A N00b's Guide to Decentralized Finance (DeFi)

We’re all aware of traditional financial products and services. However, since the emergence of blockchain technology, the concept of Decentralized Finance, aka DeFi, has been on the rise.

DeFi provides the same services as traditional financial assets but within a decentralized framework. It refers to using digital assets and financial smart contracts with protocols, and decentralized applications (DApps) built on a blockchain network. 

Bitcoin and Ethereum are the original DeFi applications, both managed by large networks of computers, and not a central authority. Due to its flexibility, Ethereum is the most common platform for the development of DeFi applications, but it’s not the only blockchain network.

What is its purpose?

The main objective of DeFi is to give you full control over your assets by providing you with an ecosystem that doesn’t require a middleman to process your operations. Although many banks and financial services companies promise you full control, you still are trusting them to manage your purchased assets and funds.

Alex Pack, managing partner at Dragonfly Capital, says, “The goal of DeFi is to reconstruct the banking system for the whole world in this open, permissionless way.” DeFi gives easy access to financial services, especially to those who cannot use the current financial system.

The DeFi ecosystem is for everyone. You can start by exploring different resources available on The DeFi list by DeFi Pulse. If you’re interested in digging deeper, here are some more helpful resources.

What are the benefits of decentralized finance?

We know that traditional finance is dependent on institutions like banks to act as intermediaries, and courts for arbitration. And as mentioned previously, DeFi applications eliminate the need for these middlemen. Since it is based on blockchain technology, DeFi benefits from many of its features

1. Autonomy

The digital assets and money that you own in the DeFi ecosystem belong to nobody but you. No central authority with the power to freeze your account, seize your assets, or block your transactions is involved.

2. Accessibility

An open ecosystem like DeFi provides ease of access for individuals who otherwise wouldn’t have access to any financial services whatsoever. 

The services of traditional finance systems are usually unaffordable for low-income communities since they rely on intermediaries earning profits. However, DeFi is significantly cheaper, providing a range of financial services, and making them affordable for low-income groups and individuals. 

3. Transparency 

A decentralized network makes data available for everybody, eliminating most opportunities for fraud. Such a system helps in keeping service providers honest. 

You can easily find out the reserves of a DeFi bank, look up accurate loan rates, and also keep tabs on transactions of public figures if you can find their public address.

4. Tradability 

Another attractive feature of DeFi is synthetic assets or tokenized assets. It allows you to trade efficiently without having to commit to an entire high-priced investment at once. You get the opportunity to purchase or sell just a portion. 

Furthermore, through tradable tokens, which represent just a portion of a real estate investment, you can create investment opportunities for people who couldn’t initially afford it.

Use-cases of decentralized finance

Decentralized Finance is a broad term encompassing a decentralized permission-less financial framework. As a result, we see various customer-oriented services packaged inside.

1. Borrowing/Lending

Open lending platforms allow you to lend cryptocurrencies and receive interest, as well as borrow cryptocurrencies and pay interest. It is one of the most popular applications of DeFi. 

It works just like a bank, except here, the smart contracts determine the loan terms, connect lenders to borrowers, and oversee the distribution of interest. Thanks to the transparency of the blockchain and the absence of an intermediary, the lender earns higher returns and better comprehends the risks.

The open lending protocol is built on a public blockchain network such as Ethereum, helping in the global adoption of digital assets. There are several advantages to an open lending protocol over the traditional financial system:

No credit checks, giving access to more individuals who cannot afford traditional financial services.

2. Stablecoins 

DeFi applications focus on financial services, including monetary banking services. Stablecoin mortgages, and insurance are common aspects of these services. 

As the crypto market continues to grow, stablecoins have also gained significant attention. In a blockchain ecosystem, stablecoins are virtual currencies that are pegged to a fiat currency.

Decentralized stablecoins could potentially offset the volatility of the crypto industry as they’re pegged to physical currency and can be used as digital cash that is not controlled by a central bank.

3. Decentralized Trading

This involves decentralized exchanges, which enable you to trade cryptocurrencies on a distributed network without the interference of a third party, or anyone taking custody of your funds.

This application of DeFi is a bit challenging, as it has a huge scope for financial innovation. Decentralized exchanges usually have lower trading charges compared to centralized exchanges, since they need less maintenance work.

MakerDAO is a smart contract that allows you to open Collateralized Debt Positions (CDPs). You can mint/borrow a token called DAI, a stablecoin pegged to USD, by depositing ETH as collateral. 

Borrowers pay a yearly interest rate as a stability fee for the opportunity to mint new DAI. After the debt is repaid, the DAI is burned with the stability fee owed in Maker’s token MKR. Here, the stability fee helps prevent the over-inflation of the DAI supply.

You don’t need to open a CDP to own DAI. You can simply buy it from the open market from someone who has opened a CDP. It is important to note that whoever you purchased the DAI from still owes the debt and their collateral remains are locked in the smart contract until the debt is cleared.

Compound is a smart contract that enables you to borrow and lend tokens. Just like a bank, Compound lends your money to borrowers and you earn interest over time. However, unlike your bank, your interest starts compounding the moment you deposit into Compound’s smart contract. Another benefit is that the rate you earn is greater than traditional banks since smart contracts don’t require a third party. 

Here, loans are secured via over-collateralization, and borrowers deposit tokens into Compound to increase their borrowing power. In case the borrower’s borrowing power drops under 0, their collateral will be sold to pay off the debt. The interest rate on a loan is different for each asset and varies depending on the demand for a particular asset.

On the other hand, lenders gain variable passive interest for providing tokens to Compound’s money market. Stablecoins such as DAI are one of the most popular assets to borrow and earn good return rates for lenders.

You receive cDAI tokens when you deposit DAI, representing your deposit and the interest it accumulates. All tokens or assets deposited into Compound are known as cTokens.

The DeFi market is still small compared to the traditional financial industry. However, it has made significant strides in bringing innovative methods for conducting business. 

In a world where technology continues to reach new heights, we can be hopeful that more projects and dApps will usher us into a truly decentralized financial reality.