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Decentralized Finance and its Place in Web3

DeFi, short for decentralized finance, is a generic term for financial instruments built on blockchain. The idea is to allow anyone with Internet access to lend, borrow and bank without intermediaries. DeFi is one of the fastest-growing areas of blockchain and decentralized internet.

Bitcoin — a payment system in which anyone on Earth can send money to anyone — was just the beginning of the crypto revolution. People building DeFi applications are looking to take the next step towards accessibility. Decentralized finance is seen as a possible solution to lower the entry barrier for those who have struggled to access bank accounts. And lately, cryptocurrency owners have been using it for a different purpose: to make more money.

DeFi applications are financial products that run on a blockchain, such as Ethereum. These products work without the participation of third parties. Instead of financial intermediaries such as brokers and banks, all processes are automated and executed through smart contracts.

Do you want to take out a loan? You do not need the bank to transfer money to you. Instead, get a loan directly from your peers. Ready to bet on Bitcoin futures or other derivatives? Forget bookmakers. You can do this through a protocol (smart contract). Do you want to exchange one asset for another? Decentralized exchanges can facilitate transactions without incurring losses.

The Key Features of DeFi

  1. First, it's public, meaning you can use apps by creating a wallet — often without showing any identifying information like name and address. This is theoretically (if not technologically) easier than having a bank account.
  2. Second, you can move funds almost instantly across the blockchain, so you don't have to wait for a bank transfer to be received.
  3. Third, the rates are (at least for now) much better than traditional banks, although transaction costs vary by blockchain.
  4. Finally, DeFi applications work together like "money legos." This buildability allows anyone to create, modify, mix and match, link, or build on top of any existing DeFi product without coordinating with anyone. Unfortunately, this feature can also be the most significant weakness because if a critical component like the DAI stablecoin becomes vulnerable or corrupted, the entire ecosystem built on DAI could collapse.

Three Types of DeFi Applications

Trading: With centralized exchanges like Coinbase and Binance, you rely on the exchange to store your assets and help you make every trade. Decentralized exchanges (DEXs) remove the middleman so that people can trade directly with each other. Moreover, DEXs like Uniswap and PancakeSwap allow people to list new tokens for trading. However, lack of due diligence increases risk and will enable people to "get in first" in asset value entering broader markets.

Lending/Borrowing: If you own cryptocurrency, you can lend it to a protocol like Aave or Compound in exchange for interest and/or rewards. Similarly, you can borrow digital assets from such a protocol, which is especially useful to make a deal. But be careful! Most DeFi protocols use over-collateral, which means you have to deposit more than you want to borrow. Moreover, if the asset's value in the deposit falls too much, the protocol can withdraw (liquidate) your invested money to avoid losses.

Many users use DeFi to earn assets through Yield Farming, where they lock funds in an asset pool to receive rewards. Because rates vary by protocol and asset, experienced farmers move stands to profit at the best rates.

Derivatives: Sometimes,, you don't want to be limited to trading individual coins or tokens. Derivatives platforms like dYdX and Synthetix allow people to do more than just spot trading. Users can make leveraged trades in which they bet more than they have or even create synthetic assets that mimic traditional stocks and commodities.