Getting Started with DeFi: A Complete Guide to Understanding Decentralized Finance from Scratch

Quick Understanding

DeFi is a financial application ecosystem built on blockchain technology. Through smart contracts and peer-to-peer technology, users can access various financial services such as lending, liquidity provision, token exchange, and staking with just a wallet and cryptocurrency assets.

Initially, DeFi projects were primarily deployed on Ethereum, but now DApps can be found on multiple public chains that support smart contracts, including Binance Smart Chain, Solana, Polkadot, and Avalanche. Additionally, Ethereum's second-layer solutions such as Arbitrum and Optimism also host numerous DeFi applications. Smart contracts are the core of DeFi operations—without them, functions like staking, lending, and trading cannot be realized.

The core advantage of DeFi lies in its ability to optimize returns, utilize decentralized markets, and access bank-level services, but it also comes with specific risks. Users must conduct thorough independent research to safely participate in this ecosystem.

Why Pay Attention to DeFi

For investors who already hold cryptocurrency assets, DeFi has opened new doors. In addition to simply holding coins and waiting for appreciation, smart contract applications provide automated earning opportunities.

But the charm of DeFi is not just this—it creates a completely new financial paradigm. Unlike traditional finance, which relies on banks as intermediaries and courts to resolve disputes, DeFi establishes and enforces rules through code, allowing users to always have control over their assets. This decentralized approach eliminates the risk of single points of failure, making it nearly impossible to inspect or shut down services.

More importantly, DeFi provides opportunities for groups that have been excluded from traditional financial systems. In areas with limited financial inclusion, the significantly reduced operational costs of DeFi mean that a broader population can access financial services.

Core Application Areas of DeFi

Innovation in the lending market

Open lending protocols are the most popular applications in the DeFi ecosystem. Compared to traditional bank loans, these services have significant advantages: instant transaction settlement, no credit checks, and allow digital assets to be used as collateral.

By operating on a public blockchain, these platforms minimize trust requirements and provide cryptographic-level verification. The blockchain lending market reduces the risk of third-party intervention, making borrowing and collateralization cheaper, faster, and more accessible.

Reconstruction of Bank Functions ###

DeFi applications are inherently financial in nature, allowing them to perform various functions of traditional banks. For example, issuing stablecoins, providing collateralized loans, and offering insurance services.

The Rise of Stablecoins: As the blockchain industry develops, stablecoins are gaining increasing attention. These types of crypto assets are usually pegged to real assets, making digital transfers easier. Due to the extreme price volatility of cryptocurrencies, decentralized stablecoins can serve as digital currency in everyday transactions, without relying on the issuance and control of any central authority.

Mortgages and Insurance: Smart contracts can significantly reduce the underwriting and legal costs of mortgages. On-chain insurance has the potential to lower insurance premiums while maintaining service quality by eliminating intermediaries and allowing numerous participants to spread the risk.

The Rise of Decentralized Trading

Decentralized exchanges (DEX) like Uniswap and PancakeSwap are among the hottest DeFi applications. They allow users to trade digital assets without trusting any intermediaries, with transactions executed directly between wallets through smart contracts.

Some exchanges adopt an Automated Market Maker (AMM) model, utilizing liquidity pools for trading. These types of exchanges are easier to maintain and manage, resulting in lower fees compared to centralized exchanges.

Blockchain technology can also be used to issue ownership tokens for traditional financial instruments, allowing them to operate in a decentralized manner without the need for custodians and eliminating single points of failure.

Yield Optimization Strategy

DeFi applications can automate and optimize yields from staking, reward pools, and other income-generating products, which is known as yield farming.

For example, you may receive regular rewards by staking BNB or providing liquidity. Smart contracts can automatically invest these rewards into the underlying assets and compound the investment, maximizing your returns. Using smart contracts saves time and optimizes the compounding effect.

Since your funds are typically pooled with those of other users, all users participating in the yield optimization smart contract share the gas fees, further enhancing efficiency.

Smart Contracts: The Engine of DeFi

Most existing and potential DeFi applications rely on the creation and execution of smart contracts.

Standard contracts define conditions using legal terminology, while smart contracts express these conditions in computer code. Since the conditions are written in the code, smart contracts automatically execute and enforce these conditions. This allows many business processes that currently require manual management to be executed reliably and automated, making the processes between trading parties faster and simpler, and reducing risks.

But this also introduces new categories of risk. Since the code may have vulnerabilities and logical errors, the sensitive data locked in smart contracts may face threats.

Major Obstacles in the Development of DeFi

performance and speed

The transaction speed of public chains is often slower than that of centralized systems, which also affects the applications built on them. DeFi developers must consider these limitations and optimize their products accordingly.

Second layer solutions like Arbitrum and Optimism have adapted to this, providing a faster and cheaper trading experience.

User Operation Risks

DeFi shifts responsibility from intermediaries to users. For many, this may be a disadvantage. It is quite difficult to design products that minimize user error risk in applications deployed on immutable blockchains.

insufficient usability

Currently, using DeFi applications still requires extra effort. For these applications to become a key part of the global financial system, they need to provide substantial benefits and incentivize users to abandon traditional systems. Recent improvements in interfaces and educational resources have facilitated this progress.

Ecological Fragmentation

Finding applications suitable for specific tasks is not simple, and selecting the best solution is even harder. Creating applications is not enough; they must also be integrated into a broader DeFi ecosystem.

Categories of Risks in DeFi

counterparty risk

When participating in crypto lending or any form of lending, there is a risk that the borrower may be unable to repay the debt.

Regulatory uncertainty

Determining the legal status of certain services and projects can be complex. If the smart contract you invested in is shut down due to regulatory issues, your funds may be at risk. The actions and recommendations of global regulators affect the development and adoption of DeFi.

Token Risks

Different assets have different risk levels - depending on liquidity, reliability, smart contract security, the project itself, and its team. The DeFi space has many low market cap tokens, which significantly increases the risk of use.

code vulnerability

Security vulnerabilities in the code may compromise the smart contracts in which you invest. Your wallet may also be hacked due to connecting to DApps and granting certain permissions. Protective measures such as multi-signature wallets and insurance funds have emerged to mitigate these risks.

impermanent loss

When staking in a liquidity pool, if the price ratio deviates from the coefficient you initially provided and you choose to withdraw funds, you may lose some tokens from the pool.

Access Guide: How to Participate in DeFi

Understand ecological distribution

DeFi projects were initially primarily on Ethereum, but now other public chains that support smart contracts have also established active DeFi ecosystems. This includes BNB Chain, Solana, Polkadot, Avalanche, and Ethereum's new second-layer solutions.

Exploring DeFi projects and protocols requires a lot of homework. Resources are scattered across various websites, forums, and communities, but it's essential to critically evaluate any recommendations. Always verify the security of any project you read about or hear about from multiple sources.

Essential tools and assets

To participate in DeFi applications, you need to prepare:

Compatible Wallets: Browser extension wallets (like MetaMask) or mobile wallets (like Trust Wallet) work best. Using custodial wallets (where you do not own the private keys) increases the likelihood of the wallet failing to connect to the DApp.

Sufficient Crypto Assets: You may need multiple assets. For example, when using DApps on Ethereum, you need ETH to pay for gas fees, as well as other tokens specific to certain services.

Dialogue Between DeFi and Traditional Financial Systems

DeFi provides an open financial system for anyone with internet access. In contrast, traditional finance has lower accessibility due to its reliance on centralized institutions and regulatory bodies.

However, the interaction between DeFi and traditional finance is becoming increasingly frequent. Banks and financial institutions are beginning to study DeFi protocols and create hybrid models that combine the advantages of both systems.

Trade-offs Between DeFi and Centralized Finance (CeFi)

In the crypto ecosystem, not all financial services are decentralized. For example, when staking on a centralized exchange, users relinquish control of their tokens to the platform. This means that one must trust that the centralized organization will manage your funds properly.

The services offered by decentralized and centralized platforms are often the same, typically utilizing the same DeFi infrastructure that users can access directly. However, CeFi alleviates the complexity of self-managed investments for users. Sometimes, CeFi also provides deposit protection.

There is no absolute superiority between the two modes; the choice depends on your preferences and needs. Choosing CeFi means less control, but it usually provides more reliable protection and reduces the burden of asset management.

DeFi and Open Banking: Concept Clarification

Open banking is a banking system that allows third-party financial service providers to securely access financial data via APIs. It enables connectivity and interoperability of accounts and data between banks and other financial institutions.

Through open banking, new products and services can be created within the traditional financial framework. However, DeFi is a completely new financial system that is entirely independent of existing infrastructure and is sometimes referred to as open finance.

For example, open banking allows managing all traditional financial tools in one application by securely accessing data from multiple banks and institutions. Decentralized finance, on the other hand, is used to manage entirely new financial tools and interactions.

Looking to the Future

DeFi has quickly built an independent ecosystem, attracting capital, developers, and new products. Although DeFi may profoundly change the financial sector, this field is still in its early stages of development.

In the future, DeFi will undergo continuous technological advancements, changes in regulatory environments, and increasingly widespread applications. Continuous innovation is crucial for the healthy growth of DeFi and for overcoming current limitations and risks.