2021 Decentralized Finance 101

What’s DeFi?

DeFi is a collective term for financial products and services that are accessible to anyone who can use Ethereum – anyone with an internet connection. With DeFi, the markets are always open and there are no centralized authorities who can block payments or deny you access to anything. Services that were previously slow and at risk of human error are automatic and safer now that they’re handled by code that anyone can inspect and scrutinize.

There’s a booming crypto economy out there, where you can lend, borrow, long/short, earn interest, and more. Crypto-savvy Argentinians have used DeFi to escape crippling inflation. Companies have started streaming their employees their wages in real time. Some folks have even taken out and paid off loans worth millions of dollars without the need for any personal identification.

DeFi vs traditional finance

One of the best ways to see the potential of DeFi is to understand the problems that exist today.

  • Some people aren’t granted access to set up a bank account or use financial services.
  • Lack of access to financial services can prevent people from being employable.
  • Financial services can block you from getting paid.
  • A hidden charge of financial services is your personal data.
  • Governments and centralized institutions can close down markets at will.
  • Trading hours often limited to business hours of specific time zone.
  • Money transfers can take days due to internal human processes.
  • There’s a premium to financial services because intermediary institutions need their cut.

A comparison

DeFiTraditional finance
You hold your money.Your money is held by companies.
You control where your money goes and how it’s spent.You have to trust companies not to mismanage your money, like lend to risky borrowers.
Transfers of funds happen in minutes.Payments can take days due to manual processes.
Transaction activity is pseudonymous.Financial activity is tightly coupled with your identity.
DeFi is open to anyone.You must apply to use financial services.
The markets are always open.Markets close because employees need breaks.
It’s built on transparency – anyone can look at a product’s data and inspect how the system works.Financial institutions are closed books: you can’t ask to see their loan history, a record of their managed assets, and so on.

It started with Bitcoin…

Bitcoin in many ways was the first DeFi application. Bitcoin lets you really own and control value and send it anywhere around the world. It does this by providing a way for a large number of people, who don’t trust each other, to agree on a ledger of accounts without the need for a trusted intermediary. Bitcoin is open to anyone and no one has the authority to change its rules. Bitcoin’s rules, like its scarcity and its openness, are written into the technology. It’s not like traditional finance where governments can print money devalue your savings and companies can shut down markets.

Ethereum builds on this. Like Bitcoin, the rules can’t change on you and everyone has access. But it also makes this digital money programmable, using smart contracts, so you can go beyond storing and sending value.

Programmable money

This sounds odd… “why would I want to program my money”? However, this is more just a default feature of tokens on Ethereum. Anyone can program logic into payments. So you can get the control and security of Bitcoin mixed with the services provided by financial institutions. This lets you do things with cryptocurrencies that you can’t do with Bitcoin like lending and borrowing, scheduling payments, investing in index funds and more.

What can you do with DeFi?

There’s a decentralized alternative to most financial services. But Ethereum also creates opportunities for creating financial products that are completely new. This is an ever-growing list.

How does DeFi work?

DeFi uses cryptocurrencies and smart contracts to provide services that don’t need intermediaries. In today’s financial world, financial institutions act as guarantors of transactions. This gives these institutions immense power because your money flows through them. Plus billions of people around the world can’t even access a bank account.

In DeFi, a smart contract replaces the financial institution in the transaction. A smart contract is a type of Ethereum account that can hold funds and can send/refund them based on certain conditions. No one can alter that smart contract when it’s live – it will always run as programmed.

A contract that’s designed to hand out an allowance or pocket money could be programmed to send money from Account A to Account B every Friday. And it will only ever do that as long as Account A has the required funds. No one can change the contract and add Account C as a recipient to steal funds.

Contracts are also public for anyone to inspect and audit. This means bad contracts will often come under community scrutiny pretty quickly.

This does mean there’s currently a need to trust the more technical members of the Ethereum community who can read code. The open-source based community helps keep developers in check, but this need will diminish over time as smart contracts become easier to read and other ways to prove trustworthiness of code are developed.

Ethereum and DeFi

Ethereum is the perfect foundation for DeFi for a number of reasons:

  1. No one owns Ethereum or the smart contracts that live on it – this gives everyone an opportunity to use DeFi. This also means no one can change the rules on you.
  • DeFi products all speak the same language behind the scenes: Ethereum. This means many of the products work together seamlessly. You can lend tokens on one platform and exchange the interest-bearing token in a different market on an entirely different application. This is like being able to cash loyalty points in at your bank.
  • Tokens and cryptocurrency are built into Ethereum, a shared ledger – keeping track of transactions and ownership is kinda Ethereum’s thing.
  • Ethereum allows complete financial freedom – most products will never take custody of your funds, leaving you in control.

You can think of DeFi in layers:

  1. The blockchain – Ethereum contains the transaction history and state of accounts.
  • The assets – ETH and the other tokens (currencies).
  • The protocols – smart contracts that provide the functionality, for example a service that allows for decentralized lending of assets.
  • The applications – the products we use to manage and access the protocols.

Closing remarks

My recommendation for my followers when it comes to investing is to start A Robinhood account (or use another platform if you aren’t into Robinhood. I prefer it because it is easy to use, I love the mobile app – which allows me to buy and sell quickly. From there, make sure to fund your account with some money so that after you do your research you can purchase your first investment. The key here is to make sure you do your own research on potential investments and their industries or markets that you are interested in. If you enjoyed this post, then please hit the like button and subscribed to my page so you can be notified when my newest investing posts are published.

Thanks for stopping by,

Cole 

Disclaimer:  I do not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.

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