For a lot of people in the crypto space, the word DeFi isn’t new to them. You have come across it multiple times and may even have a very good idea of what it is and how it works. For some, while you know what the word means, you might not understand how exactly it works and why it’s needed. For a lot of beginners, this is uncharted territory and they have no idea what DeFi means and that is what this article is for.
For starters, DeFi means decentralized finance. It’s a blockchain-based form of finance that cuts out banks or other payment processing platforms in a transaction. One of the most popular use of DeFi which you’re familiar with are the creation of stablecoins. DeFi is an open-source software that also provides access to financial services such as investing, borrowing, and lending but cuts out the need for a middleman to carry out these transactions.
Decentralized exchanges are part of DeFi and most use a liquidity pool system, originally used by Uniswap but now used by the likes of Pancake Swap, in which users can farm their coins to provide liquidity, and earn interest and rewards for providing said liquidity. So far, the DeFi space seems to be accessible to to very experienced crypto investors who understand how the technology works but leaves out the average retailer due the the high barrier of knowledge in the space.
It is important to mention that the vast majority of DeFi coins are currently operated on the Ethereum blockchain and they use smart contracts to execute transactions. Smart contracts are self-executing and irreversible protocols which are executed on a permissionless, open-source, decentralized blockchain. The use of smart contracts is how DeFi cuts out the middleman in a transaction.
At this point, you’re probably wondering, why should I be interested in DeFi? Well, I’ve got an answer for you. You can earn with DeFi. Instead of saving money like you normally would in a bank, which offer miserably low interest rates, you can place your cryptocurrency into decentralized lending protocols like AAVE and earn interest on your cryptocurrency, at a much higher rate than you would ever get with your bank. Or you could go the route of yield farming in liquidity pools like Pancake Swap, which rewards you with new coin supply and a percentage of the trading fees.
This does not come without its risks. Your risks include volatility in collateral value and impermanent loss. A good way to mitigate these risks is to provide liquidity to stablecoin pairs. With stablecoins, you eliminate the risk of collateral value volatility and impermanent loss, as the coin is pegged to a fiat currently and does not change in value quite frequent or with a wide margin as with other cryptocurrency coins. Other risks include increased gas fees, smart contract risks, etc. It is high stakes but with high returns.
It might seem daunting at first, the prospect of getting into this and understanding all of it but no one said you have to understand how everything works in one afternoon. But the most important part is taking the first step, because dear reader, DeFi is the future and it is here to stay.