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October 2, 2022

A Beginner’s Guide to DeFi

A Beginner’s Guide to DeFi

Unless you’re a technophobe, living in a cave, or have been off-grid for the last couple of years, you’ll likely have heard the term DeFi or decentralized finance. Most people have little understanding of traditional finance and financial systems, never mind this new mind-boggling creation.

So, we’ve created a DeFi for beginner’s article, introducing the concept, explaining how it works, who it benefits, and the areas it covers.

We’ll start off by debunking a myth. DeFi and cryptocurrency are the same things – this is wrong. That’s like saying every financial product is dollars – it makes no sense. Rather than being just a currency, DeFi is a movement that changes the way all of our existing financial systems and products function.

Read on to discover DeFi explained in an easy-to-understand way, perfect for beginners.

What Is DeFi?

DeFi, also known as decentralized finance, is a movement focused on making all financial products decentralized and accessible to anyone in the world with a smartphone and internet connection. Its mission is to remove control from large financial institutions and central banks, giving more power and control to individuals.

Based on a wide selection of non-custodial financial products, DeFi is a highly experimental arena, offering lucrative incentives and rewards for early adoption and investment. As mentioned, crypto and decentralized finance are different, but cryptocurrencies are the tender used to power DeFi ecosystems and products.

How Does DeFi Work?

As with traditional financial products and services, you can buy, sell, swap, borrow, or lend in the DeFi space. There is a range of platforms you can use to get access to cryptocurrencies and DeFi products, such as exchanges and lenders.

We won’t get into the nitty-gritty of the differences between some of these platforms because it can get highly confusing, and this is supposed to be DeFi for beginners.

Essentially, there are some platforms that are completely decentralized, whereas others would be considered centralized exchanges for the DeFi market – even that simple explanation sounds confusing.

This is the perfect example of how DeFi work. Two complete strangers, from opposite sides of the world, can make a loan agreement between themselves without a bank or financial institution as a middleman. Furthermore, you can fund collateral-backed loans through decentralized lending platforms to earn interest on your crypto.

Currently, we’re in the early stages of DeFi, with more proven products and services being created and launched every day. Before long, we’ll see it becoming a more viable option for the masses.

How Do People Use DeFi Products?

As with traditional online banking and other financial apps, DeFi products also have their own applications, known as dapps. Essentially, they are decentralized apps. Rather than relying on an institution or employees, they maintain their decentralized status with rules written in code.

These rules form smart contracts on the blockchain. The creation of a smart contract requires no human interaction, removing the need for an intermediary.

There are many reasons why dapps are preferred to traditional apps. Firstly, they’re permissionless. Any can create them, and anyone can use them. As a user, all you need is a crypto wallet. Whereas with fiat services, you’d have to complete in-depth verification and application forms.

In addition, with open source, transparent code, all users can see the status of transactions and understand exactly how the dapps work. This builds great trust with a user base.

Finally, they’re built to be global. Anyone from anywhere in the world can use them. You’re not limited by borders or institution rules. No matter where you are and who you want to create a transaction with, it’s easily possible.

Examples of DeFi Use Cases

P2P Lending & Borrowing

As discussed, DeFi empowers anyone in the world to lend and borrow from one another. With smart contracts and collateral-back loans, individuals can earn interest on the crypto they lend. Often, these interest rates are much higher than what you’d earn with a traditional bank account. Furthermore, it gives those who wouldn’t usually qualify or don’t have access to funds the ability to raise capital.

Payment Systems

DeFi protocols and projects are at the forefront of technological and financial development. Furthermore, removing the reliance on an intermediary and complex institutional rules means transactions can be processed much faster, and there is no cross-currency delay or charges. Furthermore, all transactions can be seen publicly, giving ultra transparency, as opposed to legacy systems.

Asset Management

Take complete control of your personal digital assets. Buy, sell, swap, stake, and put your assets to work, earning interest as you do so. Without the need for a financial institution or lawyer to draw up contracts, you’ll be able to freely move, lend, and borrow money on terms stipulated by you.

Digital Identity

At the minute, you need multiple forms of identification, address proof, contact information, and other personal details to access financial funding. This encroaches greatly on people’s privacy. However, with DeFi, you create a digital identity based on a wallet address, freeing you from the shackles of privacy intrusion yet still giving you access to all the financial services you need.

DAOs (Decentralized Autonomous Organizations)

Essentially, a DAO is a decentralized alternative to a traditional financial institution. We’ve discussed P2P – now it’s time to learn about DeFi intermediaries. Much like their centralized counterparts, DAOs exist to provide core financial operations, including implementing governance, asset management, fundraising, and more.

Savings Accounts

Regularly putting money into your savings becomes more appealing with DeFi. Many of its apps offer accounts with attractive interest rates and earning potential that clearly beats traditional savings accounts.

That’s because their interest rates are dynamic and bound to supply and demand. No matter the status of the economy, users always get all the money they put into their DeFi savings accounts back. Dharma, Argent and PoolTogether are well-known DeFisavings apps.

Connected to this is yield farming, an activity that involves moving idle crypto assets, e.g. lending cryptocurrency in exchange for interest, to maximize returns. Those who yield farm measure their gains as annual percentage yields, or APY. Although this may return high profits, it’s tied to high risks at the same time.

Insurance

While DeFi offers clear benefits, it’s not flawless. Unpredictable malfunctions, smart contract failures and other risks create a financially fragile environment that requires special protection. Some companies like Bright Union, InsurAce, and Nexus Mutual now offer insurance that covers and protects user assets by ensuring their capital is safe from the risk of loss on the DeFi platform.

Gaming

Product developers have also found opportunities in the DeFi space by building protocols directly into platforms. Ethereum-based games with their built-in economies and advanced incentive models are becoming especially popular.

One example is PoolTogether, a savings protocol that allows users to buy digital tickets. The DAI stablecoins they exchange for the tickets are then pooled together to earn interest in the Compound money market. It’s a lottery-style game that’s been gaining significant traction.

Margin Trading

Traditionally, margin traders borrow funds from brokers to buy equity shares or securities. The loan they take out allows them to buy more shares than they could have without it. However, DeFi margin trading functions under decentralized lending protocols with automated smart contracts. This creates what some call “autonomous money markets.”

Marketplaces

Another use of DeFi protocols is its application in online marketplaces. Here, buyers can exchange products and services, including graphic design, coding or copywriting services, digital collectibles, clothing, accessories, and more, all around the world.

Compliance and KYT

Compliance is a big topic in traditional finance, especially when it comes to countering-the-financing-of-terrorism (CFT) and anti-money laundering (AML). While they follow know-your-customer (KYC) guidelines, DeFi enables a simplified way of ensuring compliance.

The decentralized DeFi ecosystem relies instead on know-your-transaction (KYT), which involves advanced compliance analysis focused on the behavior of user addresses rather than user identities. This enables real-time risk assessments to protect against any type of fraud.

Other Use Cases

Outside of these use cases, you’ll see DeFi being implemented in insurance, compliance and KYT, analytics and risk management, derivatives and synthetic assets, infrastructure development, and insurance.

In Summary

This DeFifor beginners article has given you all the basics, answering what is DeFi and how does it work? Remember, this space is relatively new. As it’s in its infancy, you should always be on guard for potential scams, hacks, and malicious activity. However, expect to see the DeFi space evolve over the coming years, with it having a great impact and influence on society. Now is the perfect time to expand your knowledge before the financial system changes.

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