In this guide, we will see what decentralized finance is, what are its main uses and how to start using DeFi applications, which are so important in the world of cryptocurrencies.
What is DeFi or Decentralized Finance?
Decentralized finance or DeFi is a movement that allows users to use financial services such as requesting money, making a loan, or exchanging cryptocurrencies without the need for centralized intermediary entities. These financial services are provided through decentralized applications (Dapps), which run on platforms such as Ethereum or Binance Smart Chain.
Decentralized finance is not a single product or company, but a set of products and services that perform functions that, over time, have been typical of institutions such as banks, brokers or securities firms. credit.
How is it different from traditional centralized funding?
In traditional finance, your money is mostly held by banks, companies whose main purpose is to make money. The entire financial system is full of intermediaries who approve and facilitate the movement of money between two parties, charging interest for these services.
For example, when we make a bank deposit, apply for a loan, or buy shares in a company with a broker.
Decentralized finance removes all intermediaries, allowing individuals, entities, and businesses to transact financially quickly, cheaply, and securely.
Simply with an Internet connection, you can request money or apply for a loan through applications that automatically execute, verify and record transactions made in decentralized ledgers.
How does decentralized finance work?
Defi applications use blockchain technology and are able to operate without intermediaries. They do this through smart contract platforms such as Ethereum (ETH), Solana (SOL) or Cardano (ADA).
A smart contract or smart contract is an agreement between two parties in the form of computer code. These contracts run on the blockchain, so they are stored in a public database and cannot be changed.
Transactions that take place in a smart contract are processed by the blockchain and are executed without intermediaries involved.
The transaction or exchange between the two parties takes place only when the terms of the agreement are fulfilled.
Smart contracts enable the development of different types of decentralized applications (Dapps) that make up the entire decentralized financial ecosystem.
Ethereum (ETH) is the most widely used smart contract cryptocurrency and is the largest project after Bitcoin. One reason is that the vast majority of DeFi projects you can find on the market are built on Ethereum.
Types of DeFi apps
Once we’ve seen what decentralized finance is and how it differs from traditional finance, we’ll go over some of the most important Defi categories so you can better understand some of its uses.
Borrow and Borrow: Decentralized Lending Platforms
Applying for a loan from a bank requires having a certain level of creditworthiness and having enough collateral to convince the bank that you deserve the loan and that you will be able to repay it.
Decentralized lending solves all these procedures within the crypto ecosystem, allowing you to use your digital assets as collateral to obtain borrowed cryptocurrency.
You can also earn interest on your assets by participating in the loan market, making capital available and earning interest on it.
In other words, it connects lenders with people who want to get crypto funding. An example is the Compound (COMP) platform which allows users to lend or donate their capital.
DeFi lending systems use collateral, which means that in order to take out a loan, the user must post digital assets as collateral. You don’t need an entity to give you a credit score to access the money, rather your application needs to be supported.
Decentralized Exchanges (DEX)
Decentralized exchanges (DEX) allow us to trade cryptocurrencies with very low fees, anonymously, and retaining custody of our digital assets.
There are currently the most used DeFi Dapps and some examples are Uniswap from the Ethereum (ETH) network and Seumen from the Solana (SOL) network.
Stablecoins, or stablecoins, are cryptocurrencies whose price is tied to (and sometimes supported by) the US dollar. This means that 1 unit of stablecoin is worth 1 USD.
Tether (USDT) was one of the first centralized stablecoins to be created. Each 1 USDT is theoretically backed by 1 USD in the company’s bank accounts. However, one of the biggest issues with Tether is that users have to believe that USDT reserves are fully collateralized, which has always been a hotly debated issue.
Decentralized stablecoins like DAI solve this problem because they are created and backed by various guarantees and automatic mechanisms that keep the price stable (1 DAI = 1 USD) and in a verifiable manner.
Derivative financial instruments
A financial derivative instrument is a contract whose value is given by another asset, such as commodities, currencies, bonds or indices. An example of traditional financial derivatives are gold futures or the SP500 stock index.
In addition to being able to speculate on its price variations, a very important utility for traders is to be able to hedge their positions and reduce their risk in a trade or investment.
Until now, they have been operated through centralized platforms, but DeFi platforms are creating decentralized markets for financial derivatives.
An example is the Synthetix (SNX) platform which allows the issuance of synthetic assets representing stocks, FIAT currencies or commodities, to name a few.
We included yield farming in this list because it is a very important concept related to decentralized finance.
Yield farming is essentially depositing cryptocurrencies or digital assets to earn interest passively, with its main purpose being to provide liquidity to decentralized exchanges.
Simply put, we bring a certain amount of cryptocurrencies to an exchange, which are used so that trades can be made between different currency pairs. In return for providing liquidity to the system, we earn interest which comes from the interest users pay to use the services of the exchange.
The future CHALLENGE
A very common question about DeFi is: will they revolutionize the financial industry? The answer is difficult to know due to various factors, but what is clear is that it will not be something that will happen overnight.
Decentralized finance is in its early stages of development and currently there are no regulations in this regard.
Within cryptocurrencies, regulation has always been a hot topic, with countries banning its use and others regulating in favor of it, like El Salvador did in 2021. Therefore, one of the key drivers of the Defi development is the regulations that are enforced. the future because they can be very constraining or on the contrary favor their development.
Another problem we encounter is that decentralized finance applications are difficult for the average user to use, which means a high barrier to entry. This problem is solved by creating protocols with more friendly and user-friendly experiences.
But beyond the disadvantages, it has many advantages for the future of the because of its decentralized nature, the preservation of anonymity, the speed of transactions and the avoidance of bureaucratic procedures.
And without forgetting its great potential, offering alternatives to be able to passively obtain profits from our capital. Something particularly important in an environment like the current one where we find ourselves with very low and sometimes negative interest rates.
How to start in decentralized finance?
How to get started with decentralized finance varies depending on your experience in the crypto world and your goals.
First of all, my advice is to understand the different concepts related to DeFi as well as possible. I’ve given a few more brush strokes, but before going any further, make sure you understand the basic concepts such as:
- The difference between a centralized exchange (CEX) and a decentralized exchange (DEX)
- What are the main smart contract platforms: Ethereum, Binance Smart Chain, Avalanche, Solana…
- You know how handbags or wallets like Metamask work.
- Differences and uses of cryptocurrency lending, yield farming and staking.
And second, I think the best way to learn is to practice putting some money into it.
There are many networks with DeFi applications, the largest currently being Ethereum. The main problem is its very high fees, so it is not recommended for someone who is just starting out.
For this reason, a good option is to start with another blockchain that has a large number of users and low fees, such as Binance Smart Chain, which is the smart contract platform BNB, the currency of Binance Exchange.
With very small amounts of money, you can interact with apps like Pancakeswap and see first-hand how a decentralized exchange works or how to do yield farming.
If you want me to do a tutorial that describes the process step by step, let me know in the comments.
How to make money with decentralized finance?
There are several ways and it varies depending on the risk you want to take. One way to get passive income is on a lending platform, lending our money in exchange for interest.
Another possibility is to practice Yield Farming, with the possibility of obtaining much higher profits, but assuming more risks.
Is it safe to invest in Defi?
Yes, but with nuances, because it is a practice that involves risks.
Many projects have been running for years without a single problem and with millions of dollars invested. But you need to familiarize yourself with the mechanisms of operation of the protocols and the use of wallets, because mistakes can cause us to lose capital.
On the other hand, you need to know the difference between good and bad projects, as many are simply scams or may have bugs in their smart contracts.
What is TVL in DEFI?
Total Locked Value (TVL) is the sum of all cryptocurrency deposited into a DeFi protocol for staking, lending, or simply providing liquidity.
DeFi is a new technology worth exploring and can provide good investment opportunities.
But it is important to remember that decentralized finance and cryptocurrencies in general are taking their first steps, so investing in them comes with a high risk of losing all your money. You should always exercise caution before making an investment.