Decentralized Finance Explained: What is DeFi and How Does It Work?

In the recent Crypto bull run, DeFi or decentralized finance has become the white-hot center. And I wouldn’t be wrong to say, DeFi is the new craze in the crypto world at the moment. The popularity of DeFi clearly has surged in recent times, adding to the strength of the Blockchain.

However, DeFi remains one of the industry’s opaquest aspects, especially to the outside world. That is why in this article, we will discuss what DeFi is, how it works, how safe it is, and how as an investor, you can profit from it. So, let’s dive in!

What is DeFi (Decentralized Finance)?

Essentially, DeFi is an Ethereum-based financial service that doesn’t have any central authority. While cryptocurrency promises to make payments and money transfers more accessible to everyone universally, decentralized finance takes it a step further.

In that, DeFi introduces a global and open alternative to every currently available financial service. The loans, insurance, savings, and trading are readily available to everyone worldwide as long as you have an internet connection and a smartphone.

With DeFi, the goal is to take all the traditional systems of the existing financial system and use smart contracts to replace all the middlemen. In layman’s terms, we can say that DeFi is a merger between blockchain technology and traditional banking services. That is why a decentralized infrastructure is required for DeFi to work.

What’s more, decentralized finance is based on decentralized apps and protocols. When these dApps run on the Blockchain, they provide a reliable peer-to-peer network. Just the same as lego building blocks, dApps can be somehow combined. The connectors between the dApps are the smart contracts that are different from the traditional systems’ specified APIs.

How DeFi Works?

The majority of the decentralized finance protocols are based on the Ethereum Blockchain. However, a few migrated to competing blockchains in search of better scalability and more incredible speeds. Some of the popular DeFi Projects are lending protocols such as Compound, Maker, and Aave.

These are protocols made to let people instantaneously borrow large amounts as long as you can prove loan payback in a single transaction. These protocols also allow you to earn interest from lending out cryptos.

Another component of DeFi is Uniswap which is a decentralized exchange. This is an exchange that allows you to trade on any Ethereum-based token. Also, with DeFi, you can garner more money if you contribute to the specific token’s market liquidity.

How Decentralized Finance Influences the Financial Sector

  • Savings

The DeFi lending platforms are offering numerous innovative ways that people can use to manage their savings. Users can plug into different platforms and access services in interest-bearing accounts to maximize their earnings.

With the interest-bearing concept, users can boost their profits than with traditional savings accounts. Some of the popular savings dApps include Pool Together, Dharma, and Argent.

  • Lending and Borrowing

The most used DeFi dApps involve peer-to-peer borrowing and lending protocols. Platforms such as Maker, Compound, and Aave support these protocols.

  • Asset Management

With DeFi, users can also be custodians of their cryptocurrency assets. Some of the protocols that enable this asset management system are DeFi crypto wallets and lending protocols such as Argent, Gnosis, and Metamask. These protocols allow the users to interact with the dApps and avail services that can enable users to earn interest in their investments.

How Can You Profit from DeFi?

It’s crazy how the value locked up in the Ethereum DeFi projects has been exploding in recent times. More users are reportedly making a lot of money with these DeFi projects. But exactly how are they doing it? Read on to find out.

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We all know the real money and opportunity in DeFi is by actually using Defi and taking advantage of how smart contracts are disrupting banking and finance. Users are now able to generate passive income using the Ethereum based dApps. They can loan out money and develop their revenue from the curated interests on the loans. And not just that. There is yield farming that apparently has an even higher potential for more significant returns, although it comes with more considerable risk.

Essentially, a yield farmer will move around their assets, let’s say in Compound from time to time. The farmer chases whichever pool that can offer them the best APY over time. That means, in some cases, the yield farmer might have to deep dive into riskier pools. Fortunately, they can handle these risks.

DeFi allows its users to put their crypto assets to work with the hope of generating the best returns. All in all, before you jump in, you must understand that these systems can be complex and lack the required level of transparency. One of our favorite places that everyone should certainly look into is called BlockFi. Keeping in mind we are coders and blockchain enthusiasts and not financial advisors, DeFi is risky, as is anything in the cryptocurrency industry.

Is It Safe to Use Decentralized Finance?

what is defi

As the market stands, most people believe that DeFi is what holds the future of finance. Therefore, most investors are predicting massive gains if they invest in this disruptive technology. However, the truth is, decentralized finance is one of the riskiest areas to invest in currently.

Newcomers in the crypto world often can’t point out the good projects and bad ones. And there are plenty of harmful and risky investments out there. As the DeFi’s popularity and activity increased in 2020, many applications crashed and burned. An excellent example of such an application being YAM, whose market capitalization moved from $60 million to $0 in 35 minutes.

Other projects such as Pizza and Hotdog faced the same fate leaving many investors in deep losses. What’s more, DeFi’s bugs are still very rampant. While smart contracts are robust, it’s impossible to make changes once they are baked into the protocol. That makes emerging bugs permanent and increasing risks over time.

In Summary

As we have seen from this article, decentralized finance can reshape and bring exciting changes to the financial system. With attempts at the intriguing technology that DeFi runs on, it presents opportunities to revolutionize the financial landscape. Also, DeFi can decentralize the leading financial services such as lending, borrowing, trading, payments, and investments. All in all, if you want to invest in DeFi, you need to update yourself with the market trends constantly. The crypto world is ever-changing, not to mention very volatile.