DeFi stands for Decentralized Finance, i.e., decentralized financial markets. In contrast to traditional financial systems, DeFi projects are based on blockchains on which transactions are automatically processed via smart contracts. This allows financial services to function in a decentralized manner (without a middleman) and to be made available to everyone worldwide.
Advantages and features of DeFi
In the long term, decentralized finance has the potential to revolutionize the traditional banking sector and related financial services, if not disrupt them and make them superfluous. In doing so, DeFi goes a big step further than fintech’s, which have shaken up the long-established banks in recent years. While modern fintech’s enable new products and more convenient banking thanks to the increased use of software and elements such as artificial intelligence, they are still largely based on traditional, centralized structures. Decentralized finance is fundamentally different and stands out from the classic, centralized financial system with some special characteristics:
These are all characteristics that also apply to the pioneer of cryptocurrencies – Bitcoin. In contrast to Bitcoin, which is a free, digital money system and can serve as a simple means of payment as well as a “store of value” or digital gold, DeFi delivers many more advantages thanks to programmable smart contracts based on a blockchain like Ethereum.
With DeFi, traditional banking and financial services are moving to the blockchain, creating many new opportunities, and solving some of the problems of the traditional banking sector. This starts with the ease of access that DeFi projects offer. Traditional banks can not only refuse customers, which happens regularly under the law. You also need an account and that is a luxury that many people in the world do not have. If necessary, you first must do a lot of paperwork, verify your identity and even provide insight into your personal financial situation – keyword Schufa. Finally, when taking out a loan, you are often dependent on the goodwill of an algorithm or even a bank employee.
All you need for DeFi is a compatible wallet like MetaMask (recommended) or a Ledger hardware wallet and an internet connection, and you can use DeFi and the associated protocols – whether on your home PC or anywhere else in the world with your smartphone. Opening hours and long delays at the weekend? They don’t exist in the crypto world. Opaque contracts and hidden clauses? Thanks to the transparent blockchain and the open-source concept of DApps (Decentralized Applications) and Smart Contracts, these are out of the question.
One of the most important advantages of Decentralized Finance is the decentralized structure, which is also at the forefront of Bitcoin and other cryptocurrencies. Thanks to DeFi, you no longer must put your own capital in the hands of a few institutions. The code is law in DeFi applications, and you always retain control over your own money. Shutting down DeFi protocols and apps is practically impossible, even in the most severe crises, because everything takes place in the globally distributed blockchain and there is no central body with corresponding intervention options. Thanks to the decentralized structure, there are also no banks and no intermediaries who want to make money, which keeps the costs low for everyone involved. With DeFi, one gains a certain independence from the few decision-makers who dominate the traditional, centralized banking and financial system.
In view of the low or zero interest rate policy in the traditional banking sector, DeFi also represents an attractive alternative for investors. While hardly any interest is paid on traditional forms of investment such as call money or time deposits, and in some cases even negative or penalty interest rates are threatened, DeFi projects with staking, lending, liquidity mining and yield farming offer significantly higher return opportunities in many cases. The opportunities to earn money or generate returns with DeFi are discussed in the section below.
How does DeFi work?
Once you have familiarized yourself with DeFi and the possibilities of Decentralized Finance and decided to join in, it is comparatively easy to use. All you need is a suitable wallet, such as MetaMask, and a device with internet access – there are no other requirements. The actual interaction with the respective DeFi project and the associated DApp (Decentralized Application) then works in different ways. In wallets such as MetaMask, the purchase or exchange of tokens works with a few mouse clicks, while other DeFi projects, such as Aave or Compound, can simply be used directly in the browser, where you are guided through the process step by step after connecting the wallet. Open the website, start the app, connect the wallet, done. The rest is done fully automatically in the background by the respective protocol based on the smart contracts.
Earn money with DeFi
There are various options for investors who want to generate returns and earn money with DeFi. Through staking, lending, and advanced strategies such as yield farming, users can increase their own capital and generate passive income.
Staking is one of the easiest ways to earn money passively as a coin owner. With staking, users hold back their coins and make them available to the network, which uses the coins to find consensus or validate new blocks, for example. As a reward for making the capital available, new coins are paid out at random and the coins or tokens multiply – in principle, in the same way as one knows it from a classic savings account or a call money account. Staking is therefore a good opportunity for users who want to hold their coins for a longer period and generate passive income on the side. In DeFi projects such as Aave, users can engage in Staking by making their tokens available to the Safety Module. There, the deposited tokens are used for damage limitation in the event of liquidity problems in the Aave network. Staking is therefore not always risk-free, but in return users naturally receive compensation and can thus earn a passive income with their tokens.
Lending is one of the best-known and most popular ways to earn money with DeFi. The principle is familiar from the traditional banking sector: With lending, you make your own capital available to borrowers. In other words, you grant a loan. In return, you receive interest and can thus increase your own capital. In crypto-lending, however, you don’t lend euros or dollars, but cryptocurrencies, and everything takes place in the blockchain – fully automatically via smart contracts that also secure the lending transaction. Accordingly, there is no intermediary, no bank and no other middleman who wants to make money from the lending business. Therefore, crypto lending often promises significantly higher returns, especially compared to traditional forms of investment.
Liquidity mining and yield farming
In liquidity mining, investors invest their cryptocurrencies in so-called “liquidity pools”, which are realized in the form of DApps on smart blockchains such as Ethereum or the Binance Smart Chain. The capital in the liquidity pools is then available to lending platforms or decentralized exchanges, which fall back on it when they need liquidity. In return, the liquidity providers, i.e., the investors who make their cryptocurrencies available, receive interest from borrowers or they receive a share of the transaction fees incurred in the form of tokens. Advanced lenders then lend these tokens again to other liquidity pools, increasing their returns even further. This is called “yield farming”, which translates as “yield agriculture”. The principle is like working in the countryside: you sow a seed and after a certain amount of time you enjoy a successful harvest in the form of returns.
The crypto world and the blockchain are still in a young stage of development. Decentralized finance, however, is a particularly fresh development that was only made possible by smart blockchains like Ethereum. Since 2019 and 2020, DeFi has been the talk of the crypto scene, with the following projects and protocols in the spotlight.
Future of Decentralized Finance (DeFi)
Decentralized Finance has created a lot of hype in the crypto world for a reason. DeFi is already a good alternative to existing financial instruments and offers interesting return opportunities for investors. The decentralized structure offers independence from banks, central banks, and other entities of the traditional financial system. Access to the various DeFi projects is easy and possible worldwide – a suitable wallet is all that is needed. Decentralized Finance has the potential to powerfully turn the established financial system on its head, even if the real “killer app” is perhaps still missing now, especially with regard to the connection with classic currencies such as the euro and the US dollar. Such a use case may yet come, however; after all, the DeFi world is still young and in the early stages of its development. Decentralized Finance is here to stay and worth a look for crypto enthusiasts and technology enthusiasts as well as for potential investors and investors looking for returns.
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