DeFi is short for decentralised finance. It's a term used to describe the shift from traditional, centralised financial systems to peer-to-peer finance enabled by decentralised technologies built on the Ethereum blockchain. From lending and borrowing platforms to stablecoins and tokenised BTC, the DeFi ecosystem has launched an expansive network of integrated protocols and financial instruments.
With DeFi, crypto assets can be put to use in ways not possible with fiat currencies or traditional financial products. Decentralised exchanges, synthetic assets, and flash loans are just a few of the innovative applications built on Ethereum that are transforming how we think about money and financial contracts.
What’s more, these services are available to anyone with an Ethereum wallet, 24/7. And because they’re built on the Ethereum blockchain, they are trustless and permissionless, meaning that you don’t need to go through a centralised institution like a bank to use them.
The comprehensive list of use cases for DeFi protocols continues to grow, but the most popular applications currently center around yield generation and risk management. In other words, people are using DeFi protocols to earn interest on their crypto assets and to hedge against volatility in the crypto markets.
The explosive growth of the DeFi ecosystem over the past year is a testament to Ethereum's role as the platform of choice for building decentralised applications. The total value locked in Ethereum smart contracts reached a new all-time high of $13.9 billion in February 2021, up from just $1 billion one year earlier.
With over 8,000 ETH addresses now holding at least $1 million worth of value in DeFi protocols, it's clear that yield-seeking crypto investors are turning to DeFi as a way to earn a passive income.
Traditionally, people's money has been kept by a central authority in banks. Furthermore, the primary goal of a bank is to profit off its customers, and numerous financial intermediaries operate to do so as well. Peer-to-peer networks eliminate any financial intermediaries present in centralized finance by removing them from the equation. What's more, they render transactions transparent and immutable, thanks to the use of decentralized technologies such as blockchain.
The lack of intermediaries and decentralization make DeFi platforms incredibly attractive to users. Not only are they extremely secure, but they're also much cheaper to use than traditional financial services. In addition, many DeFi protocols allow users to earn interest on their deposited funds. This is made possible by the fact that these protocols are powered by smart contracts, which automatically execute transactions and enforce conditions.
Benefits of DeFi
There are a few key reasons why you might want to start using DeFi protocols:
Generate passive income: Many DeFi protocols offer ways to earn interest on your digital assets. For example, you can deposit your ETH into a lending platform like MakerDAO and earn interest on your loan. Access to new investment opportunities: DeFi protocols offer a whole range of new investment opportunities, from lending and borrowing platforms to tokenised BTC.
24/7 access: Because DeFi protocols are built on the Ethereum blockchain, they are available 24/7. With DeFi, you are the custodian of your own assets. This means that you don’t have to rely on centralised institutions like banks or government agencies.
Risks of DeFi
While there are many benefits to using DeFi protocols, there are also some risks that you should be aware of:
Smart contract risk: Because DeFi protocols are built on smart contracts, there is always the risk that a bug in the code could lead to loss of funds.
Liquidity risk: Some DeFi protocols may not have enough liquidity to cover all of the outstanding loans. This can lead to loan defaults and loss of funds.
Regulatory risk: The regulatory landscape around cryptocurrency is still evolving, and it’s unclear how or if DeFi protocols will be regulated in the future. This could impact the viability of some DeFi protocols.
Volatility risk: The price of Ethereum (and other cryptocurrencies) is highly volatile, and this can lead to losses in the value of your assets.
Counterparty risk: When you use a DeFi protocol, you are trusting that the other party will honour their commitments. This is known as counterparty risk.
Types of DeFi
There are a few different types of DeFi protocols that you should be aware of:
Lending platforms: Lending platforms like MakerDAO and Compound allow you to deposit your digital assets and earn interest on them.
Borrowing platforms: Borrowing platforms like Dharma and Nexo offer loans backed by your digital assets.
Exchange protocols: Exchange protocols like 0x and Kyber Network allow you to trade digital assets in a decentralised way.
Payment protocols: Payment protocols like SpankChain and Connext provide infrastructure for making payments in a decentralised way.
Prediction markets: Prediction markets like Augur and Gnosis allow you to place bets on the outcome of events.
Identity protocols: Identity protocols like uPort and Sovrin offer digital identity solutions that can be used in a decentralised way.
Data platforms: Data platforms like IPFS and Filecoin provide decentralised storage solutions.
Insurance platforms: Insurance platforms like Nexus Mutual offer decentralised insurance products.
Now that you know about some of the most popular DeFi protocols, you might be wondering how you can get started with using them. The best way to get started is to use a decentralized exchange like 0x Protocol or Kyber Network. These exchanges will allow you to trade digital assets in a decentralised way.
Once you have some digital assets, you can then deposit them into a lending platform like MakerDAO or Compound. These platforms will allow you to earn interest on your digital assets.
You can also use a borrowing platform like Dharma or Nexo to take out a loan backed by your digital assets.
Finally, you can use a prediction market like Augur or Gnosis to place bets on the outcome of events. I hope you found this article to be helpful. If you have any questions, don’t hesitate to comment! :)