There is no shortage of trends in the crypto industry. Many of them fizzle out almost as soon as they begin.
But there is one trend that ended up becoming one of the most talked-about topics in the industry. And that trend is what this article is going to be all about.
But before we get into what Decentralized Finance (or DeFi) is and why it is trending, let’s take a look at what we’ll be covering in the article.
As always, we would like to recommend the beginners to go through the entire article for proper understanding. But if you know the concepts we’re talking about well, feel free to skip to the section you’re still unsure of.
That said, let’s begin!
What is DeFi?
Simply put, DeFi is the crypto version of the finance industry. As the name suggests, it is completely decentralized. This means that unlike the traditional finance industry, DeFi has no centralized authorities. The community takes all the important decisions together.
It is worth noting here that DeFi is a concept. It’s magic lies in the different ways it has been implemented in the blockchain industry. And that is something we’ll discuss in a short while. But for now, know that DeFi’s applications are what propelled it into the limelight.
A Short History of DeFi
If we could travel back in time to May 2018, we would find a meetup called the Decentralized Finance Meetup.
Companies like the Maker Foundation, 0x, Wyre, and Compound Labs attended the meetup. These companies, along with many others, would later create a market worth billions of dollars.
The name decentralized finance stuck with the attendees and the enthusiasts. It was then that the shorthand, DeFi, came into existence.
But for a lot of crypto enthusiasts, DeFi came into existence much before the said year. A common argument is that Initial Coin Offerings (or ICOs) paved the initial path for the industry.
There is no denying that ICOs and Decentralized Exchanges (DEXes) played a key role. They made the financial functions of blockchain technology popular.
So one can argue that the DeFi movement started back in July 2013 when Mastercoin held its ICO.
With the given facts, we leave it for you to decide when it all started.
DeFi vs CeFi
When you think of finance, you’re probably thinking of centralized finance. And why shouldn’t you? That is the kind of finance we’re accustomed to.
Centralized Finance (or CeFi) is a financial structure wherein certain authorities control everything. These authorities set the rules by which the entire industry functions. So when you use CeFi based services, you put your trust in the central authority or service provider.
When it comes to DeFi, there is no central point of control. There is no authority governing how the system functions. It democratizes the system by giving all the power to the community.
So it is then the community that votes for and decides how the system would function. So when you use DeFi based services, you trust the community as well as the smart protocols involved.
Smart protocols, just in case you don’t know, are lines of code that perform an action. These protocols are vital to helping the trust-less economy of cryptos working.
Important DeFi Concepts
1. What is Yield Farming?
To understand yield farming, let’s draw some parallels between that and traditional farming.
In traditional farming, you sow some seeds and nurture them. Then you wait for them to grow and harvest them. You then sell them off to gain profits. Until the seeds grow into crops, you can’t take them out and sell them off. I mean, you can, but there’s no profit in doing that, right?
Yield farming works in a similar way. You lock some of your crypto holdings in and get rewards for it. It is also called liquidity mining which is something we’ll be discussing shortly.
How that works is beyond the scope of this article. But to get a better understanding, you can read our article explaining what yield farming is.
2. What is Liquidity Mining?
Liquidity mining is another name for yield farming. But why is it called so? Well, that’s because when you lock your crypto holdings in, you add liquidity. And you’re rewarded for that.
You can read more about its functioning by clicking on the link provided in the previous section. But for now, I’ll give you a gist of how it works.
When you deposit your crypto holdings on a platform, you enable it to trade using that cryptocurrency. And when the platform does that, it generates profit. A fraction of that profit is passed on to you as a reward.
This way, you can earn more tokens of the same cryptocurrency simply by adding liquidity.
3. What is Margin Trading?
In traditional stock markets, there is a concept of intraday trading. In this type of trading, you pay a certain amount of money to the broker and they let you invest many folds of that amount.
But you’re allowed to trade with this gigantic amount only for a day. At the end of the day, you need to return the borrowed amount back to the broker. You can keep whatever you’re left with after deducting the fee and the amount returned. That is the profit you take home.
Some DeFi services providers allow you to do marginal trading. Instead of trading in stocks, however, you trade in cryptocurrencies.
One of the most popular platforms for marginal trading in the DeFi space is Yearn Finance’ yTrade. We have talked about Yearn Finance and its DeFi services in a previous article. Feel free to check it out!
Types of DeFi applications on Ethereum
1. What are Decentralized Exchanges (DEXes)?
Planning to buy ETH against your Canadian dollars? Use a DEX! Planning to buy DAI using your ETH? Use a DEX! Planning to sell your DAI to get your local currency? Use a DEX!
Decentralized exchanges (or DEXes) are platforms that allow users to exchange their currency for other currencies. And they do that by connecting buyers with sellers.
To keep the system secure, they use the distributed ledger technology (DLT).
2. What are Stablecoins?
As you might already know, cryptocurrencies are highly volatile. To bring stability, some cryptocurrencies peg their value to a stable asset.
Now, this asset could be anything like a currency, or silver, or even a can of soda. As long as the asset holds a stable value, you can peg your cryptocurrency’s value to it and call it a stablecoin.
Some of the most famous stablecoins in the crypto market as of now are Tether (USDT), DAI, and TrueUSD (TUSD).
3. What are Lending Platforms?
In the traditional finance markets, banks are usually the key lending platforms. You can take loans from them and they’ll charge you some interest on it.
But when you come to the DeFi space, such intermediaries are completely removed. Smart contracts replace banks and manage lending on these platforms.
4. What are Prediction Markets?
If you’ve learned probability in school, you know that any event would either occur or not. While you can’t know it for sure in most cases, you can have a fair guess. And that is what prediction markets are based on.
Prediction markets allow users to place bets on whether a specific result would be seen in a certain situation or not. These situations could be anything. You could even place a bet on whether it would rain tomorrow or not.
The only difference is that everything happens with the help of smart contracts here.
What are the Risks Involved in DeFi?
Like CeFi, DeFi comes with its own set of risks that you should know about before investing.
To start with, hackers can find vulnerabilities in smart contracts. Even though these contracts are as secure as it gets, the best of hackers can find a chink in the armor. To counter that, DeFi service providers have been working toward improving the security of their smart contracts. Moreover, platforms like Nexus Mutual have insurances that safeguard you against these problems.
Another risk that you should keep in mind is the fact that at the end of the day, it’s an investment. And investments may go bad. The crypto market is volatile and this volatility can cause you to lose money. There are platforms like Uniswap that are trying to make risk-free DeFi products.
If you’re still up for it, by all means, go ahead and invest using DeFi portals.
What is the Future of DeFi?
There is a lot of speculation about what the future of DeFi would look like. Some believe that it is what’s left of the ICO hype. Others believe that it is here to stay.
All we can say is the improvements that we’re seeing month on month are impressive. And if anything, they’re indicative of a bright future.
1. How do I make money with DeFi?
One of the best ways to make money with DeFi is through yield farming which we’ve discussed already. It takes very little effort and gives good returns.
That said, you could always go for DeFi services that give higher returns but demand more of your time and effort.
2. When will DeFi go mainstream?
By the looks of it, DeFi is well on its path to going mainstream. It is debatable as to how soon that would happen, but developers believe that Ethereum 2.0 would speed the process up.
3. How will Ethereum 2.0 impact DeFi?
With Ethereum 2.0, developers would be able to scale up projects better. This would give the projects a better chance of getting popular. If that happens, DeFi could actually go mainstream.
Before You Go…
With the kind of support it has received from the community, the future of DeFi looks pretty bright. There are still issues in it but the developers are trying to resolve them.
With Ethereum 2.0, we could see the popularity of DeFi shoot up further.
That said, this article is not a financial gospel. So if and when you invest in DeFi, do so at your own risk.