Understanding DeFi And Its Uses

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DeFi
Understanding DeFi And Its Uses

What is DeFi, and why is it so popular in crypto? Click through to learn everything you need to know about DeFi (Decentralized Finance) and its most common uses!

What Is DeFi?

DeFi, or Decentralized Finance, is a fast-growing industry closely related to cryptocurrency. At its core, DeFi aims to change the financial industry by removing intermediaries like banks and empowering users to conduct independent financial transactions. 

DeFi (Decentralized Finance) is a catch-all term for financial services run on publicly available blockchains like Ethereum. DeFi allows you to perform transactions like lending money and trading assets without the help of third parties like banks. Like cryptocurrencies, DeFi has a global reach, supports peer-to-peer transactions, and is lightning-fast.

Since DeFi products are built on the blockchain, every single transaction is viewable by everyone, ensuring transparency. They’re also governed by smart contracts, minimizing the risk of human error when performing transactions.

DeFi products are non-custodial, meaning users are responsible for their DeFi tokens and private keys. Because users are responsible for their keys, it prevents massive loss of funds if a cyberattack breaches a bank or crypto exchange.

Differences Between Centralized And Decentralized Finance

DeFi is the opposite of CeFi (Centralized Finance). CeFi consists of traditional financial institutions like banks and credit unions. Additionally, CeFi also includes cryptocurrency exchanges like Binance and Coinbase.

Some prominent differences between DeFi and CeFi are:

Privacy

Most CeFi institutions require you to fill forms with personal data like your full name, home address, and phone number. While DeFi isn’t entirely anonymous, you don’t need to provide much personal information to make transactions. 

Verifiability

Banks and other traditional financial institutions keep all their transactions secret. Since DeFi works on the blockchain, any user can view any transaction, giving it an extra layer of transparency and trust.

Operating Hours

Banks, stock exchanges, and credit unions typically follow business hours and close on weekends. However, DeFi doesn’t share the same limitations – you can make transactions 24 hours a day, seven days a week.

Common Uses For DeFi

Like its CeFi counterpart, DeFi has many uses in the financial sector. Here are some common ways people use DeFi: 

Decentralized Exchanges (DEXs)

Decentralized exchanges like DeFi Swap and Uniswap allow users to trade crypto without intermediaries. Instead of a central authority, smart contracts connect sellers with buyers – the coins are transferred directly from their wallets without any third party’s help.

Stablecoins

Cryptocurrencies experience more price fluctuations than fiat, which isn’t ideal for transactions. That’s why people made stablecoins or cryptocurrencies that are pegged to real-world assets. Most stablecoins are pegged to the U.S. dollar, but some are pegged to assets like gold or silver.

Some of the most popular stablecoins include:

  • Tether (pegged to the U.S. dollar)
  • USD Coin (pegged to the U.S. dollar)
  • Binance USD (pegged to the U.S. dollar)
  • Digix Gold Token (pegged to gold prices)

Lending Platforms

Lending sites like Compound let users borrow or lend cryptocurrencies. An algorithm sets the interest rates, so interest rates on high-demand cryptocurrencies are typically higher. Unlike CeFi lending, which requires identification or credit scores, DeFi lending only requires collateral in the form of tokens.

Prediction Markets

Prediction markets are essentially betting sites where people make money by correctly guessing the outcome of an event, like presidential elections. DeFi prediction markets are growing in popularity because most governments attempt to shut down centralized prediction markets.

Understanding DeFi Wallets

Like cryptocurrency, you need a DeFi wallet to use decentralized financial services. All DeFi wallets are non-custodial, so you’re responsible for keeping your seed phrase or private key safe. 

While there are both hardware and software DeFi wallets, software wallets are by far the most popular choice for DeFi transactions. Some popular wallets include:

  • MetaMask
  • WalletConnect
  • Rainbow Wallet

Not all wallets are compatible with every blockchain – for example, MetaMask doesn’t support the Solana blockchain. Depending on your requirements and preferences, you may need several DeFi wallets.

Different wallets also have varying support features. For example, SolFlare lets you manage your staked crypto, while MetaMask lets you trade tokens directly from its app.

Before you can use DeFi services, you must connect your wallet to its protocol by clicking “Connect Wallet”. Make sure your wallet is funded with crypto to perform the transaction.

Making Money With DeFi

DeFi is a great way to earn passive income. Here are three ways to earn money on DeFi platforms:

Staking

Staking tokens on DeFi services is similar to having a bank savings account. You lock a certain amount of coins for some time and earn coins as a reward at the end of your stake period. 

These rewards come from the blockchain, which uses your staked coins to validate transactions. Staking more coins allows you to earn higher rewards at the end of your stake period.

Some cryptocurrencies like ETH have a minimum staking amount. However, crypto exchanges also open staking pools, allowing you to join with smaller deposits.

Providing Liquidity

Becoming a liquidity provider on decentralized exchanges like Uniswap works similarly to staking. You lock tokens in a liquidity pool and get liquidity pool coins as a reward for supporting token swaps. The more tokens you commit, the larger rewards you’ll get.

Lending

The most straightforward way to earn passive income with DeFi is by lending money. DeFi lending works differently because you lock the funds into a smart contract that chooses a borrower for you. Once they repay the loan with interest, you can unlock those funds and take your profits.

Benefits And Risks Of DeFi

As with any new technological breakthrough, DeFi has its pros and cons. 

Here are the benefits of DeFi:

  • DeFi is inclusive, so anybody with a DeFi wallet and an Internet connection can access its services.
  • Transactions in DeFi happen in real time, so exchange rates are always current.
  • Users are responsible for their assets, reducing the risk of mass data breaches.
  • DeFi data is tamper-proof, thanks to the blockchain.
  • All DeFi transactions are viewable on the blockchain, ensuring transparency.
  • Smart contracts that build DeFi protocols are highly customizable and can perform complex tasks.

That said, DeFi is still in its infancy, and there are many risks associated with it, such as:

  • The underlying technology of DeFi is still immature and may not hold up under extreme long-term stress.
  • DeFi has nonexistent rules and regulations, so customers have little protection if things go wrong.
  • Like traditional financial institutions, DeFi is also vulnerable to cyberattacks.
  • Most DeFi loans require high collaterals, sometimes up to 100% of the loan’s value.

Conclusion

DeFi or Decentralized Finance is a financial technology concept that empowers users to perform independent transactions. It promises private, fast, and transparent transactions for everyone.

DeFi has numerous applications, from decentralized crypto exchanges and lending platforms to stablecoins. You can also make passive income on DeFi platforms by staking and providing liquidity.

FAQs

What is the goal of DeFi?

The main goal of DeFi is to remove banks and other third parties from financial transactions. This empowers users to perform independent and private transactions without the interference of any financial institutions.

What currencies are used in DeFi?

DeFi commonly uses cryptocurrencies called DeFi tokens. Some of the top DeFi tokens include Dai, Uniswap, and Aave.

Is DeFi a risky investment?

DeFi is still a risky investment because most of its products have not been stress-tested in the long term. That said, sticking to reputable DeFi tokens is a good way to mitigate risk.

When will DeFi be mainstream?

Nobody knows yet when DeFi will be mainstream. To go mainstream, DeFi must be consistently reliable, adopted by the masses, and regulated by governments. 

Is Bitcoin DeFi?

Bitcoin can be considered DeFi since it has no central authority and is powered by a blockchain.