What is decentralized finance (DeFi)?
DeFi is an abbreviation for decentralized finance. Being decentralized means that when someone wants to make a financial operation there are no intermediaries or middlemen. The lack of an intermediary means that financial operations (such as lending, borrowing, and trading) can happen more quickly and with less amount of fees. This type of finance is based on blockchain which enables the creation of services that are very similar to traditional ones by using cryptocurrencies.
A user can access his assets through digital wallets for security. To make transactions smart contracts are used. DeFi is very accessible due to the fact that basically everyone with an Internet connection can use it. Also, it works 24/7 so everyone that is connected can use it whenever he or she wants. Most DeFi’s are built on Ethereum because it’s easier to use it to build other types of decentralized applications beyond simple transactions (Ethereum has a platform for smart contracts). All that sounds very good, however, decentralized finance is still relatively young. This means that it’s not regulated and there are little to no laws for financial crimes in that area.
How Does DeFi Work?
To describe its method of work first we will explain shortly how traditional financial institutions and CeFi work. They are intermediaries in financial operations because they guarantee that a transaction will happen without someone being scammed. If they scam the users of its services soon no one will use them and they won’t be able to generate income. That’s why instead of that they serve as grants of security making sure that everyone will fulfill his part of the contract.
In Decentralized finance, transactions are secured through blockchain technology. It allows all transactions to be recorded on blocks (which are verified by users of the network) that are ‘chained’ (that’s why it’s called blockchain). If someone wants to change the information in a certain block, he will have to alter also the following blocks, which is almost impossible making this tech very secure. Some blockchains also enable smart contracts. Smart contracts are self-executing contracts on the blockchain. To be executed certain conditions agreed upon by two people making a transaction must be fulfilled. They run automatically and are irreversible. It means that once the contract is fulfilled the funds can’t be given back. One of the smart contracts’ biggest advantages is that they are more transparent and reduce costs like bureaucracy.
What is a Decentralised Exchange (DEX)?
Decentralized finance can be used for Dapps (decentralized apps). As the name suggests they are the same as common apps with the only difference being that they have the benefits of decentralization. One of the most common types of Dapp is DEX (Decentralized Exchange) also known as peer-to-peer market. DEXes facilitate the exchange of tokens and serve as Automated Market Makers (AMM).
In a centralized exchange, market makers provide the markets with liquidity to facilitate trades. However, market makers in these markets are usually very wealthy people or organizations. DEXes use liquidity pools to ensure that it has enough market liquidity while also avoiding centralization.
Liquidity pools are collections of tokens or other digital assets. These assets of tokens are provided by strangers using the DEX meaning that almost anyone can put his assets in these pools. When making transactions in DEX there are very small fees. These fees are given to the providers (usually in the form of tokens) as a reward for providing the market with liquidity. This is known as yield farming.
DeFi Tokens, Staking & Wallets
DeFi tokens or coins are used in decentralized platforms. They provide users with a set of applications and services that are built on blockchain. Some of them possess value not only in terms of finance. An example is governance tokens which allow their owners to vote on whether a change should be made or not in a platform.
In these platforms, one of the methods to make sure that transactions will be secure is to use Proof of Stake. In the networks that imply it transactions are verified by validators that stake crypto assets by locking them into a smart contract in exchange for rewards. Staking usually requires a higher amount of capital and that’s why staking pools are created which allow people to join their capital for staking. It helps to make verification less centralized which is one of decentralized finance’s goals.
When someone wants to use decentralized exchange he must have a non-custodial wallet. These wallets are accessible only to those who possess the password and a seed phrase. When you choose the wallet you want to use first you must decide on what blockchain you will use because some may not support certain cryptocurrencies. There are two types:
- Software wallets – you access them through a web browser and are usually free;
- Hardware wallets – they are like USB sticks. Their advantage is that you can hold your capital in them while being offline (also known as “cold storage”).
Some wallets also come with certain additional features that can benefit you. That’s why research must be done before choosing one.