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Beginner’s Guide to Understanding DeFi: What is DeFi?

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What is DeFi

Decentralized finance (DeFi) is a disruptive technological innovation that uses blockchain and crypto to allow financial services and transactions. DeFi is working daily to ensure peer-to-peer transactional relationships replace centralized instructions. Developers in this ecosystem are working to ensure that individuals have access to complete financial services such as loans, mortgages, asset trading, etc.

What is DeFi

DeFi is the abbreviation for decentralized finance. Decentralized finance is a canopy term representing every financial use case of blockchain and cryptocurrency. The chief purpose of DeFi is to disrupt the existing traditional financial systems and take away the financial activity power from intermediaries while handing it over to the users. That is, individuals can directly engage each other in financial activities.

Thus, we can regard DeFi as a word representing financial products or services accessible to anyone using Ethereum with an internet connection. As a result, the market is always open, and no centralized institutions can deny you financial services. Likewise, services that are manual and prone to human errors are now automatic and safer. DeFi’s transparency makes it easy for anyone to scrutinize it.

DeFi vs Traditional Finance

The first argument for decentralized finance as a disruptive technology is the financial empowerment it brings to an average internet user. It is noteworthy to remember that the traditional finance system makes it impossible for a particular population segment to have access to financial services. This has brought different financial problems for individuals. And that’s what DeFi proposes to solve.

With DeFi, any individual can access financial services such as loans. Likewise, the government have control over the traditional finance system. They can shut it down at any time. But with DeFi, investors can lend users money without the interference of a middleman or third party. And the market is always open for transactions. There are no office-hour rules associated with DeFi.

Meanwhile, traditional financial institutions now leverage blockchain technology to provide decentralized opportunities to their clients. As a result, they are working on being competitive and relevant. An instance is a traditional bank creating a yield-farming system for its clients. However, this is subject to regulations because institutions need approvals to engage in such.

Importance of DeFi

The advent of DeFi is a disruptive process that sees the elimination of barriers to financial inclusion. DeFi has its foundation built on Bitcoin technology. This means that individuals, groups and organizations can conduct a transaction without the conventional traditional body, banks.

With a peer-to-peer (P2P) network, DeFi removes any form of third parties involved in financial transactions. This means that investors or individuals can conduct transactions without intermediaries. This introduced the beginning of decentralized banking.

DeFi’s chief aim is to create an open and permissionless financial market with no trust issues. This enables us to access a free and fair financial market that an average internet user can access. Over time, different technology available in the DeFi space is improving the user experience in the financial ecosystem.

How Does DeFi Work?

Often, you hear individuals associating DeFi with cryptocurrencies like Bitcoin, Ethereum or AABBG. But it transcends beyond that. DeFi makes use of smart contracts as a replacement for traditional financial systems. This means that no banks or financial institutions are in charge of your money and the entire transaction.

DeFi uses decentralized applications (dApps) to execute every transaction that runs on the blockchain. In the blockchain, blocks are the record sheets that hold details of each transaction. Other users verify the transactions. After verification, the block will close and encrypt. Another block with the previous block’s information is created and chained together. All of that is overseen by an immutable technology known as smart contracts.

DeFi Use Cases

DeFi technology is changing the narrative in the financial space. This is due to the emerging applications of DeFi across the blockchain ecosystem. It is growing beyond what traditional finance can offer the populace. By leveraging DeFi, you can build anything in the current financial system in a decentralized version.

DeFi has lots of interest diverted towards it due to the creativity it allows with financial inclusion. This makes the blockchain industry receives innovative products. Now, let’s examine the everyday use cases of DeFi.

  1. Decentralized Exchanges (DEX)

Decentralized exchanges are an integral part of DeFi. A decentralized exchange—such as the AABB exchange—is a peer-to-peer platform where cryptocurrency traders conduct transactions directly with each other without any form of intermediary or fund managers. This means that you can trade tokens for each other or trade them against fiat currency. That is Bitcoin for AABBG token or BTC for U.S dollars.

The smart contract is the technology decentralized exchanges leverage to facilitate transactions. They are a non-custodial platform. This explains that users have absolute control over their crypto wallet private keys, such as the AABB wallet.

  • Lending Platforms

In the DeFi space, lending and borrowing are becoming popular. With DeFi lending, you can borrow some funds while your crypto assets, such as AABBG, stand as collateral. The capital flowing through the DeFi ecosystem is vast, wherein we have billions of dollars as total value locked.

  • Margin and Leverage

Margin and leverage promote the decentralized finance market to an outstanding level. Here, users can borrow cryptocurrencies such as AABBG while using other cryptocurrencies as collateral based on margin. Additionally, the user’s return can increase by programming the smart contracts to include leverage. However, these two components increase users’ risk since the system works with algorithms without human elements.

  • Decentralized Marketplaces

Decentralized marketplaces are platforms where individuals trade and invest in digital assets without needing a third party. These are available globally. A popular example is a non-fungible token (NFT) marketplace.

NFT marketplaces are decentralized marketplaces where digital collectors buy, create, display, sell and store tokens representing unique ownership of tangible and intangible items. You need a funded crypto wallet (such as the AABB wallet) and a user account before accessing an NFT marketplace. Examples of popular NFT marketplaces OpenSea and SuperRare.

  • Payment and Stablecoins

Before DeFi can become a whole financial system, there is a need for stablecoins. Stablecoins are digital currencies pegged to fiat currencies such as U.S dollars or assets like gold. Stablecoins are integral parts of the DeFi space. Their price stability increases their demand among lenders and borrowers in the DeFi market.

FAQs about DeFi

  • Is Bitcoin a Decentralized Finance?

You might be easily confused that Bitcoin (BTC) is a DeFi since DeFi uses cryptocurrencies and BTC is crypto. But DeFi is designed to use crypto across the ecosystem. As such, Bitcoin is not DeFi. However, BTC is part of DeFi.

  • What does DeFi Do?

One primary goal of DeFi is to ensure that third parties are eliminated when conducting financial transactions.

  • How Do I Make Money with DeFi?

The number of projects available as Ethereum DeFi projects is numerous. A new project springs up daily, equating to new market value for DeFi. As a result, users have different means to make a lot of money via DeFi. One of which is the Ethereum-based lending apps. With this, you can generate passive income by loaning your money and generating interest from them.

On the other hand, you can engage in yield farming. This brings you more significant returns, but higher risks are associated with it. Yield farming allows you to make your crypto assets such as AABBG work for you while you generate substantial returns. Although the systems can be complex at times, they might not be transparent enough.

  • Is it safe to invest in DeFi?

As early adopters, investors can be easily tricked to believe that DeFi will dictate the future of finance. This is because this disruptive technology can result in huge gains if you invest in it early. However, it is noteworthy to mention that it is risky. As s newcomer, you might have difficulty distinguishing between good and bad projects. At the same time, there were numerous bad DeFi projects.

Despite the increased activity and popularity of DeFi over the years, DeFi applications, including meme coin YAM, crashed and burned. As a result, the market cap dropped to $0 from $60,000,000 in about 35 minutes. Meanwhile, investors lost their money in similar situations with Hotdog and Pizza.

Another significant challenge is the DeFi bug. This is common in DeFi projects. Smart contracts are immutable and can’t change once the rules become protocol. As a result, the bugs remain permanent, increasing the risk associated with the projects.

  • What is the total value locked in DeFi?

The total value locked (TVL) in DeFi is the addition of all cryptocurrencies deposited, loaned, staked or used in a pool or for other transactional purposes in the entire DeFi ecosystem. Likewise, you can translate it to the total of specific cryptocurrencies, such as AABBG, bitcoin or ether, leveraged for financial activities.

  • Who invented DeFi?

No one has been regarded as the inventor of DeFi. But the first DeFi applications launched on Ethereum, a blockchain ecosystem created by Vitalik Buterin. Launching DeFi has extended to other blockchain networks (such as Avalanche, Binance Smart Chain, and Solana) with a smart contract for transaction automation.

Is DeFi the Future of Finance?

The disruptive potential of DeFi has proven over time that it will serve a great purpose. Most significantly, it will give investors the flexibility to deploy their assets creatively. This might happen as things we’ve not experienced before in the financial markets. However, this comes with significant risks associated with it. 

Despite its promises, DeFi still has a long path to tread. There is a constant need to educate the general public about its potential. However, there is a significant need to build tools that will make it easy for people to conceive their potential themselves.

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Ridwan is a digital nomad. He is an experienced crypto writer that writes across blockchain and cryptocurrency topics. He buries his head in books' leaves, playing games and networking if he is not writing. He believes you will be happy if you appreciate the little things that matter while working for more.