Short for “decentralized finance,” DeFi refers to a wide variety of financial applications based on blockchain technology. Being decentralized, these applications are not controlled by a single entity or a central source. This kind of structure gives more freedom and control to the users of DeFi applications, rather than the governing bodies in the finance world.
Why is Decentralized Finance Important?
DeFi is based on blockchain, the technology behind the leading cryptocurrencies in the world. As such, it brings higher security and more transparency to users who rely on digital financial transactions. Compared to traditional finance, DeFi is capable of providing faster transactions and adding more value to digital financial assets.
Another reason why DeFi is so important is because it makes financial lending easily accessible to everyone, regardless of your status. Traditional financial institutions require lengthy verification processes and lists of requirements that customers have to meet. With DeFi, you don’t have to go through all that trouble to ensure a fast and secure loan.
Understanding DeFi Lending – How Does It Work
DeFi tools allow users to make money by lending their crypto assets to others and earning interest in return. That way, anybody can make money by providing loans and anybody can get a loan whenever necessary. As such, the DeFi loans sector has become a much better option for users compared to traditional finance.
The way DeFi lending works is quite simple. Let’s say you have a certain amount of crypto assets sitting in your wallet. The value of these assets may increase or decrease over time but you won’t be making profit actively. However, with the DeFi lending system, you can lend your assets to someone else and earn interest the same way traditional banks earn interest.
That way, anyone can become a lender and make money by collecting interest from other users. The way you can start lending money via DeFi tools is through lending pools, which we will explain below!
DeFi Lending Over Traditional Lending
In essence, DeFi tools offer all the same products as traditional banks. The only difference is that the crypto assets are decentralized and thus are much faster and way more secure. With DeFi lending, anyone can take a loan quickly without having to reveal their identity or go through lengthy verification processes required by brick and mortar financial institutions.
Overall, DeFi allows for peer-to-peer lending without a third party (such as a bank) taking a cut from the profits. Decentralized loans are a much better option both for the lender and the borrower because DeFi allows for transparency and makes the whole process much faster.
Wallets in the DeFi Ecosystem
Wallets are secure locations where you can store your crypto assets without worrying about relying on third parties such as banks. With the right wallet, you get full access and control over your crypto private keys. A good DeFi wallet should be non-custodial (users should be the only ones able to access their funds), as well as easily accessible.
Some of the most popular wallets in the DeFi ecosystem include MetaMask, Coinbase Wallet, and Argent. Besides storing your assets in a secure environment, crypto wallets allow you to send and receive multiple cryptocurrencies from one location.
Lending Pools
Lending pools are structured to distribute interest to each investor involved in making a loan. Through the use of smart contracts provided by projects such as Ethereum, users can place their crypto assets into a lending pool and thus allow borrowers to take how much they need according to the rules specified in the contract.
As an investor, you can choose between different types of pools depending on your approach to crypto lending. The borrowers should also do some research to find the right pool that fits their needs. Keep in mind that the borrowers always have to provide some sort of collateral when taking a loan.
For example, if you were to take a car loan from a bank, the car would be the collateral, that is, the bank would take your car in case you stop paying back the loan. However, things are a bit different when it comes to DeFi lending. Since the whole system is decentralized, meaning the borrower remains anonymous, there has to be some form of collateral brought to the table.
In other words, when taking a loan, the borrower must offer something more valuable than the amount of the loan itself. For instance, if you want to borrow Bitcoin, you have to deposit an equal or higher amount of any valuable cryptocurrency before you get the loan. This amount will be kept as collateral and only taken if you stop making payments.
In case you pay back the entire loan, the amount you placed as collateral will be returned to you. Once you pay the loan back, the lending pool distributes the money to the investors that were involved in your transaction.
Pros & Cons of DeFi
Although DeFi brings significant advantages to the world of finance, there are some pros and cons you should consider before getting started. Here’s a brief list to keep in mind:
Pros of DeFi:
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The whole system is decentralized – no central authority controlling the transactions.
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Lending, borrowing, and other financial services are made available to anyone and everyone.
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The decentralized system allows for anonymity when performing transactions.
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Faster transaction speeds.
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A higher level of security.
Cons of DeFi:
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Borrowers have to provide collateral before getting the loan.
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The price of crypto assets fluctuates constantly. For example, the price of the collateral can drop below the price of the loan, meaning the borrower has to make up for the difference. In case the value of the collateral drops below the value of the loan, there would be no reason for the borrower to return the loan. This is a bad situation for lenders because they are guaranteed to lose money in this scenario. However, that is what DeFi platforms offer liquidation protocols as a means of protecting lenders. Namely, if the price of the collateral starts getting way too close to the price of the loan, the platform will liquidate, that is, sell the collateral to repay the loan and return the money to the lender. In this case, the lender does not lose any money because the platform will consider their investment a priority. In other words, the lender won’t lose anything if the other party decides not to pay the loan back because the platform’s liquidation system will protect their profits.
Some Leading DeFi Protocols
Before you get started with DeFi, take time to familiarize yourself with some of the leading DeFi protocols, including the following:
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Uniswap – a New York-based decentralized exchange built on Ethereum’s smart contracts. It allows you to swap ERC-20 coins straight from your Ethereum wallet.
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Yearn Finance – offering a list of DeFi protocols that aim to provide high and risk-adjusted returns on all Ethereum-based tokens.
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Project Serum – one of the latest decentralized exchanges that uses blockchain unrelated to Ethereum.
How to Get Started with DeFi
#1 Set up a Wallet
While you can go ahead and do your own research on all the different lenders on the market, the easiest way to access DeFi services is through non-custodial wallets. As we mentioned, 1 wallets such as Metamask, Coinbase Wallet, and Argent are easy to use, which makes them a great option for beginners in the DeFi space.
With a non-custodial wallet, you are the sole owner of whatever currency you choose to place inside. Most (if not all) DeFi products will require you to connect your wallet and thus start lending, borrowing, or performing any other transactions. In order to start using any non-custodial wallet of your choice, you will need a small amount of ETH to cover the initial transaction fees.
#2 Choose a DeFi Ecosystem
Currently, one of the biggest lenders in the DeFi space is AAVE. In order to get started, head over to avee.com and connect your wallet. The platform features a simple structure that is easy to understand and navigate.
#3 Start Lending
In order to start lending, select an asset you wish to deposit and allow AAVE to pull the selected amount from your wallet. You will be asked to sign the transaction, after which your deposit will be added to the lending pool. The AAVE platform offers a detailed dashboard where you can monitor everything that is going on with your deposit in real time. The good thing about AAVE is that each asset on the platform has two interest rates: a stable rate and a variable rate. You can switch between these two at any time to gain the best possible interest on your investment.
A variable interest rate is based on an underlying index that changes periodically. In other words, the variable rate fluctuates over time and, as such, it offers one obvious advantage – if the underlying index rises, the interest payments will increase. Similarly, the payments will decrease if the index drops. The variable rate moves up and down with the rest of the market, which makes it a much riskier choice compared to the stable rate.
As its name suggests, the stable rate is fixed and it allows for more certainty when calculating your interest and expenses that will be tied to the loan. It is up to you to decide whether you want to pay a stable interest rate throughout the entire period of paying the loan back or if you want to risk things with a variable rate to get a chance at lower interest fees. The good thing about AVEE is that you can switch between these two types of rates even after you get the loan.
Conclusion- Is DeFi a Future?
Currently, the DeFi sector is growing at breath-taking rates. There is no doubt that the benefits that this system provides outrun anything that traditional banks and financial institutions can offer. On top of speed and security, DeFi makes financial products available to anyone, which can help close the social gap between people with different statuses. However, the question is whether DeFi will ever become the number one source of financial solutions, and will traditional banking disappear?
Even though it is still way too early to make such predictions, it is safe to say that decentralized finance is here to stay. The sector is growing more and more each day and its products are evolving constantly. For all we know, we might see a future where decentralized financial systems are the go-to option for making payments and providing financial products. With that in mind, consider getting started with DeFi before its products start getting more and more mainstream.
