What is DeFi – Decentralized Finance Complete Beginner Guide

How Decentralized Finance is Changing the Future of Finance

Decentralized finance also known as DeFi is a new way of handling money by blockchain technology without any need of a middleman(banks).

DeFi uses smart contracts(automatic programs) to manage transactions safely and openly. Most of the DeFi apps are built on the Ethereum network, but some other blockchains are also becoming popular.

If you want to understand what DeFi is, and its fundamentals. 

What is DeFi

Decentralized Finance (DeFi) is a new type of finance system that runs on public blockchain, mainly on ETHEREUM, and it does not need any centralized system such as, COMPANIES, BANKS, or ANY MIDDLE MAN.

Decentralized Finance uses smart contracts which offer services like, lending, borrowing, trading, or earning interest.

Anyone with an internet connection and crypto wallet can use this system. 

Decentralized Finance is like a bank without any staff, that never closes, and doesn't check your cibil score, and cannot freeze your account. Everything runs automatically through code.

Today billions of dollars are already being used on this platform which shows how fast this platform is growing.

Decentralized Finance vs Traditional Bank

The main difference between DeFi and Traditional banks are control, access, availability, and how financial services are managed.

DeFi (Decentralized Finance)

• In DeFi users have all access to their funds and don’t have to take others permission to access their own funds, DeFi uses smart contracts on blockchain which make the system safe and open for all.

In Decentralized Finance you don’t need permission from anyone to send, receive, or lend your money.

• Another major difference is accessibility and availability,that is the Decentralized Finance system is available 24/7/365 for their users, anyone with internet connection can access the financial services anytime and anywhere from the world

• Another difference is speed and transparency. DeFi is far faster and more transparent as all the recorded data is uploaded in public blockchain.

• However,  Decentralized Finance comes with a high risk such as smart contract bugs, and scams.

Traditional Bank

• A centralized system (BANKS) controls your funds, and users have to follow the bank's rules such as, maintaining the minimum balance, KYC verification, and waiting for approval for some transactions. 

• Traditional banks operate within fixed working time and do not operate full time, and can limit the user access based upon his KYC verification, location and credit history

• Some bank transactions can take some time, some time maybe hours.

• Bank systems are not fully transparent to the public.

• Banks provide customer support and are more reliable than DeFi platforms.

How Does Decentralized Finance Actually Work?

Decentralized Finance works on three core parts:

1. Blockchain: Blockchain works like a shared online notebook that many computers around the globe use together. 

• Every transaction in the blockchain is recorded and can not be changed or edited later.

• The most popular and mainly used blockchain in DeFi is ethereum.

1. Smart Contracts: Smart contracts work automatically on blockchain. It starts working automatically when certain conditions are met, smart contracts do not need any person or middleman to work.

Smart contracts are mainly used in blockchain like Ethereum, where the transactions are handled securely and transparently.

1.  Crypto Wallet: crypto wallet is a tool for cryptocurrency where you send, receive, and manage your currency.

Crypto is like your personal digital account where you store and manage your cryptocurrency. 

Aave (Lending & Borrowing Without a Bank)

Aave is a defi platform that runs on smart contracts where users can lend their crypto to earn interest, or can borrow crypto without any involvement of the bank.

HOW LENDING ON AAVE WORKS:

• DEPOSIT OF CRYPTO: Users first have to deposit their crypto in AAVE platform, after depositing the crypto you get tokens in return, token acts like a receipt that starts earning interest for you.

• BORROWING OF CRYPTO: Other users can borrow your crypto only when they put their crypto as collateral, they pay interest on the crypto which they have borrowed, and that interest goes to you.

• INTEREST RATE ADJUST AUTOMATICALLY: Interest rate can go up and down based on the demand. For example :- if there are more borrowers the interest rate will automatically go up and if the numbers of borrowers are less the interest comes down.

• WITHDRAW ANYTIME :  Users can withdraw their crypto anytime by returning the tokens they have received when they have deposited their crypto.

• IN Decentralized Finance BORROWERS NEED TO PUT MORE COLLATERAL AS NO ONE KNOWS, WHO THE BORROWERS IS.

(For example:- you need to put 1500 if you are borrowing 1000)

• LIQUIDATION:  If the value of collateral drops below a certain level, smart contract sells the crypto without informing to pay the loan.

FLASH LONES

Flash loans are introduced by AAVE where user can borrow loans of any amount without putting any collateral or security but, user have to payback on the same blockchain transaction within few second, if the user is failed to payback all the transaction will be cancelled, like it was not there happened on the first place.

Uniswap DEX

Uniswap is a crypto exchange platform which uses AMM(automated market maker), where users can exchange their crypto without creating any account or any involvement from the bank.

In traditional or normal exchange platforms buyers and sellers are matched together for the exchange, but in uniswap  users don’t have to trade with people, users trade from the pool of coins.

This pool of coins already has tokens inside of it, the prices of the token automatically changes based upon the total amount of coins that are present in the pool.

For instance if the more people started buying the tokens the prices would automatically go up and if more people started selling it prices would come down.

Liquidity Pools (The core behind the DeFi)

Now what is the liquidity pool? A Liquidity pool is the collection of two coins locked in with smart contracts, that allows users to trade their crypto in platforms like UNISWAP. 

• HOW DOES LIQUIDITY POOL WORKS: Users first deposit their crypto (also known as liquidity providers LA)  in exchange of the tokens.

These tokens act like a receipt that shows the share of the user in the pool.

• HOW TRADES HAPPENS IN THE POOL: Other users use their token to trade, and each trade charges certain fees.

• HOW LAs EARN MONEY: Every swap generates a fee. This fee is distributed among the liquidity providers based on their share in the pool.

• WITHDRAW ANYTIME: Liquidity providers can withdraw their crypto anytime by submitting their tokens.

Yield Farming

Yield farming means earning more reward using your crypto, by putting it on different DeFi platforms such as, UNISWAP, OR AAVE.

HOW DOES YIELD WORK

1. Trading fees from being a LP.

2. Lending interest from a platform like AAVE.

3. Some platforms give bonus tokens.

4. Stacking the crypto earns more money.

IMPERMANENT LOSSES (IL)

Impermanent loss is a common risk of adding your crypto to LIQUIDITY POOL,

It simply means, when you put your tokens in the liquidity polls and the value of the token has changed, and you end up making less money than the money you would have made only by keeping the crypto in your wallet.

RUG  PULL RISKS

• Rug pull is a type of  scam in crypto and decentralized finance where some developers create projects and  attract people to invest, and suddenly disappear with all the investment and token value becomes zero.

• Another risk is smart contract bugs and hacks, in this some errors in the code can allow hackers to steal money and once the money is gone there is no way of recovering.

Conclusion

Decentralized Finance, or decentralized finance is changing the traditional way of exchanging or trading where there is no need for any centralized body like banks, and can even earn rewards and interest from platforms like AAVE and UNISWAP.

However, this freedom comes with some risks like smart contract hacks and rug pull.

That’s why it is important to have knowledge about the crypto ecosystem and market.

Disclaimer

The information provided in this guide is only for educational purposes and to not be considered financial, investment, or legal advice.

Crypto and blockchain related projects  carry significant risk and prices can be volatile.

Always do your own research before investing your time and funds.