What is DeFi? The Simple Guide to Decentralized Finance
Decentralized Finance, or DeFi for short, is one of the most active sectors in the cryptocurrency world. Only emerged a few years ago, it’s quickly taking clear precedence in the blockchain and enriching the blockchain ecosystem. The DeFi boom is not without reason as the appealing benefits are already disrupting the traditional financial sector. However, some things are worth evaluating both sides in terms of risks and benefits. When it comes to considering a financial investment on a DeFi project, understanding the pros and cons can help you make an informed decision.
What is DeFi?
Decentralized Finance is a range of financial applications that operate through a decentralized blockchain network. It utilizes a set of smart contracts and algorithms to execute its services. The contracts are essentially automated agreements that don’t require intermediaries or banks and thus non-custodial. Derived from blockchain technology, DeFi allows several entities to hold a copy of a history of financial transactions, so there is no control from a single source. This is the distinctive feature of DeFi compared to centralized systems that involve human management that can limit the transactions’ speed and accuracy.
Most DeFi projects are built on the Ethereum network, which is currently the world’s second-largest cryptocurrency platform after Bitcoin. The network is more scalable and offers more flexibility, primarily when used to build other types of DeFi applications.
Advantages of DeFi
DeFi offers a series of advantages over the traditional finance systems. One of the main benefits is that you retain full control of your digital assets. Since most DeFi applications are run on the Ethereum blockchain and decentralized, there is no central authority to control, block, or revoke your transactions.
Besides ownership, DeFi also offers a better degree of autonomy. Governments or other centralized entities won’t shut down the network because each node has a full copy of the blockchain to validate the transactions. It is challenging for anyone to modify the transaction record as you would need to control at least 51% of all nodes to attempt this.
Transparency is probably the most applauded feature of DeFi. Anyone can see the transactions visible on the blockchain, verified by other users in the network. Because it is built on Ethereum’s open-source code, developers can see how the system works and build new platforms and protocols when applicable.
Types of DeFi platforms and applications
There are dozens of different DeFi applications operating on the Ethereum network. Here are some of them:
- DeFi exchanges: these platforms help traders and users convert their fiat money or crypto to another cryptocurrency and vice versa. This type of exchange is gaining popularity because it connects users directly with one another to trade cryptos without an intermediary.
- Lending platforms: an example is Compound Finance that uses smart contracts to manage lending instead of human intermediaries or other financial institutions.
- Stablecoins: such as Dai, USDT, and USDC are cryptocurrencies pegged to fiat assets such as US dollars or Euro to stabilize the price value.
- WBTC or “Wrapped Bitcoin:” allows users to send Bitcoin to the Ethereum network to be used within the DeFi system. They can also earn interest on the Bitcoin they lend on the DeFi lending platform like Compound.
Investing with DeFi
Crypto users can generate revenues when investing in a DeFi project, such as earning interest from loans in a lending platform. Another method is to Yield Farming, which allows users to leverage their crypto assets to generate the best possible returns. However, this method poses higher risks and can be complicated to understand.
Investing in a DeFi project is considered risky in general and should be done with caution. Read the fine prints before deciding because there are many questionable DeFi projects out there.
Although DeFi has been increasing in popularity and adoption, many DeFi projects have struggled to grow. Some even crashed and burned, such as YAM’s case that lost market capitalization from US 600 million to 0 in less than an hour. Also, since it’s an emerging technology, technical bugs, and even hacks are a constant threat in the DeFi ecosystem.
Decentralized Finance stands out in the cryptocurrency world for its innovative approach in redefining the way people think about money. There are many advantages and practical applications for DeFi projects. However, as with any emerging technology, there are always risks that need to be reviewed before making any investment decision with a DeFi project. Nevertheless, DeFi is here to stay, and it’s exciting to see how it will evolve in the near future.
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