Welcome to the first guide in a series of three that have been written and produced in partnership with Zerion. These guides will lay out the things you should consider as you enter the world of decentralized finance – including investment strategies you might want to follow, and how to take action today.
We’ll kick things off by explaining what decentralized finance is, how it works, what all the hype is about, and how you can get involved.
Banks take in cash deposits, make interest-bearing loans, and pay out some of what they receive as interest to depositors. That’s a prime example of banks making their (and your) money work for them.
Usually, they’ll rinse and repeat this profit-generating process time and time again, with you getting a slice of the action through interest paid on your savings accounts. For the last 10 years though, that’s been pretty much close to nothing: right now, the average interest rate in the US is just 0.09%.
Throw in the occasional financial crisis and subsequent bailout and you’ve got a tale as old as time.
But for lots of people, that doesn’t matter: they’re blocked from fully participating in the financial system in the first place. 1.7 billion adults worldwide are unbanked – and even those who are banked don’t get much say in how the banking around them works. In a way, then, access is still the problem child of modern finance.
Until now. Enter DeFi.
Decentralized Finance – a.k.a. “DeFi” – is an emerging open and global alternative to the restrictive, centralized and centuries-old traditional financial system much of the world knows today. DeFi offers anyone with a smartphone and an internet connection the opportunity to put their money to work on their terms across services like investing, borrowing, lending, and trading.
Rather than have banks act as intermediaries, DeFi puts individuals at the center of a peer-to-peer financial system run on open-source blockchains like Ethereum.
Ethereum is a decentralized, open-source blockchain that supports smart contracts – self-executing code that can implement virtually any agreement. Most of DeFi exists on the Ethereum blockchain, and this ability to encode financial transactions is what makes it so powerful. Unlike centralized finance, DeFi is uniquely:
In the end, algorithms replace manually set interest rates; global, decentralized networks of computers replace expensive, centralized data storage, and programmable, tamper-proof agreements replace the red tape that characterizes so much of traditional banking.
What’s left is a faster, more efficient and more accessible financial system. The basic concepts stay the same, like investing, borrowing, lending, and trading – what changes is how they’re carried out and who has control over them.
The following are some of the most popular and well-used types of decentralized financial tools:
Decentralized exchanges (DEXs) offer an efficient way to trade crypto without an intermediary and without giving up custody of your funds. Popular DEXs like Uniswap, Balancer and Curve are known as automated market makers (AMMs) because they use liquidity pools to manage trades.
Think of a liquidity pool as a market between two or more tokens. When someone deposits tokens to the pool, they make themselves eligible to earn trading fees proportional to their share in the pool. Each time someone else buys from the market, the exchange price is determined by a smart contract that looks at the ratio of tokens in the pool, and trading fees are subsequently split amongst liquidity providers.
Protocols such as Compound Finance offer one of the most common services offered by the financial industry: lending and borrowing of funds. If you’re paying off student loans, banks usually charge a very high interest rate. In DeFi, banks are replaced by liquidity pools where anyone can deposit tokens and borrowers can take from and pay back at an algorithmically determined interest rate. The best part is that your money compounds in real time – every 15 seconds.
Instead of a fund manager, you can choose a tokenized asset management strategy to earn passive income on your crypto portfolio. An example of this is the DeFi Pulse Index, which tracks the top market movers.
Smart contracts are the building blocks of DeFi. While exchange hacks are unlikely, sometimes there are vulnerabilities in the code or a protocol simply runs out of liquidity. To mitigate these risks, DeFi insurance like Nexus Mutual can help protect your tokens and transactions.
Stablecoins are cryptocurrencies whose value is “pegged” to other stable assets like the US dollar. Stablecoins are widely used in DeFi for trading, lending and borrowing. They’re considered one of the building blocks of the DeFi ecosystem, ensuring stability for transactions.
As DeFi has paved the way for decentralized trading and finance tools, creators and developers are now working together to build even more tools for the community. Gitcoin, for instance, is a platform where decentralized projects are funded, and educational resources are used to build open-source projects. Another example is Radicle – a decentralized network for code collaboration, aiming to develop open-source infrastructure that is secure, sovereign, and exclusively built on open protocols.
The appeal of DeFi lies in the fact that there’s no central bank or third-party intervention. You own your assets completely. DeFi eliminates the need for trust in intermediaries and instead upholds security while encouraging open-source collaboration. Traditional – or centralized – financial tools are being adapted for a DeFi world with impressive speed, so it likely won’t be long before other industries meet a decentralized future too.
That’s all for now! But you can discover more in parts two and three of this series…
This guide was produced in partnership with Zerion.
Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.