This article aims to provide an overview of decentralized finance (DeFi), how it works, and some of the most commonly asked questions. It references blockchain technology and cryptocurrency. If you are already familiar with DeFi, check out our other Learn DeFi articles for more educational content.

DeFi: An overarching term encompassing financial services available on various public blockchains. 

The Ethos Behind DeFi

Short for “decentralized finance”, DeFi refers to various financial tools and services that disrupt traditional finance (TradFi) by removing the third parties involved in typical financial transactions. To better understand DeFi, we should first understand the problem with centralization.

TradFi comprises entities such as banks, hedge funds, and brokerages. They are centralized systems where a single person or small group decides how the entire organization runs. This is often inefficient both in terms of time and money. Think of all the paperwork necessary to perform traditional bank transactions and having to pay all the people in between!

Aside from this inefficiency, centralization also means that entities get to regulate who has access to their services and have power over everyone’s assets. Issues such as exclusion, seizure, freezing of funds, and credit limits are some examples of the problems that arise from this. This makes TradFi inaccessible to many people across the globe.

DeFi gets rid of that by establishing a global, trustless, peer-to-peer financial system accessible to anyone with an internet connection.

How Does DeFi Work?

DeFi protocols are run by smart contracts on dApps (decentralized apps). This means that every transaction performed on a dApp is automated and does not require trust between the two parties. Since no trust is needed, users can remain anonymous, and no lengthy or intrusive sign-up processes are needed.

The exact mechanics of how variables such as transaction fees or interest rates are set vary depending on the individual dApp. Typically, transaction fees are fixed rates, and the market determines interest rates.

What Are DApps?

They are open-source, autonomous applications that you can access to interact with a protocol through a browser. They run on a peer-to-peer (P2P) blockchain network as opposed to a single computer. They are visibly similar to software applications on websites or mobile devices but are supported entirely by code, thus removing the need for third parties. For more information on how dApps work, refer to our article on how blockchains work here. DApps have nearly as wide a range of use as traditional financial services today.

DeFi Interest Rates

Some “safer” dApps may earn you interest ranging from 5% to 10% or even more. It is very attractive, especially when compared to interest rates offered by banks. But why are DeFi interest rates so high? The most straightforward answer is that any interest accrued is distributed directly to depositors rather than intermediaries.

You might have heard of some DeFi projects offering ridiculously high yields, like 1000% APY (annual percentage yield). The answer to why yields can get that high is more complicated, but a lot of it hinges on the widespread adoption of the project. If you encounter something like that, read their whitepaper or documentation on tokenomics to better understand how that protocol works.

DeFi Risks and Problems

It would be too good to be true if DeFi did not come with risks. That said, what you do not have to worry about is the security behind cryptography. Unless you reveal your private keys, no one will be able to hack into your wallet. In fact, the odds of your crypto wallet getting hacked are equivalent to the odds of you winning the lottery nine times consecutively.

The only real risks associated with DeFi are human error and smart contract risk. Human error refers to instances where either investors fail to do adequate research on the project, resulting in them getting rug-pulled, or where developers fail to get their project off the ground despite their best efforts, resulting in losses for everyone invested in it. Smart contract risk is the risk of hackers exploiting a smart contract and draining its funds. Most of the time, smart contract risk is not something to worry about because the odds of an exploit happening are slim, and there’s nothing you can do about it as a user (unless you can audit the code yourself!). To minimize smart contract risk, you may want to only invest in reputable projects with well-tested contracts.

On the other hand, many scams target users directly. A lot of people fall prey to these scams, even those who have dabbled in DeFi for some time, as they can be convincing. Here are a few tips on staying safe:

Do your own research (DYOR)

Never invest in a project just because someone said it is good. Always DYOR, read their documentation and ensure it is not a scam or a rugpull. Websites such as RugDoc exist to provide information on which projects are safe and which are not.

Store your private keys in a safe place

Write your private keys down on a piece of paper and store it in a safe place. It would be a bad idea to keep your private keys on an online platform that is vulnerable to hacks.

Never ever give anyone your private keys

Regardless of who they claim to be or how much they promise to pay you, never give your private keys to anyone. A legitimate DeFi project is never going to ask for your private keys.

Be alert to scams

Do not transfer tokens to anyone, even on the promise of potentially high returns. Airdrops or giveaways will never require you to transfer tokens out first. If you are trading NFTs, ensure that you do so on a trusted platform.

How to Get Started on DeFi

If you now feel better informed about DeFi and would like to start on your own DeFi journey, here are the first few steps to get you started.

1. Create a Wallet

To get started using dApps, you must create a wallet first. There are plenty of options to choose from today, but some of the most popular ones are MetaMask, TrustWallet, Coinbase Wallet, and Argent. You can then connect your wallet to dapps and interact with your chosen DeFi protocol.

2. Get Tokens

To interact with dApps, you will need some cryptocurrency tokens in your wallet. In some countries, you may purchase them directly through your wallet. Otherwise, you will need to buy tokens from a centralized exchange (CEX) and transfer them to your DeFi wallet. The actual token you require depends on which chain you are interacting with, as you will need the chain’s native token to pay for gas to interact with its protocols.

3. Connect Wallet

Once you have done your research and have decided which dApp you would like to connect your wallet to, all you have to do is go on their website and click on the “Connect Wallet” button. Some sites might have an “Enter App” button before you can find the button to connect your wallet.

4. Approve Tokens

Whether you are lending cryptocurrency, providing liquidity to a pool, or simply trading tokens, you will need to approve the tokens you would like to use. You need only approve each token once per protocol, and it will cost you a nominal amount of gas. Click on the “Approve (token name)” button and confirm it on the pop-up.

5. Perform Your First DeFi Transaction

Once the token has been approved, all you need to do is click on the transaction button, approve the transaction on your wallet, and wait for it to be added to the blockchain. Congratulations, you have successfully performed your first DeFi transaction!

Can DeFi Solve Financial Exclusion?

DeFi aims to solve many problems that TradFi brings, mainly the issue of financial accessibility. It has already brought about significant change in the way people can interact with financial services and has great potential to revolutionize the financial industry for good. However, whether that will actually come to fruition in the way it was originally intended is entirely in the hands of the community. It is easy to get carried away with how much money can be made on DeFi, so developers and users alike should remember to focus on community and inclusion rather than making the most money. If successful, DeFi could bring an unprecedented level of financial inclusion that can improve the lives of millions of people across the planet.

New to DeFi? If you found this useful, check out our other Learn DeFi articles to dive deeper into the wonderful world of DeFi! Alternatively, browse our Insights section to read more in-depth analyses on the DeFi space. You can also try out our flagship product, Harvest, to analyze your DeFi assets comprehensively. Lastly, subscribe to newsletter updates in the box below!