What is DeFi And How Does It Work? Decentralized Finance 101

Advantages of DeFi

When compared to traditional financial institutions, DeFi excels in many areas, including:

• Trust is not required for a DeFi application to work

• DeFi platforms rooted in blockchain have high security

• DeFi transactions are settled in minutes

• DeFi is much more efficient than traditional finance

• DeFi interest rates are usually more favorable than TradFi

• Low financial transaction costs

• No bank account required – open to all

• No brokerage KYC required

• Code is open-source

Another advantage of DeFi is that it democratizes financial activities typically reserved for the elite in traditional finance. Decentralized apps (dApps) in the DeFi space allow any participants to partake in numerous financial activities, including:

• Lending or borrowing digital assets (Compound and Aave)

• Speculating with derivative financial products (Lyra)

• Market making

• Staking 

• Event prediction markets (Polymarket)

📕 Read! 5 Ways to Stake Ethereum

How Does DeFi Work?

In order to best understand how DeFi works, it will help to have a basic understanding of both Bitcoin and Ethereum (ETH).

What Is Bitcoin?

Bitcoin, launched in 2009, was the first successful blockchain to receive widescale interest. This network is essentially a digital ledger. What makes Bitcoin unique is its cryptographic nature – once a transaction enters a block, and that block is added to the chain (ledger), it can never be altered or changed. 

What Is Ethereum?

Ethereum, launched in 2017, is similar to bitcoin in its ability to securely store a record of transactions within its blocks. The Ethereum blockchain goes one step further and allows its users to store both transitions and code (smart contract) in its blocks.

These smart contracts can be added together to build entire applications that mirror those of popular ones we know today, such as Twitter and Facebook. 

In finance, smart contracts are being utilized to recreate business models that deal in numerous fields, such as:

• Borrowing and lending

• Market making

• Derivatives trading

Not sure how much to invest in crypto? Read our article: Here’s Why To Invest in Crypto and How Much.

How Can I Participate in DeFi?

The tastycrypto wallet allows you to interact with any of the 17,000 Ethereum DeFi protocols currently in existence. In order to get started with DeFi, you will need to follow the following steps:

1. Sign-up for the tastycrypto wallet. The first step to participating in DeFi is to get a wallet that is compatible with the Ethereum network, as the tastycrypto wallet is. 

2. Fund your wallet with Ethereum. In order to transact within the Ethereum DeFi ecosystem, you will first need to have some ether in your wallet. 

3. Connect your wallet to a reputable protocol. Once you’re ready to transact, you will need to connect your wallet to a DeFi project. You must confirm all transactions in your wallet before they are sent. Most protocols will give you the option to ‘connect a wallet’, at which point you will connect your tastycrypto wallet. 

4. Buy A DeFi ETF Token! You can invest in DeFi protocols through the DeFi Pulse Index (DPI) token.

📕 Read! 3 Ways To Earn Yield in DeFi

How Much Does DeFi Cost?

There are two primary costs associated with transactions in DeFi:

1. The DeFi protocol fee: Most protocols charge a nominal fee to transact. For example, if you wanted to swap tokens in the Uniswap DEX (decentralized exchange) the protocol currently charges a 0.3% fee. 

2. The gas fee: After a transaction is sent on a protocol, it ultimately goes to an Ethereum validator to get added to the blockchain. Validators get paid for their work in securing a network in gas fees. These fees vary and are based on: the current demand for validations, the traffic on the network, and how many validators are currently staking.

📕 Read! TradFi vs CeFi vs DeFi: Here’s How They Differ

What Are The Risks Of DeFi?

DeFi protocols have very little human interaction. Some protocols called DAOs (decentralized autonomous organizations) are run completely by software programs. All of this code introduces risks to investors. Here are a few of the more predominate risks of DeFI:

1. Hacker/Coding risks. Poorly written code can allow hackers to gain access to a protocol, which can lead to complete failure. Hacks are the predominant risk in DeFi.

2. Counterparty Risk. In DeFi, loans are usually overcollateralized. This helps to reduce counterparty risk, but default is still possible in incredibly volatile markets.

3. Impermanent Loss. Impermanent loss refers to the opportunity cost of placing your crypto in a liquidity pool – could you have made more if you just owned the crypto outright?

4. Regulatory Risk. At any given time, a government could theoretically outlaw any aspect of crypto. This happened in China, which essentially made crypto illegal. Though future regulation poses a risk to crypto, in the US, government regulation in this space is encouraged.

5. Volatility. Crypto assets can experience high volatility (not including stablecoins that track U.S. Dollars like MakerDao’s ‘DAI’).

6. Losing Seed Phrase/Private Key
   
   

In order to assure your risks in DeFi are mitigated, it is recommended to make sure at least one independent audit has been done on your chosen protocol. It is best to interact with widely used protocols (Uniswap, Aave, Curve) as the vast majority of these have had at least one audit performed. 

Want to learn more DeFi terms? Check out our DeFi glossary!

Can Anyone Participate In DeFi?

DeFi is completely democratized. Anyone with a crypto wallet can participate. The one exception to this is in countries where DeFi (or cryptocurrency) is not legal, such as China.

Governments can also limit what activities can be done by their citizens, such as market marking, staking, and lending cryptocurrency. However, most of these limitations apply to CeFi (centralized finance) crypto organizations, like Coinbase and Gemini. 

📕 Read: Best DeFi Coins to invest in: 2023