A Guide To Understanding DeFi

‘DeFi’ stands for Decentralized Finance, and that’s exactly what it is. DeFi removes a centralized system, third party, or middleman when it comes to interacting with and growing your finances. The Ethereum DeFi ecosystem is ruled by smart contracts that execute commands automatically through immutable and community-audited code. To facilitate interaction with these contracts, DeFi platforms create decentralized applications, called DApps, that serve as front-end interfaces. Some DeFi projects employ governance models, putting power back in the hands of the global communities that use them.

The main benefit of using a decentralized financial system lies in having full control over your assets and information. In centralized systems, all assets and data are gathered under the control of a single governance body, such that the user is completely at the will of the governing party, unable to make any decisions about their money unless they follow strict rules and guidelines (which can also change at a moment’s notice).

In DeFi systems, not only do all assets and information remain in the hands of the user, but the decisions about the project are often put in the hands of the community in the form of a vote-based system.

The Rewards of DeFi:

A trustless exchange of assets
Global reach, with little geographic limitation
Your information remains yours and no one else’s
Near-instant execution with low service fees
Immutable code to ensure the process stays secure
Voting-based systems to put the power in the hands of the community
Also referred to as ‘Lego’ finance: users can stack and combine multiple DeFi protocols together for added benefit

The Risks/Downsides:

Too many new projects with unverified safety and low barrier to entry
Reliance on code that may not be audited or stable
Expensive gas fees in times of high volume
Value relies on volatile crypto markets
User is fully responsible for their security and needs to know what they’re doing
Many instances of phishing, fake companies, and FOMO-induced mistakes

The use of DeFi on Ethereum ranges across dozens of projects and platforms, and the space changes very quickly. Here, we’ll focus on six DeFi applications that are the basic and most popular building blocks of the DeFi Legos.

Decentralized Exchanges (DEX)
Lending and Borrowing
Derivatives
Stablecoins
Prediction Markets
Yield Farming (Liquidity Mining)

1. Decentralized Exchanges (DEXs)

DEXs are exchanges that rely on blockchain technology like Ethereum smart contracts, to set up and automatically execute swaps between coins and tokens. DEXs make it possible for users to exchange their assets with near-instant execution without the need for any KYC, back-end accounts, emails, or other identification. If you pair a DEX with a client-side wallet interface like MEW, neither the exchange nor the wallet is collecting any of your information or taking custody of your assets – you retain privacy and full control.

Since DEXs rely on smart contracts, they are prone to the pitfalls of this technology, such as faulty code. It’s important to do your research and make sure the DEX you want to use had its code audited thoroughly. Auditing ensures the smart contracts have been tested for bugs and errors. Once you know the smart contract is stable, you can always trust it to perform the tasks it’s set out to achieve, since blockchain code is immutable and permanent.

Another detriment of relying on code is that smart contracts can’t tell you when the market is shifting or gas fees are high. It receives an input and executes an output, no matter what. In cases of extreme market volatility, your swaps can come back less than what you expected. This slippage is generally insignificant, but it’s good to be aware that it can happen.

Many exchanges offer varying rates and discounts, some require accounts, some haven’t been audited thoroughly, and others are just plain difficult to navigate. That’s why MEW has integrated the best options available, including the DEX.AG aggregator and Changelly, to offer a wide variety of safe DeFi swaps and competitive rates right from our interface. DEX.AG brings together many different decentralized exchanges, like Uniswap and Kyber Network, to display and compare the best rates for your swaps.

2. DeFi Loans (aka Lending)

DeFi loans are a lot like traditional loans, but again, without a centralized entity or third party hovering over the process. Loans are a bit of a complicated thing to decentralize, because their very nature implies the need for a debt to a governing party. That’s why smart contracts are so necessary for this process, because their very nature is governance and the execution of code without the need for a centralized party.

DApps like MakerDAO and Aave have developed methods to offer a crypto loan that is backed by user-submitted collateral, meaning that you can offer up some coins or tokens and borrow others in exchange. You can earn interest on your deposited collateral as well, depending on the asset you choose to deposit. There are plenty of projects out there offering lending/borrowing services, so it’s important to look into their smart contract code audits and policies before jumping in. MEW has integrated two of the most trusted DeFi lending services, MakerDAO and Aave, as DApps on the MEW web interface. To learn more about the risks and rewards for these DApps, check out the Aave guide or MakerDAO guide.

The main risks of using a DeFi lending service are related to your deposited collateral. The more you deposit as collateral, the more you can borrow, but if you borrow too much, your collateral can be liquidated to make up for it. It’s always smart to deposit generously and borrow cautiously. Remember, you have to pay back all your borrowed assets before you can withdraw your collateral.

3. Derivatives (Synthetic Assets)

Derivatives are a form of more advanced investing. For the sake of simplicity, you can think of derivatives as a smart contract that manages a value derived from the worth of underlying assets. If that sounds confusing, think of it with this real-life example:

Let’s say Claudia owns a horse ranch and is worried about the value of apples in the long-term for horse treats. She enters a futures contract where she will have to buy apples on a predetermined future date at a fixed rate of $3 per apple. No matter what happens in the future, she can buy her apples for $3. This can be good or bad, depending on how the market turns, but even if it drops to $1 or rises to $5, she knows with good faith she can buy her apples for $3.

In the same way, blockchain technology can encode decentralized futures contracts to set value prices of cryptos, which can then be bought or sold at rates higher or lower than the current market. Derivatives can offer massive rewards, but they are also riddled with risks and completely dependent on changes in the market. It’s always a good idea to start small and work your way up.

4. Stablecoins

Stablecoins are assets that are similar to derivatives in a lot of ways, however they are pegged to and backed by real-world asset values. A stablecoin is typically tied to the USD value of $1, however there are many different stablecoins out there – even some that are tied to precious metals like gold and silver.

Stablecoins make it possible for users to deal with the extreme volatility of crypto markets, while having the peace of mind that their specific token’s value will not move from the value of $1, or whatever it’s tied to. This makes it safer to take out loans or pay people for their services, and easier to keep track of your own investments. DApps like MakerDAO and Aave offer loans of many different stablecoins. However, it’s important to note that not all stablecoins are made equal. Be sure to check out our Stablecoins guide to learn more.

5. Prediction markets

These are platforms that allow you to bid on the outcome of a specific event, such as an election or sporting event. You place your bid and lock it in, then get paid out depending on the outcome. Decentralization works especially well in these markets, because it takes away any bad-acting or fraud when it comes to payout. The entire system is run by smart-contracts written in permanent and generally open-source code, so you can trust your bid and payout to be exactly what you expect. You just have to make sure you can trust the platform itself.

6. Yield farming (Liquidity mining)

Yield farming is a more intermediate/advanced DeFi technique that has been gaining momentum. It involves staking your crypto through various DApps to gain rewards, maximize your profits, and earn extra crypto. Yield farming has risen in popularity in recent months and has even caused the creation of tokens specifically for the purpose, including YAM and SUSHI. These new tokens carry extreme risk and are generally only rewarding for a select few who manage to time it perfectly, often by accident. Most of the time, you end up getting burned when your $500 token plummets to under $1 in a matter of minutes.

The DeFi space is very new and highly risky, so both the rewards and the losses can be considerable. With so many DeFi options out there, it’s easy to become overwhelmed and buy into DApps that aren’t the most reputable or secure. When you use DApps on MEW, you can rest assured that the code has been audited, the community thinks well of the DApp, and the rewards are real. Just remember that you are the one in charge of your gains and losses – and we’ll do our best to help you access the best decentralized finance solutions for your goals!

What is DeFi? Lend, Borrow, and Put Your Crypto to Work