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DeFi 101: Your Guide to the Future of Finance

DeFi 101: Your Guide to the Future of Finance

Scott Kasten
October 23, 2024

Today we are journeying into a portion of the decentralized web that is more established than most of what we have already explored. Welcome to the world of DeFi, or as it's officially called, Decentralized Finance. If you've heard the term but aren’t sure what it really means (or haven’t heard anything at all), don’t worry—you're not alone. In this edition of Hashed Out, we’re diving into the basics of DeFi, explaining how it works, why it's exciting, and how it could change the way you interact with money.

What is DeFi, Anyway?

At its core, DeFi is about taking the traditional financial services we use every day—like borrowing, lending, trading, and investing—and running them on blockchain technology instead of through banks or other centralized institutions. Imagine if you could use financial services like getting a loan or earning interest on your savings, but without needing a bank to act as the middleman. That’s DeFi in a nutshell. Say what? Financial services without traditional banks?

Yep! Instead of a bank or brokerage holding onto your money, DeFi platforms let you keep full control. Everything is handled by smart contracts—self-executing programs that automatically enforce the rules of an agreement, without needing a human to get involved.

A Quick History Lesson

DeFi is built on blockchain technology, particularly Ethereum, which introduced the idea of smart contracts. These are the real superheroes of DeFi, allowing for secure, automatic transactions without any intermediaries.

Bitcoin paved the way for decentralized value transfer (i.e., money), but Ethereum expanded the idea by enabling more complex financial operations. Starting in 2017, DeFi applications like MakerDAO (which allows people to borrow and lend using crypto as collateral) and Uniswap (a decentralized exchange) took off. Today, DeFi is a rapidly growing ecosystem that’s challenging the very foundation of the traditional financial system.

Image from tokeny.com

Key DeFi Concepts

Let’s break down the key building blocks of DeFi so you can see how it fits into your life:

Smart Contracts: Imagine a vending machine. You put in your money, and the machine automatically gives you a snack—no cashier required. Smart contracts work similarly. They execute an agreement once conditions are met (like sending money when certain criteria are met), without needing a bank or middleman to facilitate the transaction. They're the brains behind all DeFi operations.
Decentralized Exchanges (DEXs): Think of these like eBay, but for cryptocurrencies. On platforms like Uniswap or SushiSwap, you can trade crypto directly with others, without a centralized exchange acting as the go-between.
Lending and Borrowing: In DeFi, you can lend your crypto to others through platforms like Aave or Compound and earn interest, just like a savings account. Or, you can borrow funds using your crypto as collateral without needing to go through a credit check or a bank. It’s like being your own lender, minus the bank drama.
Stablecoins: Cryptocurrencies like Bitcoin or Ethereum are notoriously volatile—one day you’re up, the next you’re down 20%. Stablecoins solve this by pegging their value to stable assets like the US Dollar. Think of them as the DeFi version of digital cash, stable enough to use for everyday transactions.

Ultimately, what DeFi applications do is to allow you to take on various roles (like lending out your savings) that banks currently do as a middleman and greatly increase your return on investment.

DeFi vs Traditional Finance: What's the Difference?

As I just said, DeFi removes the middlemen, while traditional finance (TradFi) is all about them. Banks, brokers, and financial institutions hold your money and charge you for managing it. In DeFi, you control your assets directly, and smart contracts do the heavy lifting.

Here’s a comparison:

Traditional Finance: You want to earn interest, so you deposit money in a savings account. The bank takes your money, lends it out, and gives you a fraction of the interest they earn (while keeping most of it for themselves). “Woohoo! I made 1% this year!”
DeFi: You deposit crypto into a platform like Compound or Aave. Someone else borrows it, and you automatically earn the interest directly—no bank required, and you get a much higher percentage of the rewards. I have seen low risk returns on Coinbase between 4% to 12%.

How DeFi Fits into Web3

DeFi is one of the biggest drivers behind the Web3 movement, which is all about decentralization and putting power back in the hands of users. Instead of relying on big tech companies or banks, Web3 aims to create a more open, user-owned internet. DeFi is the financial arm of this revolution—offering financial tools that anyone with an internet connection can access.

Think about it: with DeFi, you don’t need to live near a bank, have a perfect credit score, or meet a bunch of requirements to participate. As long as you have some crypto and a digital wallet, you’re in. This potentially opens the world of finance to many who would otherwise be shut out.

Benefits and Drawbacks of DeFi

Benefits:

Accessibility: No bank account? No problem! DeFi allows anyone with internet access to participate in global finance.
Transparency: DeFi protocols are open-source, meaning anyone can audit them. This level of transparency is unheard of in traditional finance.
Higher Rewards: Because DeFi cuts out the middleman, you can often earn higher returns on your savings or investments compared to traditional financial products.

Drawbacks:

Volatility: Crypto is volatile, and while DeFi products like stablecoins reduce that risk, it’s still something to watch out for.
Security: Hacks and bugs in smart contracts can lead to big losses. You’re responsible for your own security, which can be a learning curve.
Regulatory Uncertainty: Governments are still figuring out how to regulate DeFi, so the legal landscape is evolving.

Real-Life Example: Yield Farming

One popular DeFi activity is yield farming, where users lock up their assets in DeFi protocols in exchange for rewards (usually more tokens). Think of it like growing crops—except instead of vegetables, you’re farming tokens. While it can be profitable, it’s also risky due to the volatility of crypto prices. This will be covered more in depth in a future edition of the newsletter, but it is another way DeFi offers flexible financial options and greater potential returns than that of a bank.

The Future of DeFi

What’s next for DeFi? As it continues to evolve, DeFi could become a key part of the financial system, especially in underserved regions where traditional banking is limited. While it’s not without its risks, DeFi’s potential to reshape finance by making it more accessible and efficient is enormous.

Imagine a world where you don’t need to trust a bank to hold your savings, a credit score to get a loan, or a broker to trade your assets. In this world, you are your own bank, lender, and investor. That’s the promise of DeFi. As more people migrate into DeFi the increased demand will fuel greater innovation that will offer even more options for every risk tolerance and financial objective.

DeFi is the future of finance and the most evolved of the components under the web3 umbrella. Start small and experiment in DeFi and scale as you choose, you just might find you are ready to leave traditional banking in the past

That’s it for DeFi 101! Hopefully, this has helped you get a better understanding of decentralized finance and how it’s shaping the future. Now that you’ve got the basics down, we’ll dive deeper into specific DeFi platforms and strategies in future editions.

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