Decentralized Finance (DeFi)

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Decentralized finance (DeFi for short) is the generic term for classic financial services that are processed via a decentralized platform – such as a blockchain.

What is DeFi (Decentralized Finance)?

DeFi is the abbreviation for Decentralized Finance, which means decentralized finance or decentralized financial sector. The term is fairly general and not very clear, as it includes all financial applications that are not controlled by a central actor as in the traditional financial sector. Such a central intermediary is, for example, a bank, stock exchange or insurance company, which regulates and controls all transactions and services as a central contact and control center. In DeFi applications, this task is performed by the network of participants, which is based on the “rules of the game” in the protocol. As a rule, this is a blockchain protocol, which is a decentralized organization by so-calledSmart contracts enabled. Smart contracts are digital contracts that are embedded in program code and can therefore replace human or manual transactions.

These decentralized applications, abbreviated as dApps, enable the same services to be presented in the financial sector as we are used to from classic financial intermediaries. This can be, for example, the trading of securities or the granting and utilization of loans. Most DeFi applications are currently based on the most well -known smart contract platform, Ethereum. Tokens are used so that such a decentralized ecosystem can control itself. These tokens can be used to coordinate network decisions and provide incentives to operate the decentralized service.

How to participate in DeFi applications?

In addition to the degree of decentralization , the criterion that the protocols are open source is important, i.e. everyone has the opportunity to build their own financial services on the basis of the protocol. Unless you intend to program something yourself, you don’t need any special IT knowledge as a user. There are no entry requirements for DeFi, anyone can participate.

With an internet-enabled device and a wallet you have access to the DeFi applications. You need a wallet, i.e. a wallet for tokens, because you are responsible for storing your tokens yourself. So there is no central actor or custodian that keeps the tokens. The MetaMask wallet is often used to transfer your tokens to a DeFi platform . In most cases, you load the cryptocurrency Ether onto the wallet and then have the option of sending your tokens to the protocol or withdrawing them. The responsibility is thus passed on from the service provider to the DeFi user.

What are the applications of DeFi?

There are a wide variety of applications in the decentralized financial sector. Above all, many users appreciate the opportunity to earn money with the DeFi applications. Virtually every application in the DeFi sector has its counterpart in the traditional financial sector.

1. What is lending? The decentralized credit market explained

The biggest DeFi protocols like MakerDAO, Compound and Aave have one thing in common: their main use case is built around lending and borrowing. Specifically, tokens are awarded for which you then get interest in return. So instead of doing a lending deal with the bank, the network itself settles the deals based on the decentralized lending protocol. The standard case is that you “log in” tokens that you own for lending. This means that you make your tokens available to other participants. In return, you receive interest on your borrowed tokens.

What is staking? The mining alternative as an attractive source of income

Instead of having to do complex mining, with staking it is enough to make your cryptocurrencies available to the network. In contrast to lending, no credit is granted, but only the network is secured by deposit. In return, stakers can look forward to interest income in the respective cryptocurrency . The higher the cryptocurrency volume deposited, the greater the participation in the settlement volume of the blocks. You can see how high this reward is on sites such as  Staking Rewards  .

What are derivatives in the DeFi sector all about?

There are also financial derivatives in the decentralized financial sector that are familiar from the traditional financial sector. So anyone who likes to trade options, futures or other financial products can also do so in a decentralized market environment. Theoretically, any underlying asset, such as Bitcoin or gold, can be represented by derivatives in the DeFi sector. 

What are Decentralized Exchanges (DEX)? Crypto trading without a middleman

Unlike traditional exchanges, decentralized exchanges (DEX) never have access to traders’ assets. Since there is no central authority that can be hacked, the credits are particularly safe. Anyone can trade their digital assets on decentralized exchanges in no time and without registering.

What are payments in the DeFi sector all about?

There are already DeFi applications for decentralized payment processing. Since transactions on many blockchains such as Bitcoin or Ethereum cannot be processed particularly quickly or can only be scaled to a limited extent, alternatives are being sought. These alternatives can include so-called second-layer solutions, i.e. additional payment infrastructures that are “put on top” of the actual blockchain . This allows more off-chain transactions to be processed faster. One of the best known is the Bitcoin Lightning Network .

What are stable coins? Do they fulfill this utility in the DeFi sector ?

As the name suggests, stable coins are intended to ensure stability. These are therefore images of, for example, less volatile fiat currencies such as US dollars or euros. This avoids an exchange rate risk. After all, cryptocurrencies can fluctuate greatly, which can lead to problems, for example when repaying a loan. Consequently, stable coins represent derivatives on a token basis in order to represent an underlying value – mostly US dollars – and to make it usable for token applications. Stable coins can be secured in different ways. It is possible to deposit cryptocurrencies , real fiat currencies or an algorithm.

What are the advantages and opportunities of DeFi?

  • While the traditional financial sector is exclusive and virtually excludes the unbanked, DeFi does not have this barrier to entry.
  • There are no opening hours or regulatory restrictions, so financial services, such as asset trading, are available 24/7.
  • Particularly high protection of privacy, since no personal data is processed by third parties, while at the same time high transparency through publicly visible transactions.
  • By eliminating costly financial intermediaries, costs for financial services can be significantly reduced, especially since the higher degree of automation enables quick processing.
  • Like every new market that is still in its infancy, DeFi also offers particularly high return opportunities.

What are the disadvantages and risks of DeFi?

  • DeFi is still at the very beginning of its development, so there are only few empirical values ​​and no long-term observations were possible.
  • The smart contracts used can be faulty and thus become the target of hacker attacks, among other things, and the technical solutions are often still user-unfriendly and immature.
  • The advantage of personal responsibility can also be a disadvantage at the same time, since you are responsible for storing the tokens yourself.
  • A lack of regulation or consumer protection can have a detrimental effect on the legal certainty of decentralized financial transactions, while at the same time speculation and the formation of bubbles can spread particularly quickly.

Investing in DeFi – You need to know that

High returns are possible, especially in the decentralized credit sector, i.e. lending. By depositing and lending tokens at the same time, high returns have been achieved in the past. Basically, you should only invest as much as you are willing to lose. In order to further reduce the risk, it makes sense to diversify your DeFi investment capital across different protocols. Basically, the higher the risk, the higher the return. So when interest rates are very high, you have to be aware that the risk involved is also high. In particular, the speculative method of yield farming and liquidity mining has emerged.

Yield farming and liquidity mining simply explained

In order to generate particularly high returns, yield farming has established itself in the DeFi sector. The principle is as follows: You deposit tokens as security and receive interest on them. In the next step, you can borrow part of the deposited amount yourself and log into other lending protocols. This process is repeated again and again in order to leverage the capital employed and thus the interest generated. In order to further optimize the already attractive interest rates, the next step is liquidity mining.

To further increase returns, some protocols such as Compound (COMP) offer the possibility of liquidity mining. The network or governance token is mined or generated when lending and borrowing or providing liquidity. For example, every time a user borrows or lends Compound, COMP is paid. Consequently, the goal of DeFi speculators is to generate as much COMP as possible. The effect of yield mining can thus be expanded to include additional price increases in the underlying token, which enables returns that are well above average. Of course, this is pure speculation with enormous risks.

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