What is Decentralized Finance & How does it Actually work? DeFi Easy Explained (Beginner’s Guide!)

Decentralized Finance (DeFi) has seen a lot of media attention within the past year, and for a good reason.

DeFi as a whole is equipped to fundamentally change the economy of our world and enables even the unbanked to enter the economic system. It can lower the costs of doing business and offer a lot of new investment opportunities for people across the globe.

Quick Summary for Fast-Readers

  • Decentralized Finance (DeFi) is a term that describes a financial system that operates without any central intermediaries.
  • There are many DeFi use cases, including decentralized exchanges, insurance, yield farming, and staking.
  • There are also many open lending platforms and tokens that have enjoyed a high level of popularity.
  • Some of the most popular DeFi coins are Uniswap, Sushiswap, Maker, and Compound.

Definition of DeFi

Decentralized Finance is a system that is available for everyone to use without the requirement to go through a middleman. The middlemen, in this case, would be banks or brokerages that issue specific services. Unlike them, in DeFi, you are not required to submit any government-issued ID, any social security number, or a proof of address.

DeFi Financial Services

What is DeFi when it comes to Crypto?

DeFi is a system through which software is written, one that runs through a blockchain network, which makes it a possibility for buyers, sellers, lenders, and borrowers to interact with each other on a peer-to-peer basis. Each transaction is facilitated through software exclusively, and no other entities are involved.

The original cryptocurrency asset, known as Bitcoin, functions through a public ledger we know as the blockchain. This is decentralized due to the fact that transactions are recorded in databases on many different computers. That record, which is stored across a multitude of databases, is secured through the usage of cryptography. The computer ensures that it has not been tampered with.

Decentralization is the part of Bitcoin which makes it truly unique, this Is due to the fact that multiple computers, known as nodes, run the blockchain, and as such, no single entity or party is in control of it. 

Even if the government or a bank tries to change or manage some of the computers that run the network, the asset can continue functioning as normal due to the fact that the other computers on the network retain the full record of transactions and just take over.

DeFi takes things further. You have decentralized exchanges and lending systems that can host programs. Ethereum introduced smart contracts with are a key part of DeFi, as they are operations written in software code that run on the blockchain platform. 

When a certain, pre-programmed condition is met, only then can they execute their commands?

Different DeFi Applications

Many DeFi applications have taken advantage of this technology to truly bring a new level of innovation to the industry when it comes to financial services and other use-cases.

Ethereum and DeFi Apps

DeFi essentially leverages cryptocurrencies as well as smart contracts to provide services that do not require any intermediaries. In DeFi, a smart contract can replace the financial institution that would otherwise process the transaction and be a requirement. A smart contract is a type of Ethereum account that can hold funds and send or refund them when specific conditions get met, which are pre-programmed in the contract in question that is used at the time.

Note that there are also other blockchain networks that fully support decentralized finance, but Ethereum is the largest one among them and the second-largest cryptocurrency in terms of market capitalization.

Popular DApps and Use Cases

DeFi has been around for quite a while now. However, its utilitarian purposes are being pursued and evolved on an everyday basis. What this means is that the use-cases we have today are not finite, and as such, can evolve, grow, and be a part of something much bigger in the future. 

Decentralized Exchanges

Decentralized Exchanges (DEXs) are DApps that allow cryptocurrency buyers as well as sellers the opportunity to trade their assets without needing to lose control or give over their funds to an intermediary or custodian. 

Uniswap is one of the most popular DEXs, which uses an automated market maker. This allows Uniswap to offer various pairs of tokens to trade, where the prices are set through the usage of mathematical formulas, and every trade occurs through the usage of smart contracts. For all of this to be possible, the exchange takes advantage of liquidity pools as well.

Decentralized Insurance

DeFi insurance leverages the power of the blockchain as well as smart contracts to offer users cover against specific events, wallet hacks, smart contract exploits, and other potential issues that can occur. DeFi coverage platforms are based on poling, transfer, as well as a share of risk.

Yield Farming

Yield Farming is the process of staking your cryptocurrencies, through which you can provide liquidity to a liquidity pool or a farm, where people can borrow the tokens you stake and pay an interest rate for it.

Yield farming is an excellent use-case for decentralized finance, as you do not have to provide anything except collateral against the coins you borrow.

Staking

DeFi Staking is the process of locking cryptocurrency assets into a smart contract or a liquidity pool.

Users can stake for a variety of different reasons. For one, they can stake to get a percentage of the fees generated, which are generated by the lenders, or they can stake their assets to become a validator in a DeFi protocol.

Open Lending Platforms

DeFi has also paved the way for many open, permissionless crypto lending platforms, DApps, built on the blockchain, which anyone can access and lend crypt from, no matter their geographical location.

Stablecoins

In short, Stablecoins offer price stability in a volatile market and are cryptocurrencies that have their price pegged to another asset, such as being 1:1 with USD.

How Can you invest in DeFi?

Investing in Decentralized Finance (DeFi) is actually quite a simple process. Here is everything you need to know, step-by-step.

  • Step 1: Create an Account at an exchange

The first step you need to make is to find the cryptocurrency exchange you are interested in using, one that offers fair fees, solid features and is easy to use. We recommend using the DXOne exchange due to the competitive fee structure and excellent overall offering. 

  • Step 2: Completing the Know-Your-Customer procedure or another verification process

In most exchanges, you will be required to complete some sort of verification process. KYC or know-your-customer is one of the most popular types of verification processes out there, and you will need to submit your government-issued ID, passport, utility bill, driver’s license, or something else to prove that you are who you claim to be.

  • Step 3: Depositing FIAT Money into the Exchange

One the verification process is completed, you will then need to deposit FIAT money into the exchange. Go to the deposit part of the exchange, and select your preferred deposit option. Typically, you will be able to make a deposit through the usage of a credit card, a debit card, or a direct bank transfer. In some cases, they even offer e-wallet support, so PayPal is also available. Those are the best fiat to crypto exchanges.

  • Step 4: Visiting the Trading Section

Go to the trading section of the page next. Here, you should be able to view a list of all of the available tokens that you can buy and invest in.

  • Step 5: Buying your favorite DeFi project’s native cryptocurrency token

Make sure that you conduct a lot of research before jumping in and supporting a project. Once a project has caught your attention, all you have to do is look it up and buy it. For example, if you were investing in or buying Uniswap, you would need to purchase the UNI token.

What are the most popular DeFi Coins?

Some of the most popular DeFi coins out there are the ones that a lot of people tend to use on an everyday basis. This is mostly due to the fact that they serve the role of a utility token in some decentralized exchange or are a reward for yield farming. Let’s look at some of the most popular tokens. Remember that this is not financial advice, and any investment you make in DeFi coins is made at your own risk. Never invest more money in crypto than you are willing to lose.

Uniswap

Uniswap is a DEX and an AMM that lets users exchange different types of tokens that are built on the Ethereum blockchain. The UNI token is designed to govern the protocol, community treasury, and as a protocol fee switch for liquidity providers. 

Sushiswap

Sushiswap is a decentralized exchange that uses the SUSHI token as its native utility token. Holders of this SUSHI token can participate in community governance and even stake their tokens to receive a portion of all the transaction fees that occur on the DEX.

Maker

MKR is the native utility token of Maker, and it is used for governance. Anyone who owns MKR tokens can cast a vote on key decisions during a process called Executive Voting. Votes are measured by the amount of MKR tokens that are committed to a proposal. 

Compound

Compound lets users deposit crypto into lending pools which borrowers can access. Lenders earn interest on any assets that they deposit. COMP is the native utility token that enables community governance of the protocol.

Is there a difference between DeFi and Crypto?

Decentralized Finance (DeFi) applications or DApps are created to recreate traditional financial systems through the usage of the blockchain. Cryptocurrencies are what power a blockchain network and are a means for its operation.

Is Bitcoin also DeFi?

Yes, but there’s a catch. Bitcoin by default is not a DApp. However, it can be wrapped in Ethereum, and this is what we know as wBTC or Wrapped Bitcoin. wBTC is a tokenized version of Bitcoin that runs on Ethereum, and in turn, allows it to take advantage of DeFi. This is why Bitcoin can be DeFi.

Summary

Decentralized Finance (DeFi) plays a major role in the current state of financial services and is leading the path to its future. It has undoubtedly had an impact on the way we perceive money and the way we conduct transactions. What was once conceptualized and thought to be impossible is now being leveraged on an everyday basis.

The power for people to control their own finances has been brought back to them, and even the unbanked can now have access to specific services, all of which are powered through the usage of smart contracts and the blockchain.