What is a DeFi in Сrypto and How Does It Work?



When the concept of cryptocurrencies was first proposed to the financial community, its biggest draw was decentralization. Contemporary retail traders use a variety of tools like running a crypto trading bot or staking their tokens, but all of that is possible only because many loved the idea of using a decentralized financial system.

The dawn of DeFi philosophy

Here is a simple DeFi definition: Decentralized Finance means a structure without a central authority. What it means is that all the data about transactions is stored independently and can be effortlessly audited by anyone. The very design of blockchain facilitates the transparency so that all participants of the ecosystem believed each other without even knowing who is who.

Decentralization was a good sales pitch in the 2010s when the world was trying to shake off the consequences of the 2008 financial crisis. It wiped away fortunes and creates gaping holes in many economies. It was caused by uncontrollable financial institutions that acquired assets using nothing but debts and created assets from debt.

The situation was chaotic and many people became disappointed in the traditional financial system. So, what does decentralized mean in cryptocurrency?

The brief history of Bitcoin

The blockchain technology is not a novel thing that appeared out of nowhere. First iterations of blockchain networks were proposed in the end of the 1980s. The idea of having a digital ledger that can be easily monitored and controlled could be applied to many industries, but the world decided to go in a different direction.

Bitcoin started its history in 2008 when an anonymous developer proposed the concept and started the development process with some help from enthusiasts. It was a slow process at the beginning, but quickly picked up the pace during the 2010s. The price of BTC exploded during the rise of the “silk road”, a darknet website that facilitated trading of illegal substances and services.

The connection to illegal trading should have been condemning, but it actually showed many investors and financiers that BTC can be used for many purposes thanks to its anonymity and decentralization. Speculators saw the potential of this new type of assets.

What is decentralized finance?

Traditional finance is a system where large institutions control the economy. For example, a modern western country has a Central bank that issues currency. It controls everything and can cause extreme inflation or slow it down depending on the current policy. Other banks and investment companies interact with the central bank to gain access to capital.

Centralization means the concentration of power in certain institution regardless of whether other participants of the economy have anything to say about decisions made by central authorities.

DeFi platforms are new organizations within the crypto world that try to make finance more democratic by implementing new governance mechanics and offering their users access to the data. For example, a decentralized bank will have a governance system that allows stake holders to decide where to invest money or how to lend it.

Here are several important features of a decentralized platform:

  1. It operates within a blockchain network or can be a blockchain network of its own. The blockchain is used as a digital ledger that can be accessed by anyone at any moment.
  2. The governance is fully decentralized with all decisions made after voting. All stake holders and even token holders may have the right to vote.
  3. The development process is often conducted with the help from the community. Many DeFi platforms are open source projects.

You may use a wide range of DeFi strategies to improve the quality of your investments. When it comes to the world of crypto, finding the right instrument or service can cause a huge bump in performance of your trading strategy. For example, what is the best way to manage crypto? Oftentimes, using DeFi tools that offer portfolio management services is a great choice since they can easily integrate with other DeFi platforms.

What is the difference between DeFi and crypto?

Some people assume that DeFi means crypto since many digital assets look and feel so similar. Newcomers to the industry do not distinguish the term DeFi and crypto believing that every single token in the market is a part of the larger decentralized ecosystem. Nothing can be farther from the truth than this belief.

The crypto industry is quite large with many startups offering unique products and services based on using the blockchain technology. Not all them are DeFi or even decentralized for that matter. They can still issue digital tokens and many use them similarly to stocks allowing token holders to receive quarterly or yearly returns.

One of the reasons many believe that DeFi is crypto meaning that these are two interchangeable terms is that all platforms in the crypto industry want to appear as decentralized and democratic despite not having many hallmarks of a fully decentralized platform.

What are DeFi coins?

Tokens issued by truly decentralized finance platforms are considered DeFi coins. Chainlink, DAI, Wrapped Bitcoin, Uniswap, and many others are tokens services that have all the necessary features to position themselves as DeFi. They have democratic governance systems, transparent business processes, independent development, and the absence of any central authority.

These tokens are gradually growing in popularity and price. The biggest recent jump was caused by the FTX failure which many blamed on centralization. The top management of the company was able to conduct all sorts of shady operations without any oversight. Reckless spending, fraud, and deceit were possible only because there was no transparency and many investors became victims of the now-infamous CEO.

Users who saw the writings on the wall quickly migrated to various decentralized exchanges including Uniswap and PancakeSwap causing many DeFi crypto coins to jump up in price. It was a good moment to learn how to trade DeFi assets and many smart investors made huge profits thanks to the increased interest toward fully decentralized financial platforms that offered transparency and openness to their users.

Here are some of the DeFi coins that are quite popular among retail traders:

  • Wrapped Bitcoin (WBTC) is a token that represents BTC on the Ethereum network. Many users believe that using wrapped coins is faster and allows for more flexibility in terms of investment opportunities. The current market cap of WBTC is roughly $4.86 billion.
  • DAI is one of the most popular stablecoin for people interested in working with ERC-20 tokens and other Ethereum-based digital assets. The issuance and circulation is controlled by the MakerDAO, a fully decentralized governance organization.
  • Avalanche (AVAX) is the native token for the blockchain network that offers various development environments and tools for projects that want to focus on decentralized finance and products aimed at crypto investors. Avalanche is the layer-one network similar to Cardano or Ethereum.
  • Chainlink (LINK) offers its users the ability to seamlessly connect different smart contracts to each other regardless of their origin. It is a great platform that has been around since 2017. Many DeFi protocols use the Chainlink architecture.
  • Uniswap (UNI) is the native token of the platform that facilitates automatic trading of DeFi assets within the crypto ecosystem. It is one of the best exchanges in the decentralized finance space and offers its users a wide range of financial instruments to work with.

The diversity in the DeFi domain is quite impressive. Whether you want to focus on trading tokens representing specific platforms or want to use your hardware for DeFi mining, you will find a good way of benefiting from interacting with this environment.

Now when you know all of the above, what is DeFi in crypto? It is an ecosystem where various unique financial products and services are integrated with each other in a transparent and open manner. The ability to audit everything and oversee how finances are moved from one place to another is the definitive feature of the whole space.

How to use DeFi?

Simply become a token holder or use platforms that position themselves as true decentralized finance organizations. You don’t need to use specialized hardware to start using these products. However, you must remember that decentralization is often associated with slow transactions and low liquidity since validation and transparency are such important qualities of the ecosystem.

Many efficient instruments used by contemporary investors do not work in the DeFi domain:

  • Social trading. Many people like the idea of simply following established traders and copying their market orders. It can be a bad idea on decentralized exchanges that are slow to react. By the time, your order is processed, the situation in the market may change dramatically. It means that utilizing crypto copy trading in the DeFi environment is not feasible.
  • Any form of automation. While it is possible to use bots for DeFi, many decentralized platforms do not integrate with third-party providers making it quite hard for retail traders to use popular automation vendors like WunderTrading to deploy bots and meaningfully interact with various digital assets featured on DEX platforms.
  • Leveraged trading. Margin accounts are not offered by DEX platforms. You can use specific lending services, but they do not work similarly. You will need to get used to how debt works in the crypto market.

You should remember that the reason why so many people became obsessed by the idea of decentralization is that we all want to work with trustworthy businesses and operate in an environment where your money can’t be tampered with.

The common tradeoff is a significant slowdown of all processes. From validation to execution, everything takes more time in the DeFi ecosystem. The clunky nature of transactions makes platforms like Uniswap so popular as users desperately try to optimize their operations and increase the speed of operations.

If you want to make money by speculating on the price or engaging in established trading systems like arbitrage or statistical arbitrage, you should not even think of working with DeFi assets, at least, for the time being. We still need several technological breakthroughs to happen in the industry before we can start trading as efficiently as in the case with CEX platforms.

Downsides of decentralization

While many crypto enthusiasts believe that DeFi is the future, the ecosystem still has some issues and can be exploited. Evidently, the story of price manipulations using Aave’s flash loans which were uncollateralized is one of the best illustrations of many loopholes that exist in the domain.

Let us talk about many disadvantages of the DeFi domain.

People do not know who they are dealing with

The anonymity and the absence of “Know Your Customer” practices in the industry make it impossible to cancel or revert any transactions. It means that security and protection of your credentials become a critical issue.

The market never has enough funds to go around

Low liquidity is an issue that may significantly affect the price action and cause issues for retail traders using DEX platforms. Sudden volatility, slippages, and tailgating are all consequences of liquidity issues that plague the DeFi industry.

Dependence on the host-chain

Since many DeFi platform run on a layer-one host blockchain network, it inherits all the weaknesses and downsides of the host chain making it hard to build truly unique products that will remain relevant indefinitely.

Potential problems with smart contract design

Flawed smart contracts can have catastrophic consequences for token holders as funds vanish if these contracts have vulnerabilities, exploits, or other weaknesses. Many DeFi platforms made terrible mistakes in the past.

The lack of interoperability hinders the progress

Differences between architectures create the problem of reduced interoperability preventing users from using their tokens when they want to engage with other products and services within the same domain.

The low liquidity is the biggest challenge for retail traders and investors who want to explore the world of crypto. Due to frequent slippages and incorrect price listings (market makers impact the market faster than it can react thanks to very low liquidity), many decentralized exchanges have to address the problem and offer their solutions.

The most common answer to the issue is to offer “slippage tolerance” feature to users which is, in essence, the lowest price you will accept for your asset after the order is executed. It is a form of protection from market manipulations which are inevitable when there is such liquidity deficit.

The main takeaway

Decentralization is a good thing for many financial services and platforms, but it should be done correctly and with enough accountability on the part of developers and prominent users. While full anonymity seems like a great idea, without any KYC processes, these platforms will never gain the necessary level of popularity!


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