First time outside of Coinbase? This guide will explain some of the basics of Decentralized Finance so you can yield farm, swap, lend (decentralized, of course), or provide liquidity with more confidence.
Using a Decentralized Exchange (or DEX) for the first time can be scary and a little intimidating. It's a little less overwhelming if you know a thing or two before making your first non-custodial swap.
Ready to learn more about DeFi? Keep scrolling...
DeFi stands for "decentralized finance," which refers to a rapidly growing ecosystem of decentralized applications (dApps) built on blockchain technology that provide financial services to users without the need for intermediaries like banks or other centralized financial institutions. DeFi applications use smart contracts to automate financial transactions and allow users to interact with them directly using cryptocurrency wallets.
Remember 'not your keys, not your crypto?' DeFi lets you utilize your crypto as a financial vehicle in ways that custodial centralized exchanges can't.
Here's What You Need to Know About DeFi?
In this article, we'll take a look at a few of the most popular DeFi dApps that cover a good chunk of the spectrum of DeFi including swapping, decentralized lending, and yield farming. There are other DeFi tools and protocols, most of which are beyond the scope of this article. You can click the anchor text below to navigate to different parts of the article.
DeFi dApps
DeFi dApps are becoming increasingly popular due to their potential to provide faster, cheaper, and more transparent financial services compared to traditional finance. Some of the most popular DeFi dApps include:
Uniswap:
Uniswap is a decentralized exchange (DEX) that allows users to trade Ethereum-based tokens without the need for an intermediary. It uses an automated market maker (AMM) system to provide liquidity to traders, and users can earn fees by providing liquidity to liquidity pools.
Aave:
Aave is a decentralized lending platform that allows users to borrow and lend cryptocurrency without the need for an intermediary. It uses smart contracts to automate lending and borrowing, and users can earn interest by lending out their cryptocurrency.
Compound:
Compound is another decentralized lending platform that allows users to borrow and lend cryptocurrency without intermediaries. It also uses smart contracts to automate lending and borrowing, and users can earn interest by lending out their cryptocurrency.
Yearn Finance:
Yearn Finance is a DeFi platform that automates yield farming strategies across different DeFi protocols. It optimizes yield for users by automatically moving funds between different yield farming protocols.
Most of these DeFi dApps and protocols are Ethereum-specific. While several DeFi protocols now have bridging mechanisms and cross-chain protocols to bridge assets, for the most part, each blockchain has it's own DeFi products. Binance for example has Pancakeswap, Cardano has Sundaeswap, and LoopNetwork has LoopSwap. Try and find the best protocol for your application and your preferred cryptocurrency on your favorite blockchain network.
Benefits of Decentralized Finance
Decentralization:
DeFi applications are decentralized, meaning that they are not controlled by a single entity or organization. This provides greater transparency, security, and resilience compared to traditional finance. This also means that you have control over your trades, and the protocols in which you wish to participate.
Lower fees:
DeFi applications can offer lower fees compared to traditional finance because they do not require intermediaries like banks or other financial institutions. Some decentralized exchanges (DEX's) take a small fee to broker transactions on their platforms, but in many cases, additional costs of your transactions will be limited to the gas required to process the transaction
Faster transactions:
DeFi applications can process transactions faster than traditional finance because they use blockchain technology, which allows for instant settlement. Centralized exchanges and banks are limited to traditional banking settlement times to fully process transactions and withdrawals.
Risks Associated With DeFi
Smart contract risk:
Smart contracts are still relatively new technology and are not yet fully tested. Bugs or vulnerabilities in smart contracts could potentially lead to the loss of funds. Most smart contracts on the most trusted platforms have been audited and stress-tested to avoid vulnerabilities such as reentrancy attacks, but there are still active bug bounties on some high-value smart contracts.
Market risk:
DeFi applications are subject to market risk, just like any other financial instrument. Prices of cryptocurrencies and tokens can be volatile, and users can potentially lose money if the value of their holdings decreases. While DeFi does give you a lot of control over how you manage your crypto, it does not give you control over the market itself.
Impermanent loss:
Impermanent loss is a risk that is unique to liquidity providers in DeFi applications. It occurs when the value of one asset in a liquidity pool changes relative to another asset, causing the liquidity provider to lose money. Which leads to our next section:
A Quick Note About Impermanent Loss
Impermanent loss occurs when a liquidity provider provides liquidity to a liquidity pool with two different assets, usually in equal value. When the relative value of the two assets changes, the liquidity provider may end up with fewer assets than they started with, even if the overall value of the pool has increased. This is because the liquidity provider must always maintain a balance of the two assets in the pool, even if the price of one asset has gone up or down. Impermanent loss is generally regarded as one of the greatest risks in participating in DeFi.
Despite the Risks, People are Interested
Here are some of the reasons why someone might be interested in DeFi regardless of the risks involved:
Access to financial services:
DeFi applications can provide access to financial services to people who are underserved by traditional finance, such as those in developing countries or those without access to banks or other financial institutions.
Decentralization:
DeFi applications offer greater decentralization and transparency compared to traditional finance, which can provide greater security and resilience.
Potential for high yields:
Some DeFi applications, such as yield farming and staking, can potentially offer high yields offer high yields compared to traditional financial instruments. Yield farming involves lending out cryptocurrency to DeFi protocols in exchange for high yields, while staking involves holding cryptocurrency in a particular DeFi protocol in exchange for rewards. These rewards are often paid out in the form of the protocol's native token, which can increase in value over time.
Always Exercise Caution
It's important to note that the potential for high yields comes with significant risk. DeFi protocols can be highly complex and subject to market fluctuations, and the value of rewards earned through yield farming or staking can be highly volatile. In addition, smart contract risk and market risk can lead to significant losses if not managed carefully.
Conclusion
DeFi is a rapidly growing ecosystem of decentralized financial applications built on blockchain technology. Popular DeFi dApps include Uniswap, Aave, Compound, and Yearn Finance, among others. DeFi offers several benefits over traditional finance, including decentralization, lower fees, and faster transactions. However, it also comes with risks, including smart contract risk, market risk, and impermanent loss. Despite the risks, many people are interested in DeFi for its potential to provide access to financial services, offer greater decentralization and transparency, and potentially offer high yields.
With many users now on Arbitrum, Optimism, and Polygon for DeFi applications, it's worth taking a look at our write-up on Layer 2 solutions. Click below to check it out!