Before Investing in Crypto, You Need to Understand What DeFi Is and How It Works
My friends and I entered the crypto scene early when most of the world wasn’t quite aware of what it could actually mean.
Things were easier in those early days, especially if you just wanted to invest a few hundred dollars into tokens that you felt would go a long way. Then, with the launch of Ethereum and its smart contract capabilities, the fresh crypto market underwent rapid changes, unlocking multiple new investment opportunities.
Between 2017 and 2021, the crypto market registered meteoric growth, pushing its aggregate market capitalization past the $2 trillion mark. Over this period, we witnessed a massive inflow of new retail and institutional investors.
2022 is no different!
New investors are flooding the crypto market. Primarily it’s due to the immense return generating potential offered by the ever-evolving decentralized finance (DeFi) segment.
But there’s a problem: The concept of DeFi is relatively new and many novice investors can’t wrap their heads around it. If you’re investing in crypto and want to generate better returns on your investment, it is critical that you first understand DeFi — what it is, how it works, and how you can benefit from it.
To be fair, I do understand that the DeFi ecosystem is full of fancy words and complicated tech jargon can easily confuse even the sharpest minds. But I’ve also realized that without a deep understanding of DeFi, growing your portfolio is challenging.
While the team and I were working on adding DeFi products to our CoinStats app to make DeFi accessible for everyone, I learned a great deal about it. And I would like to share my newly acquired knowledge with you in the simplest way possible.
DeFi: The Holy Grail of Crypto
Decentralized finance, DeFi for short, isn’t just a buzzword. It is, in fact, one of the biggest and most disruptive trends in the blockchain ecosystem. Many believe that it will overtake the traditional finance (TradFi) industry in the near future.
DeFi is an umbrella term that describes a range of peer-to-peer (P2P) financial services. Everything is operated, handled, and managed through smart contracts and the blockchain’s distributed ledger technology (DLT). In this context, smart contracts are autonomous programs built into DeFi protocols and decentralized applications (dApps) that auto-execute when certain preset conditions are met.
Too complicated?
Let me try again!
Decentralized finance (DeFi) is the total opposite of centralized finance (CeFi). DeFi offers many familiar financial products like lending, investments, savings accounts, payments, insurance, mortgage, and loans without any centralized authorities or intermediaries.
In the CeFi model, everything comes with a price tag. Most of the services are unnecessarily complicated, lengthy, and time-consuming. For example, if I want to transfer funds to a friend of mine, I need to rely on a payment service provider like a bank or another similar third-party service. If I want to invest in shares and stocks, I also have to go through an intermediary. If I want a loan, I have no other option but to approach a bank, a nonbank lending organization, or another centralized financial institution.
So what’s the running theme in all these scenarios?
Overdependence on centralized service providers!
This is where DeFi stands out. Imagine a financial ecosystem where:
- Everything is owned, operated, and managed by the users.
- Intermediaries are replaced by autonomous smart contracts, thereby substantially reducing the need for bureaucracy and redundant processes.
- No single person or organization is in control.
- Everything is decentralized, permissionless, and borderless.
Compared to CeFi services, DeFi offers low-cost transactions and better returns. For instance, the average gas fee on decentralized apps (dApps) built on top of the third-generation blockchain protocols is as low as $0.0001. That’s a fraction of what centralized service providers charge. Just think about credit card fees, the minimum balance requirement for your bank account, or any other conversion, transfer, and account management fee you must pay just to maintain your money!
Or consider the average 0–1% annual interest on your savings account on top of the irony of banks charging us money for holding our money. Whereas, if you park your crypto in savings accounts offered by DeFi dApps, you have a chance to earn 5–10% APY. More importantly, these dApps won’t charge you a fee for holding your assets.
Then there’s the lingering problem of finding and receiving approval for a loan in the traditional financial market. You and I both know that securing a loan from a centralized financial institution may take weeks or even months. You’ll also have to deal with additional hurdles, including the lengthy verification processes to check your credit score and financial history. Finally, if you’re approved for the loan, you’ll probably need to pay the origination fee, a processing fee, and possibly other hidden fees, which essentially chip off a considerable amount from the actual loan amount.
These realities don’t exist in the DeFi realm. All you need to do is connect a wallet to any decentralized lending platform that best suits your needs and deposit the required collateral. You’ll have the funds you need in a matter of minutes.
Now that I have pointed out the key differences between CeFi and DeFi, let me break down the technical aspects of DeFi for you. All transactions across DeFi dApps and protocols are conducted within peer-to-peer networks, meaning that the transactions occur directly between two parties without any intermediary. Smart contracts govern these transactions as per preset agreements between all parties involved in the transaction.
DeFi is an ever-evolving ecosystem, and I can’t cover all of it in a single go. That said, I think the most popular use cases of DeFi applications include:
- Decentralized Exchanges (DEXs): DEXs are decentralized marketplaces where you can trade cryptocurrencies. I prefer decentralized exchanges over centralized exchanges (CEXs) because DEXs aren’t governed by any central authority. Besides, I don’t have to pay massive fees for trading. I only pay the gas fee charged by the particular network.
- Margin Trading: Although riskier than other available DeFi primitives, margin trading is considered a highly lucrative opportunity. In this model, you need to deposit a certain amount, borrow funds from a broker, and allocate them to the open market with leverage. The deposited funds act as collateral and are returned once you return the borrowed funds alongside the broker’s cut. The best part of this is the leverage. You can receive as much as 100x leverage by depositing a relatively small amount, which may vary widely across platforms.
- Decentralized lending and borrowing: Borrowing and lending money has never been easier. With decentralized lending and borrowing platforms, investors can either opt to become liquidity providers (offer loans) to earn a decent interest rate or borrow money (mostly offered in stablecoins) at nominal interest rates and near-zero fees.
- Staking and Liquidity mining: If you have a lot of tokens that belong to any Proof-of-Stake (PoS) blockchain, you can actually stake the tokens to earn staking rewards. It’s an easy way to grow your portfolio! Likewise, liquidity mining (also known as yield farming) is another interesting way to put your assets to work. Instead of keeping them idle in your wallet, speculating on price increase, you have the option to put them to work on various protocols across different networks. In return, you will receive interest, and in many cases, a portion of the platform’s transaction fees.
I hope by now you have realized the immense potential of DeFi and how it can help you accelerate the growth of your crypto portfolio. And there’s no need for direct involvement on your end. Most existing DeFi products and services are designed to ensure passive returns, something that works in favor of all stakeholders.
If you’re new to crypto investing, I highly recommend that you start getting acquainted with DeFi. Investing in crypto with the sole aim of speculation is increasingly becoming a sub-optimal way to make the best of your investment. Instead, join the DeFi revolution, select some interesting protocols, leverage DeFi’s emerging power, and watch your crypto yield more crypto.
