Introductory Guide to Decentralized Finance (DeFi)

  • Vanshika Kaushik
  • Oct 12, 2021
  • Financial Analytics
Introductory Guide to Decentralized Finance (DeFi) title banner

Imagine stepping into a free finance world, where no rechecks are done for approving our loans , where we can open a bank account within seconds, where sending money abroad is just a click away looks dreamy right!! If you feel it isn't possible in today’s world let me whisper something magical to you, “it's all possible now”. 

 

The term that is reinventing the basis of financial systems, that is making it all simple (from investing to borrowing), is decentralized finance. DeFi that’s what the world calls it. Now you must be curious to know about this new to the fame financial concept. 

 

Let’s start from scratch so first what is DeFi?

 

Decentralized Finance

 

Decentralized Finance or DeFi is a system that allows people to make investments, borrow money, send money abroad, and practically enables them to do anything and everything (related to digital money) without stepping out.

 

DeFi can be thought of as a bank that conducts multiple operations but has no physical branches. It facilitates trading, simplifies the exchange processes, provides interest on investments and can do all of it without having a physical office and human employees. 

 

This system of finance works on the decentralized blockchain network. The concept of DeFi is closely connected to cryptocurrency and blockchains. Interacting with DeFi simply means that you are interacting with a software. 

 

A decentralized system can be a combination of blockchain and other open technologies. DeFi seeks to remove the middlemen involved in transactions. 

 

(Must Check: What is Digital Money? Types, Working, Benefits, & Risks)


Whether opening an account or taking a bank loan an individual has to perform a long list of operations (in centralized finance)  like submitting their original IDs, submitting the address proof, with DeFi you can open an account, trade, lend without submitting your IDs all that without any human rechecks. 

 

Open Banking is a new concept by DeFi. Every user on the DeFi system has a wallet. This wallet is the key to performing financial transactions on the DeFi ecosystem. Users get access to private crypto keys via the wallet. 

 

(Related Blog: Centralized and Decentralized Cryptocurrency Exchanges)

 

DeFi wallet is just a normal wallet except it stores the digital currencies. You can send cryptocurrency via your DeFi wallet, and perform other financial transactions. Most of the DeFi applications are built on the ethereum blockchain network. DeFi increases the transparency in the workings that never existed in centralized finance. 

 

Watch this video for a super simple explanation of Decentralized Finance. 



Now let’s understand how DeFi works. 

 

How does DeFi work?

 

A major difference that sets DeFi apart from traditional financial institutions is the way it works. Aforesaid, the main purpose of DeFi is to remove the middlemen that are involved in financial transactions, and DeFi does so by its ethereum blockchain  powered “smart contracts”. 

 

(Related Reading: What is Ethereum - All you need to know)

 

Ethereum blockchain network can automatically validate the authenticity of transactions. Smart Contracts (self executing contract) on the ethereum blockchain, can automatically perform transactions, if specific conditions are met i.e. “invest $50 in dogecoin if elon musk tweets this saturday”, if anyhow Elon Musk tweeted on Saturday, $50 will be automatically invested in dogecoin (sounds cool right!)

 

That means Smart Contracts enables DeFi to remove all the second and third parties that are involved in making a transaction. Smart Contracts are live contracts that are programmed in programming languages. 

 

It is practically impossible to make changes in the source code of smart contracts. When smart contracts are live, they only take up the details (and no code changes are permitted by an external party)

 

Smart Contracts are always under the public radar that would also mean that “bad contracts”(the ones where contract conditions remain unfulfilled) will be quickly set apart from the good ones. 

 

(Related Reading: What is Blockchain Mining in 2022?)

 

Selected members of the Ethereum community can read the code, this community always assists developers to stay in check. Though DeFi’s working system might appear simple it is robust as its foundation is laid by rocksolid programming languages like “Solidity”. 

 

Basically DeFi’s working is all about technology and software so if you are from Gen Z or even if you trust technology you can trust DeFi. 


This image describes working system of decentralized finance

Working system of DeFi


 

6 Applications of Decentralized Finance

 

(Please note Coindesk is used as a reference for this section)

 

Following are some popular DeFi applications:- 

 

  1. Stablecoins: Stablecoins are cryptocurrencies that are pegged to an actual asset to stabilize their prices. The actual asset can be fiat currency or even an asset like gold. Pegging cryptocurrency to an actual asset helps in controlling the extreme fluctuations and price change. 

       

  1. Wrapped Bitcoins : Wrapped bitcoin, is a type of bitcoin that can be used on the ethereum network. Put simply it enables the bitcoin holders to use DeFi wallets and other DeFi applications without liquidating their bitcoin holdings. (So users can use their bitcoin on any ethereum based platform). 

 

  1. Decentralized Exchange System: A decentralized exchange system ensures that cryptocurrencies can be freely traded via the system. Users can exchange one cryptocurrency for another, lend a cryptocurrency to generate passive income, purchase a new cryptocurrency through these exchanges. 

 

  1. Cryptocurrency Lending Platforms: This specific application of DeFi is the one that has garnered the most attention. These lending platforms provide people a means to generate passive income, via these lending platforms people can extend their bitcoin, ethereum, dogecoin, litecoin as a loan. Further the rate of interest is their income. 

 

  1. Yield Farming: Yield farming is an investment strategy to earn maximum return in the minimum time frame. For the investors who are well acquainted with the cryptocurrency investment strategies, yield farming can be the best source to earn higher returns. 

 

An investor simply deposits a unit of cryptocurrency and earns money from the trading fees i.e. a DeFi investor can make money from their cryptocurrency holdings. 

 

  1. Prediction Markets: Making money through predictions, is an old concept. And though illegal, a lot of people are still making money by speculating about future. The main purpose of DeFi is to remove the multiple parties that are involved in the prediction markets. 

 

Some DeFi applications support the prediction market, here also people make money by just speculating what might happen in the future. 


This image describes applications of DeFi

Applications of decentralized finance


4 Practical Examples of DeFi

 

  1. Advanced Payment Solutions: DeFi can increase transparency in payments, this is the biggest reason companies are exploring the use cases of DeFi in their payment methods. Paybito and Wyre are using DeFi to provide simple payment solutions to their consumers. Sending and receiving money through DeFi is simple, DeFi’s infrastructure will offer a scalable payment solution.

 

  1. Risk Management: DeFi can be used for risk management. Smart Contracts will open new avenues to tap organization's threats and risks. Users will get new tactics and tools via DeFi. Also keeping a track of organizations key risk factors is simple on the smart contracts. Ondo Finance is exploring the use cases of DeFi in Risk Management. 

 

     (Must Check: AI in Risk management - Applications and Challenges)


 

  1. Peer -to- Peer Borrowing and Lending:  With DeFi individuals can directly obtain loans. Peer-to-Peer Borrowing means loans can be obtained without any middlemen. With DeFi both lending and borrowing operations are simplified. Antier is a DeFi lending platform that connects borrowers and lenders and facilitates P2P borrowing and lending.  

 

 

How to make money through Decentralized Finance?

 

Cryptocurrencies, Non-Fungible Tokens and now stablecoins have opened up new and distinct platforms that never existed before, making money via decentralized finance is easy. The best thing is it guarantees an interest rate that is quite higher when compared to centralized finance. 

 

Lending (providing loan in the form of cryptocurrencies), staking (this process involves staking the cryptocurrency token, on the smart contract to earn money from the staked token).  Yield farming (depositing a unit of cryptocurrency to earn money via trade fees) are some of the ways in which passive income can be generated from decentralized applications. 

 

By simply getting registered on any DeFi application (polygon, aave, the graph, fantom, pancake swap etc.), users can start with the process of making money.

 

 

DeFi and the Future of Finance

 

“Decentralized Finance (DeFi) is one of the hottest applications of cryptocurrency and blockchain technologies––taking traditional financial concepts like securities, bonds, money markets, and more, and putting them on the blockchain puts significantly more power in the hands of those who participate in these markets, not just the middlemen who manage them. - ― Jenco Tech

 

DeFi holds a massive potential for the future. DeFi will provide the basis for all the future transactions, in the future even the people new to the cryptocurrency world will be able to make money through “decentralized finance”. 

 

DeFi will have an explosion in the future, the transparency in its operations, its quicker way to make transactions will attract new investors to this. Decentralized systems will soon lead the future of economies.

 

(Related Reading: What is the Future of Cryptocurrency?)

 

Though critics are still vary about this new technology a lot of people are already trading, staking, lending, and borrowing through DeFi platforms, this fresh idea has already showered millions on many and will continue doing so even in the future.

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