DeFi 101 - How Decentralized Finance Works, Pros, Cons & Use Cases

Decentralized Finance (DeFi) has been growing in popularity since 2017, and especially after 2020, when we saw the launch of several DeFi projects. It's a new mode of financial transactions that uses a peer-to-peer model instead of going through intermediaries like banks. Everything is powered by code and community, which brings in a whole level of flexibility and user control.

But like any evolving system, DeFi can feel a little intimidating if you are not into crypto. In this guide, we'll look at the basics. We'll go through how it works, the popular uses, and the upsides and downsides.

What Is DeFi?

Decentralized Finance is based on the fact that there's no single entity that handles the transactions. Everything is powered by blockchain, and there are small programs that control the entire transaction process (smart contracts).

This does away with the need for middlemen like financial institutions. If you want to transact with a person, you can do so directly. There are no bureaucracies, and costs are greatly reduced as you only need to pay a small network fee.

The possibilities are quite similar to traditional finance, but you get more control, freedom, and flexibility.

How DeFi Works

Now, let's look at the key pieces that make it work.

Blockchain

Blockchain

This is the foundation of DeFi. Basically, it's a digital ledger (like a record book). Its job is to store transaction records in a way that can't be tampered with but is still visible to everybody.

But unlike regular systems, blockchain isn't stored on a single server. Rather, it's distributed across many computers (nodes), which makes it hard to shut down or tamper with.

While there are many blockchains, most DeFi platforms are built on Ethereum. It was the first blockchain that allowed the use of smart contracts, although others like Solana and Avalanche have since come up.

Smart Contracts

Smart Contracts

Smart Contracts are what power DeFi. They make it possible to carry out transactions like borrowing and lending, as they carry the code that controls the transaction. So, they replace the traditional paperwork and processes we deal with in banks.

Stablecoins

Stablecoins

Stablecoins are cryptocurrencies that are different from the likes of Bitcoin and Ethereum in that they are designed to maintain a stable value. To do this, they are pegged to traditional assets like the US dollar. Some popular ones are USDT, USDC, and DAI. They are the "cash" of the DeFi world.

Decentralized Applications

Decentralized Applications (dApps)

Since everything we've mentioned is code, these are what make it possible to interact with the various DeFi services. They have an interface like regular apps, but they are built on blockchain and often run entirely on smart contracts. Some popular ones are Uniswap, Aave, and MakerDAO.

Popular DeFi Use Cases

DeFi has been growing fast, and there are lots of services that run there to create a complete ecosystem.

DEX

Decentralized Exchanges (DEXs)

These are the most popular use of DeFi for most users. Basically, they are marketplaces. One of the most well-known options is Uniswap, which lets you swap tokens with other users in seconds. You only need to pick a trading pair, and the smart contract will take over everything. No need to fear a financial institution freezing your account or limiting access.

Borrowing Platforms

Lending and Borrowing Platforms

If you are holding long-term, you can lend out your crypto to earn interest. For this, you only need to submit it to a lending protocol like Aave or Compound. Other users will borrow the funds under preset terms, and you'll get paid interest in crypto. No, paperwork.

You can also borrow if you don't want to liquidate your assets. Say you are holding a coin you believe will appreciate, but you need liquidity for real-life expenses. You can set your crypto as collateral, then borrow a stablecoin. However, you'll need to keep an eye on the collateral ratio as volatility can liquidate your position.

Yield Farming

Yield Farming & Liquidity Pools

Here, you don't lend to a specific person but provide liquidity to a pool. It's being the middleman in a transaction. People can transact, and you get rewarded with interest, tokens, or both. You can get double-digit yields, but the risk is also higher.

Other popular DeFi use cases include:

  • NFTs
  • Stablecoins
  • Prediction Markets
  • Stablecoins & Synthetic Assets

All these allow you to trade or earn in different ways.

Advantages of DeFi

Since DeFi pretty much reimages finance, it offers lots of benefits.

  • Universal access: All you need is internet access. Even a bank account isn't necessary.
  • Full transparency: Unlike in banks, everything here is transparent. All transactions are visible to everyone. You know how funds move, how interests are set, and how tokens are distributed.
  • Lower costs: Since you eliminate the middleman, the fees are much lower. You'll still need to pay a network fee, but you aren't covering salaries and bureaucracy.
  • Total asset control: You hold the keys to your assets, not the bank. However, that also means that you are responsible for your asset security.
  • 24/7 availability: If you want to borrow at 11 p.m. on a Sunday, go ahead. DeFi never sleeps.

As you can see, all these are a flip of how centralized finance works.

Risks and Disadvantages

While DeFi opens up exciting opportunities, it's far from perfect.

Here are some possible issues you should brace for:

  • Smart contract vulnerabilities: These are written code, and code can have bugs. And if it's there, it can be exploited. Some platforms reduce the risk by auditing all contracts, but even audits aren't perfect.
  • Unclear regulations: Since it's a young industry, laws are still catching up. Depending on where you live, some, like KYC, can come in and disrupt access.
  • Crypto volatility: Prices swing wildly in crypto, so you'll be exposing yourself to depreciation or even liquidation when borrowing.
  • Risk of scams and hacks: Some projects can be built with bad intentions. For example, a developer can pull a project and disappear with users' funds (rug pull scams).
  • A steep learning curve: If you are just getting started, you'll need to understand many things around blockchain, crypto, and security. There's no support line to call if things go wrong.

To minimize these, take some time to understand how everything works, from the basics to the fine print in DeFi platforms. This will give you a good basis, and you can then start small as you build up.

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