DeFi is an abbreviation of the phrase Decentralized Finance, and it encompasses all financial tools and applications built on decentralized cryptocurrency networks. It includes decentralized exchanges, lending and borrowing protocols, liquidity protocols, staking, NFT marketplaces, prediction markets, and many other finance tools built on the Ethereum blockchain and other EVM networks.
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What can I do with DeFi?
While there are a multitude of DeFi protocols and combinations (in fact, they are sometimes called ‘DeFi legos’ because of their endless combinability), the main uses of DeFi can be summarized in several categories: trading, staking, lending, and borrowing.
Decentralized exchanges allow users to swap crypto and trade real world assets (RWAs) like stablecoins and tokenized stocks. Onchain markets have developed to encompass all the capabilities of traditional equity markets with the additional benefits of expanded geographic access, 24/7 trading, self custody of assets, and the ability to use crypto and RWAs in other DeFi instruments.
Staking is one of the easiest and most low-risk ways of earning yield on crypto, and it's essential for keeping the Ethereum ecosystem secure and decentralized. Read our articles 'Understanding Staking' and 'Staking on Ethereum with MEW' to learn more about the benefits of staking ETH.
Crypto lending, whether by putting it into a savings-account-like smart contract or into a pool to provide liquidity, allows users to earn interest on crypto, with the returns often exceeding those provided by traditional finance instruments. Some protocols also give additional rewards in the form of the protocol’s governance tokens. These tokens let users vote on proposals about changes to the DeFi protocol, investors have some control over the project’s direction.
When users borrow crypto, they can take advantage of immediate loans without the need for approval from any third parties – BUT, most of the time, collateral is required. This means a user would deposit some ETH, for example, and take out a loan of in US-dollar denominated stablecoins. In the best case scenario, the value of the collateral grows while the user takes advantage of the loan. On the other hand, if market volatility leads to a drop in the collateral’s price, this collateral could be liquidated.
An advanced user might leverage the borrowing and lending capabilities to combine DeFi legos, taking out loans on one platform to provide liquidity on another, earning governance tokens on multiple platforms, and maximizing returns. However, this strategy should only be used by experts who are able to navigate the complexities of the market and have a high risk tolerance.
To summarize, let’s look at the main benefits and risks of DeFi:
DeFi Benefits
Near-instant execution without reliance on third parties
Virtually no geographic limitations
Full control over your funds and information
Unlimited combinability of protocols
Returns on investment that may be unavailable in traditional finance
DeFi Risks
Market volatility can devalue your collateral, raising the risk of liquidation and making it more difficult to repay a loan
Because of volatility and interest accrual over time, it’s essential to monitor loans and positions closely to avoid liquidation
Crypto has many scams and projects that haven’t had their code properly audited; it's essential to evaluate whether a protocol is trustworthy before depositing assets
Full control over funds also means full responsibility for their security - you alone are responsible for your wallet keys or secret recovery phrase
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