Beginner’s Guide to DeFi
“DeFi” has been hyped as the “next big thing” in financial services.
Here’s how to actually get started with it.
If you’ve been paying attention to the financial news, you’ve probably run across the term “DeFi.” It stands for “decentralized finance,” and it’s often hyped as “the next big thing” in financial services. But what is DeFi? How does it work?
These are great questions to ask. But perhaps most importantly you need to concern yourself with the digital security risks of DeFi investments, and understand what measures you will need to take in order to protect your investments. These markets can feel a bit like the wild west, so you want to make sure you’re doing everything you can to stay secure.
I’ll touch on all of this over the course of this article. I’ll go over how DeFi works, what its benefits are, what security risks to keep in mind when using it, and how to get started investing in it.
Let’s begin with a basic definition.
What Is DeFi?
DeFi is “decentralized finance.” It’s a set of financial services that are provided without any authority controlling it.
The easiest way to understand DeFi is to compare it with centralized financial services like banks and brokerages.
Take Acorns, for example, which is a popular centralized app for saving and investing. When you deposit money into Acorns and use it to buy stocks, you have to trust the app to accurately keep track of your deposits and investments. The developer of the app completely controls its database, and it could steal all of your money if it wanted to.
Luckily, Acorns has a reputation for being honest. So most of its users aren’t worried.
But many app developers don’t have this ability to prove that they are honest. They don’t have the capital required to get licenses from the government, file a bunch of paperwork, hire lawyers, etc., all of which are needed in order to convince customers they are trustworthy.
This need for trust in centralized applications creates a huge barrier to entry for developers of centralized financial apps, and this leads to many great apps just not being available to you, the user.
By contrast, if a developer creates a DeFi app, it doesn’t control the app. Instead, the app runs on a blockchain network; a computer network that is not under the control of any central authority.
This means that you don’t need to trust the developer. So the developer doesn’t need to spend money complying with regulations and convincing you that it’s trustworthy. This also means that you have access to apps that you otherwise wouldn’t be able to use.
FYI: DeFi is a new, emerging technology. It’s still a very small part of the financial market, but is growing rapidly. This often creates a bottleneck that drives up yields. Annual percentage yields of 4 percent or more are common in the DeFi space at the same time that banks are paying less than 1 percent for savings accounts. It’s these high rates of return that have led to the DeFi media hype you’ve probably noticed.
So basically DeFi is a set of financial apps that run on decentralized networks. In the next section, I’ll explain how it works.
How Does DeFi Work?
In a DeFi app, all of the balances, investments, and other data is stored on a blockchain or cryptocurrency network. A copy of this data is kept on thousands of different computers spread throughout the world. This helps to prevent any person or company from altering your balance without your consent.
In a DeFi app, you don’t log in with a username or password, nor do you need to create an “account.” Instead, you use a cryptocurrency wallet to authorize transactions. Your “username” or “account number” is simply your cryptocurrency wallet address.
Each time you deposit or withdraw money into a DeFi app, you have to confirm the transaction in your wallet. This helps to prevent anyone from stealing your money.
FYI: Want to know more about how a crypto wallet works? You can read all about it in my beginner’s guide to crypto wallets.
When you make a deposit to a DeFi app, the experience is similar to using a centralized app. You open your browser, navigate to the app’s page, and push a button to make a deposit. Once you confirm the deposit on your wallet, it appears in the app.
So that’s how DeFi works in a nutshell. Now let’s talk about its benefits.
Benefits of DeFi
There are a number of benefits to using DeFi apps instead of centralized ones.
The biggest benefit is the high yields offered. For example, as of this writing, Tranquil Finance is offering between 3.87 percent and 4.73 percent APY to lenders of U.S. dollar stablecoins like Harmony DAI (1DAI), Harmony US Dollar Coin (1USDC), and Harmony US Dollar Tether (1USDT). Compare this to bank savings account APYs, which are currently below 1 percent.
FYI: US dollar stablecoins are cryptocurrencies that are designed to be equal to $1 per coin in value.
For another example, you can currently earn rewards of around 76 percent, per year, to become a dealer in USDC and Fantom (FTM) through SpookySwap.
To be fair, these yields aren’t always this high. They tend to be very high when a network is first released, but fall off once investors start piling in. Still, even very old networks like Ethereum still have yields that are higher than the traditional financial system.
No need for trust
Another big benefit of using DeFi apps over traditional ones is, again, the lack of need for trust. As long as the smart contracts are written correctly (this happens on the developer’s end), the developer shouldn’t be able to do anything funny with an investor’s funds.
Despite these benefits, there are some risks to DeFi apps, which we’ll consider next.
The Risks of DeFi
It might seem like investing in DeFi is foolproof. But there are some significant risks that you should be aware of.
- Hacks: Contracts are written in code. So if this code contains a vulnerability, it can be exploited to allow an attacker to do things he isn’t supposed to do, like steal the crypto held in the contract.
- Bugs: Some DeFi apps may have bugs in them that cause them to not work correctly. For example, if the withdraw function on a contract wasn’t written correctly, users may not be able to withdraw their crypto from it.
- No insurance: Unlike money in a bank account, DeFi apps are not insured. So if the money you put into a smart contract is lost through a bug or hack, there is no way to recover it.
The good news is that smart contract code is public. Unlike the code used in centralized apps, it can be vetted by the community and searched for vulnerabilities.
But the bad news is that this doesn’t guarantee that every DeFi app is safe. Some newer DeFi apps may not have had enough time for these vulnerabilities to be discovered.
Despite these risks, most popular DeFi apps work just fine, and millions of dollars have been earned by their users. As of April 2022, over $200 billion worth of cryptocurrencies is invested in DeFi apps,1 and this amount has been growing over time.
But these are the risks you should be aware of if you decide to invest in DeFi.
FYI: It’s not always easy to discern between a safe and an unsafe DeFi app. So check out my guide to how to tell if a crypto coin is safe to better understand what to look out for.
Now here are some ways to start using DeFi.
How to Invest in DeFi
Over the past few years, DeFi has exploded in popularity. There are now decentralized crypto exchanges (DEXs), crypto lending platforms, yield maximizing farms, algorithmic stablecoins, rebaseDAOs, and many other kinds of exotic decentralized financial platforms.
It can be confusing to know where to get started. In this section, I’ll go over two of the simplest ways to start using DeFi.
One of the most basic ways to get involved in DeFi is to become a liquidity provider for a “DEX.” DEXs have customers showing up every day who want to buy or sell tokens. But someone has to provide these tokens to be traded.
If you decide to fulfill this role, you can earn transaction fees from every trade done with your tokens.
To become a liquidity provider, you’ll need to have an equal value of two different tokens. For example, let’s say that you want to provide liquidity for the Ethereum (ETH)/USDC pair at Uniswap, and let’s say further that you have $200 of capital. You’ll need to have $100 worth of Ethereum and $100 worth of USDC.
Once you’ve got an equal amount of each coin, you can deposit these coins into the liquidity pool and start earning transaction fees.
Keep in mind though that the value of your coins may go up or down over time. If one of the coins you’ve deposited falls faster than you earn transaction fees, your total deposit can fall in value. So this isn’t a risk-free business to get involved with.
Here are some popular DEXs that always need liquidity providers.
The other really simple option for investing in DeFi is to use a lending platform. Crypto traders always need loans to gain leverage in trades. If you’re willing to loan them capital, you can earn an interest rate for each day that the loan is active.
Decentralized lending platforms require the borrower to put up crypto collateral that is of greater value than what is borrowed. And if the borrower defaults, this collateral is sold off to pay you back. So there is very little lending risk. But the app itself could become undercapitalized if some kind of catastrophic “black swan” event occurs in the crypto market. So, as with other types of DeFi apps, decentralized lending platforms are not 100 percent free of risk.
Here are a few decentralized lending platforms that are always looking for lenders.
So these are some easy ways to get started. Now let’s talk about what kinds of DeFi apps might be coming down the pipeline.
Pro Tip: You’ll need a wallet to get started with DeFi. Here’s a list of some of the best crypto wallets available right now.
The Future of DeFi
The DeFi movement is just getting started. In the future, it may replace large parts of the traditional financial services industry. Here are a few changes to DeFi that may emerge in the future.
DeFi stock and bond trading
DeFi began with the creation of US dollar stablecoins. These were tokens issued by crypto companies, and backed by real dollars in a bank account. What if the same could be done for equities or even for government bonds?
We can imagine a future where decentralized investing platforms allow people to buy and sell stocks, exchange-traded funds, and treasuries without the need for an intermediary. This could eliminate the need for stock exchanges and stock brokers, which could prevent future problems like the Robinhood Gamestop scandal.2
One of the biggest problems with DeFi right now is the learning curve to getting started. In order to get started in DeFi, you need to take the following steps:
- Buy cryptocurrency from a centralized cryptocurrency exchange
- Download a wallet extension and set it up
- Withdraw your crypto into your wallet
- Use your wallet to deposit crypto into the app of your choice
To make matters worse, there is no automated way to arrange your DeFi portfolio. Everything has to be done manually, and it is very difficult even to track all of your holdings.
A few companies are working on ways to fix this problem. Argent is a wallet that allows you to buy crypto directly from within it. And it directly connects to all of the most popular DeFi apps on Ethereum, including MakerDAO, Uniswap, Compound, and others. This bypasses the need for exchanges and “withdrawals,” and it allows users to quickly and easily deposit crypto into DeFi apps and start earning an income.
The team at Harmony is doing something similar with their new wallet, 1wallet. It is currently in beta. But the final version should allow users to buy Harmony, swap it for a stablecoin, and deposit it into a Harmony DeFi app to earn interest — all in just a few clicks.
Yet another example is a company called Unstoppable Finance. This company is trying to combine something like Argent and 1wallet with a robotrader that will automatically allocate crypto to your DeFi portfolio, based on your risk preferences. This will also solve the problem of portfolio tracking, since the app will be set up to track all of your DeFi investments at once.
These apps will allow DeFi to offer a much better onboarding experience. In the meantime, you’ll most likely have to get started the old-fashioned way. This means you’ll need to purchase crypto from an exchange and withdraw it into your wallet. Never fear though, this guide to buying crypto safely in the U.S. will walk you through the process in step-by-step detail.
For thousands of years, human beings have needed to trust and rely on third parties to handle their financial transactions. The first banks were created in 1,800 B.C., in Babylon. And in order for these ancient people to make loans and earn an income, they needed to trust the banks to deal with them fairly and at a low cost.
In the 19th and 20th centuries, governments argued that bank panics and bankruptcies were endangering the public. They created central banks and financial regulations to try to stop these problems. But these regulations increased costs and caused hassles to customers, and they required people to trust their governments.
The creation of the World Wide Web in the 1990s led to even more financial innovation as online banks, online stock brokerages, robo traders, savings apps, and other financial web apps took over. But these apps still relied on databases that were under the control of an authority.
For the first time, we’re now seeing savers becoming free from these authorities with the advent of DeFi. But it’s still in its infancy, and it’s too soon yet to see how revolutionary it will be.
In the meantime, you can use this guide to understand what DeFi is, how it works, and how you can get started investing in it.
Blockworks. Large Institutional Transactions Push Total Value Locked in DeFi to $239B. (2022).
CNBC. Robinhood restricts trading in GameStop, other names involved in frenzy. (2019).