What is and how to start with Decentralized Finance (DeFi)
A Decentralized Finance (DeFi) guide for Absolute Beginners
1. Well kept billion-dollar secret at your fingertips
If you are not into Cryptocurrencies these days you probably missed the news that there is something called DeFi that became a Unicorn (a billion-dollar company).
It’s a bit of a joke because DeFi is not a company or a startup, but some kind of a pool of independent and interconnected financial services built on the blockchain.
The term Decentralized Finances (DeFi) or Open Finance goes back to late 2018 when a movement of fifteen decentralized projects set a common goal of creating a more open financial system that doesn’t need traditional banks.
2. So what is DeFi?
Long story short: DeFi is to finances what cryptocurrencies are to money. It brings decentralization and digitalized trust to finances.
A bit more complex: DeFi is a set of services, protocols, and technologies that offer various ways to handle your cryptocurrency funds.
3. So what can you do with DeFi?
Same things you do you with your money and finances, but the difference is that you don’t have to use banks or financial companies and you don’t have to deliver any proofs or have any papers signed.
You don’t even need an ID or additional proofs. Everything can be done online with your phone and computer.
All these proofs and trust is made by blockchain technologies and you don’t need any middle-men for verifications.
4. Where’s the catch?
There is none. Smart people around us created technologies like programmable money, smart contracts, and blockchain (and some others).
The point of these technologies is that they should provide a safe and trustworthy environment for managing and exchanging your crypto funds and financial operations.
5. Ok, good, can you give me more context?
Today we use traditional financial services, so we borrow money, we invest, or we keep a pile of our hard-earned money at some safe places (usually bank).
Now when we need to borrow, we go to the local bank, then we fill out some simple and demanding papers and if everything is well, we get the loan. And then we have to be the good guys and make sure we pay it back.
Similar to our investments. When we want to invest we have to find the accredited company, where our money is entrusted to some smart and nice people with an expectation they will take good care of it.
DeFi has the same purpose. It provides us with an opportunity to take care of our funds. Where things are different from classic finances is that in this case, we are in full control of our funds and investments, without anyone else having any control over what you have and what you agree upon. So no entity can take anything away from you or interfere with your funds.
6. Why would I jump on this train?
DeFi makes sense if you:
- want to experiment a bit with exciting tech and appear smart in bar
- have some cryptos lying around and you want to earn some interest without risk (theoretically)
- want to invest but don’t have time to go with all the paperwork and institutional providers
- don’t have access to banking or financial services
- play with real investing schemas (for advanced users)
7. What're the minimum funds I need?
It’s really up to you. You can start with 1 USD or so but makes sense to start with at least 10 USD not to spend everything on gas (transaction cost) and exchanges.
8. Interesting. It’s time for a more advanced explanation.
Remember, DeFi is built on the blockchain, mostly on Ethereum.
A central part of the blockchain is the Shared database (Ledger) where all the data is stored. What data would be written to this ledger is taken care of by some algorithms (officially called Consensus Algorithm).
The important part is, that once something is written to the ledger, it can’t be changed without a new consensus. So, if the consensus algorithm made an agreement you paid 10 units to someone, then this can’t be changed by anyone.
Furthermore, all the data and transactions that get stored into the ledger are synchronized to thousands of computers. So the ledger is distributed to all the computers.
If one (or more) computer fails (or is taken down by the government, service provider or bad people), the system still works. So, your payment of 10 units is distributed and not written in every single computer (node).
Let’s get the basics
Decentralization means that there is no central authority (bank, company, government…) needed to take care of what is written into this ledger because digital consensus takes care of it.
This means we digitalize Trust, or put the trust mechanism in the hands of technology. Sounds spooky I know, but it comes with many benefits. One of them is that we can automate many things.
Cryptocurrencies are digital money that are built on blockchain, so decentralized technologies, this means that there is no central organization having any control over them. So they can’t decide whether you can spend your money or block your actions in any way.
Smart contracts are digital contracts that act similarly as paper contracts but they programmed online and protected by advance encryption technology and distributed over blockchain, so decentralized. They are triggered by some actions and executed on decentralized manner, meaning no central entity or bad actor can prevent their delivery. This comes with many benefits.
9. Huh, wait, stop. Can we go back to DeFi like I am 5 years old?
You can easily imagine DeFi as shared (financial) Legos.
Imagine that red Legos represent coins and tokens (so crypto money), yellow Legos represent some crypto lending services (banks) and then we have different colors of legos for all the different things we know from classic finances (investments, liquidity providers, insurances and other more or less complex financial instruments).
In classic finances every piece of Lego is isolated, so you have to go to one provider and fill up and verify papers (ie credit score, earnings) and then take them to some other provider for some other services.
With DeFi all this becomes unnecessary. All you need is a Wallet (imagine like a pocket wallet but for cryptocurrencies) and crypto funds. From there on you can do everything in a pretty much-automated way, because these Legos are verified, trusted and shared between each other.
So once you have funds in a wallet you can start putting Legos together. For example, you can use this finds as collateral to borrow some new funds directly from other DeFi service and then you can lend these funds further to some other person and you take margin in interest rates. And as for next Lego, you can put interest rates instantly to some DeFi service, say prediction funds.
There are a million combinations of how you put Legos together and how you take care of your funds. And the new services are popping up every day.
But what’s even more exciting is how new DeFi services are created.
In the DeFi world, anyone can issue or create their own Legos. So you can create tokens or build protocols that enable lending or some financial options (like futures). The beauty is, that anyone can build on top of other services without any permission from these services, because, smart contracts and data is shared and always available.
10. I am confused with these newly issued tokens and coins. How can they have value?
True. There has been a lot of bad blood and scams in this crypto world. And it would be an illusion thinking that we are way over that. We will cover more in the next episodes.
11. And this shared data? Can other people see how much I have in the wallet and how much I borrowed?
Yes, they can see how much is some wallet, or how much of the funds is locked in a smart contract. What they don’t know is who is the owner of that wallet. So if you don’t advertise your wallet publicly, you are pretty anonymous.
12. Also, these smart contracts are a bit confusing.
True.
As we said, smart contracts enable signing a digital agreement where you pledge some action or funds into it. What you pledge into this contract cannot be revoked, because it’s written into a blockchain and distributed to a thousand computers.
Smart Contracts are enforceable and they can’t be taken down (eliminated).
For example, if we agreed that I will pay to Joanna 10 Ethereums (cryptocurrency) on the 1st of May 2020 and we signed this into smart contract (I lock my 10 Eth to this contract), this will be executed no matter what and Joanna will get her money.
The other thing is, that these smart contracts are publicly available, so everyone can use and reuse them.
Now Joanna can take this smart contract and use it for another smart contract, i.e. pledging that on the 1st of May I will have 10 Eth and next day I would like to use these funds as collateral to take the crypto loan at lending service. All this would be automated and would execute exactly as it’s written in the contract.
13. Ok, fair enough. Tell me the pluses?
It’s easy to start and everything happens instantly. You don’t need any papers or proofs to start. If you live in countries when it’s hard to open the bank account, with DeFi there are no obstacles.
It’s transparent, because smart contracts are open-sourced so you can check (or someone else can) exactly what the contract does.
It’s safe because you can’t really spend or lose more than you have (in theory) and you can’t gamble with more than you have. Whatever you do, you have to collateralize with something valuable (digital assets with value)
There are no credit checks and financial companies have no power to cut you off or do anything unpredictable with your funds.
14. What about minuses?
If something goes wrong, there is no central entity that would protect you, since no one controls the system. So you can’t run to your nice financial manager and claim money back or complain.
It’s still an experimental technology. At the end of the day, you trust everything to technology which can be buggy, unstable and unpredictable. You have to know that when the smart contract is executed, there is no way back.
It’s a very experimental investment mechanism. What will happen if people start to panic? Will protocols are stable, financial setups sustainable, will entities (companies) behind some services keep their promises.
15. So what do I need to start?
Well, not much. You need some Cryptocurrency and a crypto Wallet.
16. Where can I get the Wallet?
We have more Wallet types, and we will talk about that in the next episodes.
The thing to remember now is that you should always use open-source and non-custodial wallets. This means that you keep your funds (private keys with access to own funds on the ledger) under your ownership and control. It’s like keeping your cash in your pocket, not at the bank or some other financial service account.
There are many wallets out there. If you want to have it on a mobile phone, a safe choice would be Trust Wallet.
Also Read: Best Smart Contract Wallets (DeFi Wallets)
But more about this in other episodes.
17. So what would be the first useful and simple case for me?
If you have cryptocurrency (say Ethereum) and you want to exchange it to something else (f.e. stable coin called DAI) the most common way is through Exchange. But doing that at exchanges is mostly quite expensive.
With Swaps, you can swap one token to another with minimum cost, and everything is done in your pocket (wallet).
So this is a very useful way if you want to trade tokens with the lowest cost possible.
At Trust Wallet you can do these Swaps at DEX menu -> Swaps.
DEX means Decentralized Exchange (yes, we will cover that soon).
18. What do I risk?
Again, you play with your own money and there is none that will give you back your lost funds. Don’t be greedy, don’t spend what you can’t afford and don’t do things you don’t understand.
Also, no matter how these things are exciting, they are still an experimental technology and experimental business models
We will cover more exciting things in the next posts, so buckle up!
