How does DeFi work?
With the use of decentralized blockchain technology, DeFi aims to offer most of the financial products and services that consumers and companies already take advantage of, including loans, interest rates, remittances, and more.
DeFi effectively transforms the financial space by developing new infrastructure to offer comparable financial products and services as traditional institutions would. It does this by leveraging smart contracts and blockchain technology. Blockchain refers to a specific type of ledger that stores public records of every transaction made on any DeFi platform.
Smart contracts are the foundation of DeFi. Smart contract functionality uses programmable algorithms in a digital contract that automatically activates when its predetermined conditions are met based on a mutual agreement between two parties. The unique feature of a smart contract—and a common feature of decentralized technology—is removing a supervising intermediary such as a lawyer.
DeFi enables peer-to-peer (P2P) transactions to replace third parties like banks and brokerages. Thanks to smart contracts, P2P transactions allow two parties to interact directly without worrying about transparency and accountability.
With DeFi, cryptocurrencies like Bitcoin (BTC), Ethereum (ETH), Solana (SOL), Dai (DAI), can provide similar services to fiat currencies, like the U.S. dollar.
How does DeFi challenge traditional banking?
DeFi is a trustless financial concept, meaning users don’t have to trust third-party institutions to manage their finances. One of the main assertions made by DeFi supporters is that this new financial system will disrupt traditional banking. They claim that DeFi would remove the intermediary from financial transactions, allowing decentralized blockchains to take their place.
Banking systems exist primarily to enable transactions, whether domestically or internationally. Transferring money domestically may be a fairly straightforward task, but sending money internationally is fraught with complications and intermediary fees.
When it comes to funding, many of us invest by handing over authority to mediators like fund managers, who are portrayed as knowledgeable advisors who know the best use of our money. However, we end up paying fees and commissions for their services if we make a profit, and if we incur any losses, they’re only ours to bear. As a result, money managers tend to generate higher returns than the individuals whose money they’re managing.
Banks can’t make money with DeFi. By removing the intermediary, we eliminate many additional and hidden costs that the average user often pays without question or notice. Individuals who lean on traditional banking have little authority over their finances. DeFi aims to solve this.
Decentralized vs. centralized finance
The primary difference between decentralized finance (DeFi) and centralized finance (CeFi) is that the latter requires a centralized entity governing transactions. The CeFi landscape depends on the market value of different shares in exchanges, while DeFi relies on blockchain technology. This enables DeFi users to access many emerging financial products and services, such as decentralized applications (dApps), non-fungible tokens (NFTs), and staking.
Users can shift their risk to exchanges as these exchanges are responsible for safeguarding their funds. DeFi removes these intermediaries. Instead, users place their faith in smart contracts and the security blockchains provide.
Still, many consider DeFi to be open and unobtrusive. It doesn’t request sensitive details from its users; instead, it offers non-custodial services. DeFi can’t impose user limitations or stop trade, but CeFi may. If necessary, CeFi can also transfer money to support its clients or halt trade in the event of a cyberattack. Conversion from fiat currency to crypto is made more accessible by CeFi.
Key benefits of DeFi
DeFi provides many benefits beyond the products and services of traditional financial institutions. Some of DeFi’s benefits include:
- New ways to earn interest: DeFi provides new ways to earn money that were previously only available to centralized institutions. This takes value capture away from big banks and gives it to the people.
- Live transactions: Users can make transactions in real time, with market values and interest rates updated every few seconds.
- Open-source software: The code used to create Ethereum and many other blockchain networks is open-source, making it possible for anybody to access, review, and modify it. Without requesting permission, developers and coders can quickly integrate various DeFi apps built on open-source software to create new financial instruments for users.
- Self-custody: DeFi users enjoy custody of their crypto assets via non-custodial crypto wallets or smart contract-powered escrow accounts.
- Trustless and inclusive: Individuals with a crypto wallet and access to an internet connection can use DeFi services. They don't need to wait for delayed bank transfers or pay standard fees to process transactions or shift their funds. However, it's worth noting that some crypto-specific expenses, like gas fees, could be necessary.
Like every other aspect, DeFi also has its cons. Here are a few risks one should consider when using DeFi:
- Complexity: DeFi participation is a complicated component of the crypto space that requires a learning curve. This makes it difficult for beginners to involve themselves in DeFi immediately.
- Hacks: As they’re newer assets, many DeFi protocols have suffered hacks, and because they aren’t regulated, users may lose their money without repercussions.
- Scams: Many scammers try to snag new cryptocurrency investors after promising returns that might far surpass those provided by traditional financial institutions.
- Theft: It's possible for scammers to steal digital currency, particularly given the code flaws in some dApps.
- Volatility: Cryptocurrency is known to be a volatile digital asset. DeFi works on the same underlying framework, which tends to experience constant fluctuations in market values.
- Gas fees: Users must pay gas fees, which are paid to facilitate blockchain transactions, on DeFi platforms. Gas fees can be fairly high, and even these fluctuate.
DeFi offers financial instruments without the assistance of banks by utilizing cryptocurrency and smart contracts. The financial opportunities for what users can accomplish with DeFi keep expanding as more dApps are added to the ever-growing crypto ecosystem.
Some popular DeFi use cases are:
- Transferring money internationally with low transaction fees
- Storing funds in crypto wallets and earning interest through staking
- P2P borrowing and lending
- 24/7 crypto trading
- Trading alternative assets like NFTs
- Buying insurance
- Creating decentralized marketplaces
How can I make money with DeFi?
One of DeFi's most appealing features is its potential for passive income. Many users and businesses are already taking advantage of having access to financial services and products that differ from fiat-run banks, such as:
- Providing liquidity: Some DeFi exchanges offer swaps between token pairs. The liquidity for such transactions is provided by pooled tokens owned by liquidity providers (LPs). As a result, users earn a fee from all swaps on the exchange per their pool share. Before, only centralized market makers like Citadel would be able to make money for providing liquidity!
- Lending money: Banks generate revenue by lending money at higher rates than their customers' deposits. With DeFi, users can lend funds with the guarantee that they'll get their money back while earning better returns than their initial deposits through smart contracts that auto-liquidate the other party if they’re going to default. Now users can act as banks without risk the counterparty will default!
- Staking: Staking allows users to "stake"—or lock—a certain amount of crypto into smart contracts while receiving additional crypto of the same token in return. This process is a prime feature of Ethereum 2.0.
Most—if not all of these methods—can be highly profitable. However, they all carry significant financial risks. As a result, it’s essential to do your research before trying to turn a profit on DeFi platforms.
How to invest in DeFi
If you’re looking to start investing on DeFi platforms, here are a few ways that can help you get started:
Create a crypto wallet
The first thing you'll want to do is create a digital wallet and fund it with cryptocurrency. However, be sure to safeguard your seed phrases and keys if you lose access to your wallet.
Take small steps
If you’re new to crypto, a safe rule of thumb is to trade small amounts of different assets on a decentralized exchange (DEX). This can help you gauge the market and manage risk, although crypto markets tend to be so volatile that you must be ready to lose all your money in a worst-case scenario.
Stablecoins are cryptocurrencies that aim to maintain a value as close to the U.S. dollar as possible. Stablecoins are nowhere near as volatile as “traditional” cryptocurrencies like BTC and ETH, so they may be a safe route to get started.
DeFi protocols are independent programs designed to combat specific traditional financial issues. The idea behind launching these programs was to revolutionize the financial sector. For example, 50% of the world’s population doesn’t have a bank account; DeFi protocols aim to change that by making banking available to more people around the globe. These protocols have witnessed skyrocketing growth over the past few years. In 2020, the total value locked (TVL) of DeFi assets surpassed $12 billion.
Below are the top five DeFi protocols by TVL (at the time of writing):
- Maker: $7.90 billion
- Uniswap: $7.04 billion
- Aave: $4.93 billion
- Curve Finance: $4.90 billion
- Convex Finance: $3.24 billion
Invest in DeFi with Worldcoin
DeFi offers an array of new opportunities in the cryptocurrency world. One of these opportunities comes via a new company called Worldcoin.
At Worldcoin, we aim to enhance the DeFi space by going one step further. We want to give away a free share of our cryptocurrency to every individual on the planet, all while maintaining our users’ anonymity and privacy. Sound interesting? Subscribe to our blog for all the latest updates in the DeFi space and all things crypto.