized, some exchanges function as centralized platforms to connect buyers and sellers. Decentralized exchanges like Uniswap do the work of centralized platforms but with the help of smart contracts and liquidity providers (LPs). DEXs function as P2P marketplaces, with smart contracts ensuring cryptocurrencies are worth their real market values and LPs supplying the protocols with enough capital.

Founded in 2018 on Ethereum, Uniswap is currently the most popular and biggest DEX, with a cumulative trading volume of over $2 trillion. The platform pioneered the automated market maker (AMM) model used by DEXs today, creating an alternative to centralized exchanges’ traditional order book-based model. The native token of the Uniswap ecosystem is UNI.

Compound

Compound is one of the largest DeFi borrowing and lending protocols. The platform allows users to earn interest on their crypto assets by depositing them into several pools supported by the protocol and to borrow cryptocurrencies by depositing collateral.

Users who deposit into Compound pools earn cTokens in return. You use these tokens to redeem underlying assets deposited into the pool at any time. On the other hand, the positions of borrowers can be automatically liquidated if their collateral falls below a specific threshold. 

Compound’s native token is COMP, and the protocol is based on the Ethereum network.

Jupiter

Jupiter is another top-ranked DeFi protocol that serves as a decentralized exchange. The platform is one of the largest and most popular swap aggregators on Solana, doubling as a liquidity aggregator for the blockchain.

Jupiter’s native token is JUP, and the protocol has over 12,000 token pairs. It offers a wide range of DeFi services, including perpetuals trading, limit orders, and bridge comparator.

Benefits of Decentralized Finance

  • Easy Access and High Speed: One of the main benefits of DeFi is easy access. Users can access dApps and protocols from anywhere with a good internet connection. The best part? They can execute their transactions without much delay.
  • Low Fees and High Interest Rates: While users pay low fees for their transactions, they also enjoy high interest rates for several activities. Several crypto platforms pay as much as 20% or more to users annually for depositing their assets in their lending pools. Users could potentially build a DeFi side hustle as we explained in another blog.
  • Transparency and Pseudonymity: Transactions are traceable in DeFi without revealing the true identity of users. While the crypto community can see how you are moving your assets, they can only see your real name and data if you want them to.

Risks of Decentralized Finance

  • High volatility: The volatile nature of cryptocurrencies can cause sharp spikes or declines in investments and portfolios. It can also cause a momentary spike in transaction fees on several dApps and DEXs.
  • Collateralization: Some users may be ineligible for DeFi loans due to the high rate of collateral required by dApps. DeFi loans require collateral equal to at least 100% of the assets borrowed to prevent liquidation in cases of dramatic plunges. Worse still, users face the risk of immediate liquidation if the value of their collateral falls below a threshold. 
  • No safety: The openness and permissionlessness of DeFi means it is also available to hackers worldwide. Since DeFi protocols and dApps are not responsible for users’ cryptocurrencies, they do not bear the brunt of hack incidents. Hence, there are no consumer protection systems or safety nets in place.

Also Read: 50 Easy-to-Rank Cryptocurrency Blog Post Ideas

Conclusion

Despite the risks of getting involved in a decentralized sector, DeFi still offers investors an opportunity to have more independence over the crypto assets. Being responsible for your assets requires that you learn safety practices like keeping your crypto in cold storage to stay immune to hacks and minimize losses.

Moreover, DeFi is a novel sector that is not yet regulated. The ecosystem could see substantial development in the future with measures put in place to help protect users.

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Emenike Emmanuel is a multiple award-winning blogger, CEO of Entrepreneur Business Blog, Chief Evangelist of Ebusinessroom Ventures, and the Lead Coach of an online community of over 12,000 business owners called, The Excellent Entrepreneurs' Network. He’s here to help you start, manage and grow a profitable and sustainable business using digital marketing strategies. Follow him on Facebook, Twitter, Instagram, LinkedIn & Pinterest with this handle, @emenikeng. Telegram group - t.me/yourfirst1000 | Email: [email protected]

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