What is DeFi? A Beginner’s Guide To Decentralized Finance
A world where everyone has equal access to every financial service, no matter where you live –– this is the promise of Decentralized Finance (DeFi).
Unlike conventional finance, DeFi doesn't require opening a bank account, filling out an application, or verifying your identity.
Everything happens without intermediaries and is done online through blockchain technology, cryptocurrency, and smart contracts.
In this guide, we will unravel the inner workings of Decentralized Finance, reveal its potential, and help you take your first steps in DeFi.
What is Decentralized Finance?
In traditional finance, transactions occur through a middleman (e.g., banks, financial institutions). These intermediaries maintain the infrastructure, enforce rules, and hold the authority to approve or decline transactions based on their criteria.
While such institutions offer a structured system, they also create bottlenecks and impose limitations such as high fees, long wait times, and restricted accessibility.
DeFi replaces this centralized control with a decentralized, transparent, and programmable system (on the blockchain). It removes the need for these middlemen and gives participants direct control over their assets.
Every transaction on the blockchain is validated by multiple nodes (computers on the network). This ensures all transactions made on DeFi platforms within the network are highly secure and resistant to fraud.
How Does DeFi Work?
On first impressions, DeFi might come across as an enigmatic, cutting-edge technology that only the brightest programming prodigies can comprehend.
However, at its core, DeFi is quite simple. Here's how it works:
Smart Contracts
The backbone of Decentralized Finance is Smart Contracts. They power everything from decentralized loans, and digital asset swaps, to any decentralized application (dApp).
You can imagine these contracts as digital agreements that execute actions automatically when specific conditions are met. They work by following simple "if/when…then…" statements written into their code.
An example of this in the physical world is a vending machine. If you insert a coin into the machine, then it will release a drink/snack.
Smart contracts act similarly — but on a much larger scale.
Smart Contract Lego
No matter how special, a single smart contract on its own can't be considered "DeFi."
For a DeFi service to function, it will need multiple smart contracts working together in tandem.
Take a DeFi Lending platform; for it to function properly, it needs several smart contracts:
- The Verification Contract: The first smart contract is responsible for verifying and managing collateral. It will authenticate the legitimacy of the collateral and either lock or release the collateral based on the loan status.
- The Issuance Contract: The lending process can commence once the collateral is verified and locked. A separate smart contract takes the reins here. It distributes the loan to the borrower, taking note of the amount, the borrower's details, and the repayment schedule.
- The Interest Management Contract: Finally, the interest rate is a fundamental part of any loan. In DeFi, this is handled by yet another dedicated smart contract. It updates interest rates according to pre-determined conditions (usually the supply and demand within the lending pool).
When looked at independently, these contracts perform single, 'vending machine' like tasks. But together, they create a fully-functioning automated lending system.
This concept can be applied to create a multitude of decentralized financial tools and services — creating an alternative, digital financial system accessible to anyone with an internet connection.
How Do I Access DeFi?
Step 1: Get a Crypto Wallet
The first thing you'll need to access DeFi is a digital wallet. These wallets are like your digital bank account. You use them to store, send, and receive cryptocurrency.
There are various crypto wallets available, each with its own unique features. Some of the popular ones include MetaMask, Trust Wallet, and Bake.
Step 2: Purchase Crypto
The next step is to purchase crypto. This is done directly within the crypto wallet or through other means.
Thanks to its well-established and versatile ecosystem, Ethereum (ETH) is the most widely used crypto in DeFi. However, there is a rising tide of alternative blockchain networks that are also making their mark in the DeFi space.
These include Solana (SOL) — known for its high speed. And DeFiChain (DFI) — a blockchain specifically dedicated to decentralized financial applications.
Discover the best way to purchase crypto in the Bake Ultimate Guide.
Step 3: Connect Your Wallet to a DeFi Platform
The next step is to connect to the DeFi ecosystem. You may be able to do this directly via your crypto wallet — depending on which wallet you decide to use.
If you are using Bake, then it's simple. By selecting the 'Bake' tab in-app, you gain direct access to various DeFi services — all of which you can start using in just a few clicks.
Suppose you use an alternative wallet, such as MetaMask. In that case, you must visit the DeFi platform's website and click the "connect wallet" button.
You'll be prompted to select your wallet provider and approve the connection before you can begin interacting with the platform.
Step 4: Start Using DeFi Services
Now your wallet is connected, you can use the DeFi service. The specific options available to you will depend on the platform you've chosen.
Typically, you'll see options to lend your assets, borrow assets, earn interest, and trade tokens.
Note that you will need some ‘gas’ to pay the selected platform's fees. Depending on the network, gas fees can be high during peak times (e.g., Ethereum gas fees are notorious for spiking during increased network activity).
Always take caution and check the gas fees before confirming any transaction on a DeFi platform.
What Can You Do With DeFi?
Borrowing/Lending
One of the most successful applications of DeFi has been through lending and borrowing platforms. Such platforms allow users to lend their cryptocurrencies to others in a decentralized and trustless manner.
They allow everyday people to lend out their assets and earn interest on them in a way only big banks can in traditional finance.
Borrowers can take out loans directly from the lenders via the DeFi lending protocols. The lending protocol automatically distributes interest payments (paid by the borrower over time) to the lender.
Borrowers and lenders don't need to trust each other or any third party — they only need to trust the smart contract managing the transaction.
Trade/Swap
Decentralized Exchanges (DEXs) are decentralized platforms that allow users to buy, sell and trade digital assets.
Unlike traditional exchanges, which require users to give up control of their assets to make trades provisionally, DEXs operate on a purely peer-to-peer basis. You trade directly from your wallet, and transactions are settled instantly on the blockchain.
Try it out yourself using the DeFiChain DEX.
DEXs allow users to exchange all different types of digital tokens, not only between cryptocurrencies but also between various types of assets.
For example, trading tokens representing commodities, equities, or real estate on a DEX is possible. Thanks to another DeFi use case — Synthetics.
Synthetic Assets and Derivatives
Synthetic assets represent and track the value of another 'real-world' asset. These assets can be virtually anything –– interest rates, precious metals, or even an index of various assets.
In DeFi, Synthetic assets are created through a process called 'tokenization.' This is where real-world assets are converted into a blockchain token, representing the underlying asset.
The price of this tokenized asset is pegged to the price of the real-world asset. It can be bought, sold, and traded on various DeFi platforms without ever requiring the transfer of the actual asset.
For instance, a synthetic asset representing gold (e.g., sGOLD on the Synthetix platform) will track the price of gold. If the price of gold increases, the value of sGOLD will also increase.
A further progression of DeFi Synthetics is Derivatives. Derivatives in DeFi add another layer of complexity by introducing tokenized futures and options. They enable investors to speculate on the future price of an asset without actually owning it — completely free from intermediaries.
The biggest platform in the DeFi Synthetics/Derivatives space is Synthetix. However, other projects, like DeFiChain, are beginning to crop up with even more sophisticated and secure Synthetics/Derivative platforms.
Yield Farming
Yield Farming is one of the most popular ways to earn interest on your crypto. The idea is to move your assets from platform to platform — based on which one is dispensing the highest returns — in order to optimize your yields.
This process generally results in higher returns than leaving your assets to earn interest on a single DeFi platform. However, it can be time-consuming if you are trying to do it manually.
This is where Yield Optimization platforms come in. They streamline the process by allowing you to deposit your assets and have them automatically allocated to the protocol with the highest returns.
Check out Bake’s YiledVault service, which utilizes Yield Farming strategies to optimize returns on your assets.
DAOs
Lastly, DeFi allows you to participate in Decentralized Autonomous Organizations (DAOs). DAOs are a decentralized, community-governed voting system. They can govern anything from a DeFi protocol to a non-profit organization.
Generally, DAOs are used by DeFi projects to decide upgrades/changes to the protocol. Such changes are proposed by someone within the organization or a community member. The community as a whole can then vote on whether to enact that change or not.
A user's voting power is generally determined by the number of the project's tokens they hold. If you own 100 tokens, you get 100 'votes' (or 'voting power') in the proposals.
Different DAOs have different systems for determining the user's voting power. Many are becoming increasingly sophisticated to prevent single 'wealthier' users from dictating the votes to their preference.
What Is Bake’s Role In DeFi?
Bake connects the traditional financial industry with the new, exciting DeFi ecosystem. Despite all the positive aspects of DeFi, it still lags behind conventional banking apps when it comes to usability.
Bake changes that by offering a simple and intuitive interface for DeFi. This drastically flattens the learning curve and makes DeFi services accessible to everyone — regardless of technical knowledge.
Bake takes you by the hand and guides you through the DeFi jungle — making it as easy as using a credit card (without sacrificing the high DeFi yields). It's the easiest way for beginners and experts alike to get exposure to Decentralized Finance.
DISCLAIMER: Please note that the information on this blog and in any articles posted on this blog is for general information only and should not be relied upon as financial advice. Cake Pte. Ltd., Cake DeFi, UAB, and its affiliates (the “Cake Group”) are not licensed financial advisers. You may wish to approach your own independent financial advisor before making any decision to buy, sell or hold any product and/or digital assets mentioned in this blog.
Any views, opinions, references, assertions of fact and/or other statements are not necessarily the views held by the Cake Group. The Cake Group disclaims any liability whatsoever that may arise out of or in connection with such statements. Always do your own research before investing in any financial assets and consult a qualified financial advisor if necessary.
