One of the keys to financial success is to have control over your money. This is the most fundamental concept underlying almost all defi use cases. Because we live in a complex economy, this control is essential both for investing and protecting wealth. Yet, almost every bank and institution is based on the opposite.
In exchange for financial services, you delegate control to other companies. You have to trust and hope that they’ll manage your money safely. That they won’t make mistakes, have conflicts of interest, change term conditions, suspend your account, have cyber-attacks, or go out of business in uncertain times like these.
If you trust traditional finance, you’ll soon find out how all these problems make it unreliable. Thankfully, blockchain innovations have brought a new approach to money. It removes trust from the equation (along with all issues that it causes), and it’s called decentralized finance.
Decentralized finance is the application of public blockchains to financial sectors. The main difference with centralized finance (CeFi) is that DeFi platforms have no central authority. They’re run by autonomous programs called smart contracts, which manage all balances and can’t be manipulated.
DeFi apps make finance simple by removing all the complicated steps we once needed to guarantee security. Trust is replaced with a fault-tolerant algorithm (the consensus model), which allows users to directly exchange assets and services. Instead of trusting an exchange broker or a bank, you can instead:
The way we interact with DeFi is by connecting a wallet to different financial apps.
The list of DeFi use cases gets longer every year. And while there might be thousands of financial dApps, most of them fall under these 11 types:
DEXs are trading platforms without a central exchange authority. Everything is run with smart contracts, liquidity pools, and automated market makers (AMMs). With these tools, DEXs can always fulfill trade orders for any coin, even when there aren’t sellers.
Using a DEX is easier than centralized exchanges (CEX). You connect your Metamask wallet by clicking a button, and you can immediately start swapping tokens. It’s available to anyone anywhere anytime (there’s no company that can shut them down).
CEXs may seem more liquid and secure. And they are as long as it’s convenient to them. If too many people start selling, or they consider you a risky trader, they can shut down your account or disable exchange features.
DEXs are autonomous so nobody can disrupt the service. There’s no KYC or registration.
UniSwap v3 is the standard for decentralized exchanges. Most other DEXs are forks of UniSwap v2, and will fork UniSwap v3 when the licensure is available.
DeFi risk management is about automatic compliance. Whatever you sign in smart contracts will be programmed to happen. It’s a trustless agreement that doesn’t require 3rd parties to moderate (and once signed, not even the two parties).
Thus, risk management comes down to code security and your decisions. It’s a big deal because, in conventional finance, you delegate that control to someone else (your bank, government, service provider, broker…). Not only trusted the only solution to financial risk, but also the cause of it.
Because a trusted party isn’t some safe box where you can store your life savings. It’s simply the least risky of the two. Trustworthy or not, parties still have to deal with conflicts of interest, transparency, and security risks for having a “single-point-of-failure.”
Not in DeFi.
Yield farming is a broad term that includes all strategies used for interest earning and risk management. If you can earn passive income (in crypto) while keeping your initial amount safe, you have a valid yield farming strategy. Yield platforms achieve this via lending, stacking, liquidity providing, and such.
Yield farming is easy to learn but hard to master. It usually involves depositing crypto on some platform or token. This amount can contribute to securing networks (e.g., ETH 2.0.) and liquidity pools (e.g., Uniswap), which generates more platform revenue. As long as you don’t withdraw the initial amount, you keep collecting rewards like interest, fees, or liquidity tokens. Some strategies have generated well over 100% APY in the past.
In traditional finance, anything 10% would be overly optimistic. You can expect 0.01% to ~3% per year from most banks and 5 to 10% from the best bonds and indexes. Centralized exchanges do offer crypto staking with ~10% APY, but they’re still not as rewarding as decentralized platforms (and there are lock periods).
The cornerstone of DeFi is Web3 wallets. Regardless of what your dApp does, you’ll need to connect a wallet to use it. One wallet and balance gives you access to the entire dApp ecosystem.
Traditionally, every financial platform requires registration. Enter your email, fill up legal information, verify documents for KYC. These platforms still can shut down accounts anytime.
In Web3, all dApps are autonomous and don’t allow any intervention. All registration is replaced with a wallet, which has the simplest registration you’ll ever see. Click Create wallet, save this code, type the code you saved, and it’s ready to connect.
You can import to different devices and switch accounts.
NFT marketplaces are peer-to-peer exchanges of non-fungible tokens. The difference between coins and NFTs is that the latter has a token supply limit of 1. Because they’re unique and have subjective value, they’re linked to digital assets and considered collectibles.
There are no “exchanges,” as trading NFTs would be trading apples for oranges. Instead, users list them in a marketplace and give them a price in native tokens (ETH for Ethereum NFTs, BNB for BNB Chain’s…). Creators can change NFT parameters and prices for a network fee.
Proof of ownership isn’t that simple outside of DeFi. You would need to buy intellectual property or trademarks, which is essentially trusting a provider or legal entity. Like cryptocurrencies, NFTs have public histories of everyone who ever traded them, including the creator. You can tell which one is real among NFTs with the same picture.
For years, there have been marketplaces in video games and artist platforms. But the missing piece was the seamless link between real and digital economies. Game developers aren’t economists, and connecting both leads to typical real-world problems. Currency inflation, bug exploits, black markets, along with the legal and revenue risks involved.
NFTs allow to separate these platforms from the marketplace. This means that game studios can create NFT items, but they’re not running the marketplace. It’s decentralized. Users do.
It also makes counterfeits easier to avoid because the official platform will link to the original listing. For example, there may be an in-game NFT giving your character certain stats, abilities, or cosmetics. If you buy a fake NFT with the same listing picture and description, you won’t get those parameters.
Now that NFTs make proof-of-ownership simple, it’s just as easy to transfer or tokenize it. To tokenize an asset is to derive another that identifies with it (like the ID card that governments use to identify you). Whoever has this identifier has “ownership” of the underlying asset and its utility.
This ownership can be fractionalized the same way public companies use stocks. Illiquid assets become tradeable this way. For example:
Tokenization can also increase DeFi liquidity. For example, one downside of staking is that users can’t use those tokens. Here’s a solution:
It’s like lending and borrowing at once.
Traditional cybersecurity involves encryption and verification methods. The problem is that even the most secure networks can be compromised. Cyber-attackers can break into anywhere with the right skill and timing. And all code can be vulnerable.
Finance-based secure is known better as proof-of-stake (PoS) variants. A stake is the tokens that users lock in the blockchain, because doing so rewards them for securing the network. In PoS mechanisms are probabilistic systems that favor the biggest and longest token holders.
If you owned over 50% of the network’s tokens, you could theoretically control the blockchain. But because you have the most at stake, you have the most to lose should the blockchain be manipulated or stolen.
Multisig wallets are balances managed by a list of one or more accounts. These accounts are other Metamask wallets, which you use to connect to multisig wallets like Gnosis Safe. Once connected, you can perform actions based on the conditions you set.
For example, a multisig of 5 wallets may require 3 confirmations to approve transactions, 4 to add new addresses, or 2 to approve dApp contracts. Anyone member can see the balance, add funds, perform actions that need no confirmations, or confirm someone else’s. If sending crypto needs three, you’ll need another two accounts to click Confirm.
In centralized finance, the equivalents are joint accounts managed by banks, brokers, or escrow companies. Not only are permissions less customizable, but there’s the risk of third-party fraud.
In DeFi, multi-signatures are as easy as sending crypto. No KYC, no agreements needed.
On-chain governance is a voting system based on tokens. Periodically, developers will publish potential code updates and improvement proposals (IPs). Users have a few days to either approve or reject it by staking their tokens.
The difference between on and off-chain is that on-chain involves locking tokens. By “putting money where your mouth is”, members make better decisions and prove that they actually support them. While decisions depend on the vote majority, votes have different weights depending on stake amount and history length.
One equivalent in centralized finance is activist investing. The biggest investors can join a company’s Board of Directors to participate in decisions, and thus, partially control their investments. By contrast, DAOs are flat organizations that give everyone the same opportunities as insiders.
Derivative tokens are inherently worthless tokens that represent an underlying asset. For example, your bank account balance (fiat money) can represent cash (paper money), and those dollar bills represent hard money like gold, silver, and other universally accepted commodities.
While hard currency is the most reliable, paper and fiat (derivatives) allow far more liquidity and economic growth. In crypto, for example:
A token doesn’t necessarily have to go up or down based on demand. Developers can code whatever behavior is convenient. They can design, say, a BTCDOWN token that does the opposite of Bitcoin’s price (like short positions).
Blockchain has introduced a new approach to finance and banking. Not only does DeFi bring new use cases, but it can also do better what CeFi already does. Whether it will replace traditional finance or not, the future is indeed decentralized.
Disclaimer: Please note that nothing on this website constitutes financial advice. Whilst every effort has been made to ensure that the information provided on this website is accurate, individuals must not rely on this information to make a financial or investment decision. Before making any decision, we strongly recommend you consult a qualified professional who should take into account your specific investment objectives, financial situation and individual needs.
Max is a European based crypto specialist, marketer, and all-around writer. He brings an original and practical approach for timeless blockchain knowledge such as: in-depth guides on crypto 101, blockchain analysis, dApp reviews, and DeFi risk management. Max also wrote for news outlets, saas entrepreneurs, crypto exchanges, fintech B2B agencies, Metaverse game studios, trading coaches, and Web3 leaders like Enjin.