The Ultimate Beginners Guide For New DeFi Users
It is common knowledge that decentralized finance (DeFi) has revitalized the crypto narrative so much so that it has become fashionable for entrepreneurs and developers to incorporate elements of DeFi in their offerings. Seeing that this explosive trend is showing no signs of slowing down anytime soon, it is imperative to understand the many moving parts that make up the DeFi landscape before going all out to adopt it as an investment instrument or in your daily operations. Hence, we have created a comprehensive beginners guide on everything DeFi. Here, we will provide all the answers to your DeFi-related questions.
What Is the Historical Background of Decentralized Finance?
Decentralization is not a new concept, neither has it just begun to feature in the financial realm. The introduction of Bitcoin in 2009 birthed the concept of decentralized finance and marked the start of its rise to prominence. Buoyed by the emergence of Ethereum and other smart contract blockchains, decentralized finance became a mainstay in the financial industry in 2017. And it sparked a plethora of solutions designed to eliminate some of the hurdles of traditional payment and monetary services. Although many of these solutions failed to make a mark, the successes of a few protocols set the stage for the ongoing DeFi boom. Today, the DeFi narrative is stronger than ever and promises to propel the crypto industry to the next phase of growth.
What is DeFi?
Having explored the history of DeFi, it is worth mentioning that the concept is a compelling financial experimentation that has begun to yield good results. From its name, it is clear that the core propelling factor for DeFi is its framework, which rids financial networks and applications of the influences of centralized entities. In other words, decentralized finance looks to eliminate intermediate processes and enable a financial order powered by open, permissionless, and autonomous systems. The goal is to employ blockchain to create borderless services free from the political, systemic, and regulatory hurdles prevalent in traditional alternatives. As a result of the focus on finance, DeFi has developed innovative financial iterations for exchanging, borrowing, and lending assets, processing payments, creating stablecoins, trading synthetic assets, insuring funds, and much more.
Developers have identified ways to optimize these operations by incorporating smart contracts at the heart of DeFi applications. Ordinarily, smart contracts are automated systems that execute transactions when certain terms have been met by the parties involved. The incorporation of smart contracts in DeFi applications draws from this capacity to offer automated transactions as long as the terms and conditions are met. However, note that the DeFi community has found new ways to expand the functionalities of smart contracts such that decentralized platforms can take on more complex financial processes.
What Are the Characteristics of DeFi?
Although our definition encapsulates the core workings of DeFi, a closer look at the characteristics of this financial order breaks the concept a little further. Below are some of the factors responsible for the innovative nature of DeFi.
One of the factors that separate DeFi from conventional financial systems is its non-custodial framework. Every participant has autonomy over his or her assets. Hence, when you opt for a Defi application, be rest assured that no bank or financial institution has control over your funds. The same cannot be said of conventional financial systems that overly rely on centralized custodial solutions for even the most basic operations.
Apart from adopting a non-custodial architecture, DeFi also promotes an open landscape. In simpler terms, DeFi permits borderless transactions and financial deals. Thus, the applications are available globally. This characteristic of DeFi solves the restrictiveness of the traditional financial order. By incorporating DeFi, users do not encounter restrictions or fall victim to a lopsided monetary policy designed to favor a region, a race, or people with specific backgrounds or political leanings.
The DeFi terrain has established a transparent culture by creating open-source platforms. Therefore, anyone can inspect the viability of DeFi applications as the codes which make up these protocols are publicly available. With this, investors and users can track their funds, search for vulnerabilities, and criticize the design decisions of developers.
Since DeFi protocols are open-source, it is possible to build new applications on top of them for even more robust functionalities. The endless possibilities brought about by the composability of DeFi has accelerated innovation and inspired the term, “Money Legos.” Each application is just a piece of a jigsaw connecting users to more value providing features. The integrative architecture of DeFi is far more advantageous than the siloed design of established cryptocurrencies.
As its name implies, DeFi upholds a decentralized landscape that puts up various measures to ensure that the governance of protocols is distributed among users. More importantly, thousands of nodes spread out across the world run these applications. As such, financial institutions or banks cannot take up the roles of gatekeepers like they commonly do in the traditional finance market. Likewise, it makes it difficult for attackers to alter or cripple DeFi networks successfully.
Open Finance VS Decentralized Finance?
From the characteristics listed above, it is clear that DeFi itself is a standard framework for developers. While these are the accepted attributes of DeFi on paper, the majority of developers have found it hard to meet all these requirements. In particular, decentralization has been the hardest to replicate.
Developers often decide against giving up control over their protocol completely, especially at the early stages of developments. Running a fully decentralized protocol makes it almost impossible for developers to react quickly to issues since they have to consult the community and reach a consensus before any changes can take effect on the network. Hence, a majority of developers tend to retain a degree of control over their projects. However, more often than not, they set a roadmap for the establishment of fully decentralized applications. This milestone entails a series of updates, which allows the developers to relinquish control to users gradually.
Although decentralization has remained a controversial topic in the DeFi scene, no one can downplay the openness of these protocols. Hence, some choose to call this financial order “Open Finance” instead of “Decentralized Finance.”
How Large Is the DeFi Market?
Due to DeFi’s unique makeup and the nascency of the technology, it is hard to track the real size of the market. Some of the metrics used to showcase the performance of the sector are the total market capitalization and total value locked TVL. The latter, in particular, has emerged as a widely used metric because it connotes the value of the capital invested in the market. A lot of DeFi metrics sites use this standard to calculate the market performance of DeFi.
However, it is critical to note that some metric sites like DeFi Pulse limit the scope of their operations to Ethereum-based DeFi protocols. The data from such websites may not accurately represent the size of the market since the DeFi landscape is much more than the Ethereum ecosystem.
At the time of writing, the DeFi sector had a total market cap valued at over $30 billion, according to Coinmarketcap. Likewise, DeFi Llama pegged the TVL at $32 billion. Considering that TVL was a little under $1 billion at the start of last year, it is safe to say that a large share of the funds locked in the market today was generated in 2020. The explosive increase of the TVL tells the story of how attractive DeFi has been against the backdrop of a pandemic-induced financial crisis.
Is DeFi a Bubble?
Owing to the explosiveness of the DeFi sector and its semblance with the ICO boom of 2017, it is easy to see why skeptics believe that the sector is nothing but hype. The bubble tag has often been used to connote the ecosystem. Critics have gone ahead to downplay the achievements recorded so far and even suggested that the sector is bound to crash. And so, it has become necessary to reevaluate the current state of the DeFi market and to an extent determine the sustainability of the technology.
The first argument that we need to examine is the claim that DeFi shares a similar framework with ICO, and so may suffer a similar fate. While this notion is the most rehashed argument against the long-term viability of the crypto market as a whole, it is far from the truth. First and foremost, the ICO era produced a plethora of applications that were only good on paper and not necessarily functional.
In contrast, the DeFi boom stems from the performance of a long list of projects that already have working products. Hence, investors are not just buying and holding tokens with the hope of eventually generating returns in the not-too-distant future as they did in the ICO era. Instead, they are putting their funds into functioning applications and are generating value immediately. However, this counterargument does not exonerate the DeFi sector from all suspicions. Like every newly introduced innovation, DeFi tends to attract individuals and companies hoping to bankroll half-baked projects and make money off the DeFi hype. As such, every intending investor and user must carry out extensive research to separate viable projects from mediocre ones. Nonetheless, the activities of these illicit entities do not take anything away from the efforts put into establishing the DeFi sector.
DeFi Terminologies and Concepts
When exploring the DeFi world, you will most likely encounter unfamiliar terminologies used to describe certain activities or processes. Some these concepts include:
Whenever you see DEX, just have it at the back of your mind that it is the short form for decentralized exchange. DEXs are platforms designed to allow token swaps and exchanges without requiring users to transfer control of their digital assets to them. Also, new users do not need to scale KYC procedures to have full access to the exchange’s features. As a result of their decentralized nature, the transaction fees are low compared to what centralized exchanges usually charge.
DAO is the shortened form of Decentralized Autonomous Organization, which connotes a company powered by an automated governance system. In other words, there are no staff or employees. Instead, the organization relies on open-source protocols programmed to initiate automated management functions without any human elements or influence from centralized institutions. Also, it is censorship-resistant.
For every transaction executed on the Ethereum blockchain, the sender pays a processing fee in ETH called Gas Fees. The volume of transactions executed on the blockchain determines the amount paid as gas fees. As such, network congestions usually attract high Gas fees.
Liquidity Mining/ Yield Farming
Liquidity mining and yield farming is a DeFi process that requires users to deposit funds on liquidity pools on DEX or decentralized applications for the chance of earning rewards. This opportunity is only applicable to platforms that distribute tokens to users as rewards for staking their holdings and providing liquidity to other users.
This is a feature of DEXs and other platforms that permit liquidity mining or yield farming. The goal is to encourage investors to lock funds in pools and create liquidity for exchanges executed on DExs. In turn, liquidity providers earn a share of the transaction fees generated by the pool.
Non-fungible tokens (NFTs)
NFT is a token standard that represents unique digital and real-world assets. This framework is becoming a vital crypto implementation used to tokenize physical or virtual items and facilitate their trades and establish ownership. NFTs are becoming particularly useful in creating complex DeFi products.
Automated Market Makers (AMM)
This concept eliminates the human elements from trading and the process involved in borrowing or lending cryptocurrency. Rather than communicating or making agreements with another user, users interact with smart contracts.
This is an advanced means of lending and borrowing that enable loans without borrowers having to deposit collateral. However, borrowers must repay instantly, or else the protocol may cancel the transaction.
For many decentralized apps, the best way to establish decentralization is to distribute the voting rights to users via governance tokens. By owning the governance token of a particular DeFi protocol, you can unlock the opportunity to have a say in the running of the project and other vital issues like upgrades and transaction fees policies.
A fair share of DeFi projects favors a deflationary architecture to ensure that the value of their native digital assets maintains an upward trajectory. And so, they implement systems that reduce the number of such tokens in circulation over time. DeFi networks that adopt this economic model issue deflationary tokens.
What Are the Applications of DeFi?
As mentioned earlier, developers have begun to infuse the concept of DeFi to a broad range of financial services. While some are simple and straightforward, others are somewhat complex and suitable for experienced users and investors. Below are some of the common use cases of DeFi.
Borrowing and Lending
Open lending platforms have become the most popular DeFi protocols as they offer a broad range of opportunities to participants via blockchain-based credit systems. These protocols encourage investors to lend crypto out to borrowers to earn interest rates. Borrowers, on the other hand, can collateralize their crypto holdings and access loans, albeit with a system free from the cumbersome processes associated with traditional loan systems. In some cases, these protocols go a step further to distribute governance tokens to active participants.
Ultimately, DeFi-based borrowing and lending platforms promote trustless ecosystems, cryptography-powered verification systems, cheap loan facilities, and faster services. More so, they reduce counterparty risks and enable borderless lending and borrowing networks.
In addition to enabling open lending protocols, DeFi has also excelled as a system for establishing unconventional but functioning monetary banking services like the generation of stablecoins. Before the advent of DeFi, the crypto market had relied solely on centralized stablecoins, which are not big on transparency. The core workings of centralized stablecoins hinges on the ability of the issuer to convince users that the value of the token is pegged to a real-world asset as advertised. You will agree that a lot could go wrong, most especially when a system heavily relies on the human factor. As such, it made sense to create trustless versions that suit the decentralization narrative nicely and are free from bureaucracies of central authorities. Herein lies the importance of decentralized stablecoins. They are digital assets that provide the much-needed stability to the crypto market and yet retain an open and trustless framework.
As discussed earlier, decentralized exchanges are peer-to-peer trading or coin swapping smart contract-based platforms. Dexs provide non-custodial and privacy-focused exchange facilities. They incorporate automated contracts at the heart of their offerings and do not impose compliance requirements on users. Over the years, decentralized exchanges have taken up a strategic position in the DeFi landscape as they permit unrestricted listings for obscure or new projects. In other words, it is way cheaper and more seamless to onboard new tokens on decentralized exchanges than on the centralized counterparts.
Derivatives and Synthetic Asset Issuance
Like the case of centralized exchanges, DeFi also offers a means to trade derivatives without the inputs of trusted intermediaries. In essence, there are DeFi protocols that allow users to trade contracts that draw their value from underlying assets. This use case has emerged as one of the more complex applications of DeFi. This possibility exposes users to a wide array of investment instruments, including traditional assets, albeit in a decentralized and open manner.
Insurance has become a touchy subject in the DeFi landscape. A fair share of this controversy stems from the risks associated with DeFi opportunities. Recall that the sector is still very much in its experimental phase. Therefore, users are prone to all sorts of risks. In response to this prevalent threat, developers have begun to design decentralized insurance and risk management protocols to reduce the effects of unforeseen events like smart contract failure, hacks, market dump, and so on. More importantly, these protocols incorporate public smart contracts to ensure that all participants can access the terms of payouts. This insurance framework is more transparent than the traditional alternative, which is often riddled with loads of paperwork.
This is another marketplace powered by decentralized infrastructures to provide users with a high level of autonomy. Here, users can bet on future events like the outcome of a presidential election. However, unlike the conventional method of running prediction markets, the DeFi alternatives try as much as possible to introduce processes that eliminate the need for intermediaries.
Owing to the explosiveness of DeFi and the rate at which new tokens flow into the landscape, it has become imperative for users to own asset management tools like dashboards where they can track all their holdings. As with most DeFi-based applications, these tools and systems should incorporate decentralization as their core theme. Hence, DeFi asset management tools are decentralized protocols that provide interfaces for easy access to portfolios and other DeFi platforms.
What Are the Examples of DeFi Projects?
Having listed the core utilities of DeFi, the next section explores projects, which are crucial to the DeFi narrative. These platforms have emerged as some of the most viable DeFi protocols today and unlocked new possibilities for decentralization in the financial sector.
MakerDAO ignited the DeFi movement in 2015 by offering an alternative issuance model for stablecoins. With decentralization as the main propelling factor for their offering, the founders of MakerDAO introduced DAI, a US dollar-pegged stablecoin. In contrast to the intermediate design of centralized stablecoin, Maker accepts digital assets as collaterals and rely on smart contracts to ensure that DAI retains a 1:1 peg with $1. More importantly, the smart contract implementations establish the censorship resistance attributes of DAI.
Users must deposit collateral worth 150% of the number of DAI they intend to borrow. For example, To borrow 20 DAI, you will need to deposit $50 worth of supported coins as collateral. Besides, you will also pay a stability fee, which functions as the borrowing interest rates. Note that the protocol adjusts the fees based on the demand for DAI loans. Also, you must ensure that the value of your collateral does not drop below the 150% ratio. If you cannot fulfill this requirement, the protocol will automatically liquidate your loan, sell off the collateral at a discount, and impose a fine on you.
Alternatively, you can buy DAI on exchanges and save yourself from the stress of borrowing on the Maker platform. Once you borrow or buy DAI, you can use it to unlock other monetary services on secondary markets. Another core component of the MakerDAO ecosystem is the MKR token. Unlike DAI, the value of MKR fluctuates. It primarily serves as the governance token of the Maker protocol. As such, holders have voting rights to alter or upgrade the network.
Compound Finance has built formidable lending and borrowing protocol on the Ethereum blockchain and incorporated incentive-based innovations to spur engagements. Launched in 2018, Compound adopts an open financial model and utilizes financial contracts to regulate and execute loans. Like Maker, Compound does not base the eligibility of users to access loans on credit scores. Instead, the ability of the borrower to deposit the required collateral to a large extent determines the success of loan requests. Also, it implements an over-collateralization model to reduce the risk involved and ensure that the entire process remains automated.
The interest rates generated from borrowers are distributed to lenders. Remarkably, lenders do not necessarily have to wait for a lockup period to lapse before withdrawing their earnings and original investment. This is due to the absence of restrictions. It is worth mentioning that lenders receive the derivatives, called cTokens, of their funds and earnings. For example, if you deposit DAI on Compound, the protocol issues cDAI tokens with a value equivalent to the worth of your initial deposit and the interest earned. Subsequently, you can collateralize this token to receive a loan or sell it for other cryptocurrencies.
Notably, Compound launched its governance token, named COMP, in 2020. As expected, this token offers voting rights to holders, and it is a critical shift on the part of the development team to cede control of the Compound ecosystem to users.
Uniswap is fast becoming one of the most critical protocols in the DeFi market because it provides a suitable pooling system to facilitate trades and coin swaps in a decentralized manner. It is one of the pioneers of the automated market maker, which eliminates the need for order books. This innovative approach makes it a lot easier to trade obscure tokens because users do not have to wait for the exchange to match their orders before successfully executing trades. The automated market maker system initiates liquidity pools specially designed for tokens paired with Ethereum.
The AMM system uses a special formula introduced by Vitalik Buterin in 2018 to determine the appropriate size of the reserves of each token available in the liquidity pool. Apart from its reliance on mathematics for sustainable liquidity, Uniswap also automates the process involved in listing new tokens. There are no listing fees imposed on developers. Hence, it has become an integral exchange facility for newly issued coins. There is also no form of restrictions imposed on traders residing in a specific country, as is commonly found on centralized exchanges. The absence of KYC or AML requirements makes Uniswap a truly borderless crypto infrastructure. Lastly, anyone can provide liquidity on Uniswap for a chance of receiving a share of revenues generated from trading fees.
Founded in 2017, Synthetix has played a pivotal role in the emergence of DeFi-based synthetic assets or synths. It allows the minting and trading of tokens designed to mimic the value of non-crypto assets. Some of the assets that fall within the scope of synthetic assets are tokenized forex, commodities, and indexes. Already, over 50 tradable pairs, ranging from gold synths to UK’s FTSE stock index, are available on the platform.
As practices on most permissionless and open protocols, you do not need to give up your personal details to use Synthetix. As such, the platform is rightly placed to democratize the process of accessing and trading securities. To create new synths, users deposit the platform’s native token, SNX, in smart contracts, and in turn, Synthetix enables automated contractual-based trades for other synths. The protocol pays liquidity providers a share of the generated exchange fees. However, note that it is not mandatory to hold SNX to trade synths.
Furthermore, the project team kicked off a plan in 2020 to reduce the influence of Synthetix Foundation on the governance of the platform. In place of the foundation, Synthetix looks to cede control to three on-chain DAOs. It is safe to say that this decision is vital to the establishment of a fully decentralized governance system for Synthetix.
Like Uniswap, Curve Finance is also a decentralized exchange. However, it focuses on creating liquidity pools for stablecoins. Since the supported digital assets have a stable value, the risks involved are reduced significantly. For one, traders rarely incur impermanent losses caused by the volatility of DeFi tokens against ETH on Uniswap. Another difference between Curve and Uniswap is that the former allows users to lend out tokens in liquidity pools to decentralized money markets. Hence, liquidity providers have the option of earning trading fees and interest rates.
Unsurprisingly, Curve also introduced its governance token, called CRV, to reward liquidity providers and distribute the governing power among active users.
Yearn.Finance functions as a DeFi aggregating platform which redirects users to the most profitable lending and liquidity pools. Yearn.Finance integrates with established DeFi protocols like Dydx, Compound, and Curve. Users stand a chance of unlocking an array of DeFi opportunities through Yearn. All you need to do is deposit one of the supported coins on Yearn and receive a derivative token like you would on Compound. For example, if you deposit Dai, you will get yDAI. Subsequently, you can use these ytokens on liquidity pools of the supported protocols and generate earnings accordingly.
In July 2020, Curve began to issue its governance token, YFI, to users staking ytokens on selected pools. This token has managed to break price records and spurred developers to create similar platforms.
Yam Finance is one of the spin-offs inspired by the success of Yearn.Finance. The protocol rewards users for contributing liquidity to pools. In addition to interest rates, users earn the platform’s native token, YAM, as rewards. Although the platform managed to attract investors following the initial release of its token, the discovery of a bug in the code was detrimental to its long-term viability. This bug complicated the governance of Yam Protocol and forced the development team to create a new version.
What Are the Challenges of DeFi?
Like every other nascent sector, DeFi has its fair share of challenges. While some of these limitations currently reduce the efficacy of the technology, it is imperative to note that DeFi is still in its early stage of development, and there is enough room for improvements. Below are some of the challenges you may encounter while using DeFi products.
Every now and then, the hurdles of blockchain technology tend to limit the performance of DeFi protocols. This observation is common on protocols running the Ethereum blockchain, which is the bedrock of the present DeFi landscape. In light of this, some developers are launching their DeFi products on alternative blockchain infrastructures. For those who are not considering this option, the launch of Ethereum 2.0 slated for 2022 serves as the only viable solution to the unsavory speed of DeFi protocols.
Like we mentioned earlier in this guide, the risks associated with DeFi are very high because it is still in the experimental phase. There are no market standards for running or securing products. alAso, the anonymity provided by DeFi has inspired lots of substandard projects, hacks, and scams. Users must research platforms extensively before investing in DeFi tokens or adopting their services.
Below Par User Experience
It takes a lot of effort on the part of users to understand and navigate the DeFi landscape. A majority of the top protocols are more suitable to technical savvy users. As such, DeFi still has a long way to go before it can replace the current financial order. Developers must create simpler iterations of DeFi products that focus on user experience, accessibility, and customer support.
What Does the Future Hold for DeFi?
Judging by the rate at which developers created innovative use cases for DeFi in the last couple of years, it is safe to say that innovation will continue to drive the growth of the landscape. In the coming months, expect unsustainable platforms to become redundant and replaced by advanced iterations. Also, strides achieved in the risk management and insurance sub sectors could propel the influx of new capital. All in all, DeFi must integrate with the conventional financial system to enable seamless gateways and attract institutional engagements.
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