Navigating Crypto as a Beginner #2: Simplifying DeFi
A series of 5-minute flashletters outlining the basics of getting started with blockchain and cryptocurrency.
The aim of this series is to offer some guidance on what not to do as you start out in the crypto space so to help break down some of the barriers to entry to Web3.
Kicking off the first of our ‘simplify’ posts, we have Decentralized Finance - widely referred to as DeFi. I believe this is a good place to start as it is arguably one of the main motivations for the creation of Bitcoin and many other cryptocurrencies, but also one which people most struggle to understand.
Topics we’ll cover:
Centralized finance
What is DeFi
How to use DeFi
Further reading and wrap up
Even though crypto has only really been mainstream for around 14 years - since the inception of Bitcoin in 2008 - it has a deep and fascinating history of trials and tribulations. For the sake of length and scope, I will refrain from going too much in depth about the background or people involved in the projects I touch on. But because there are countless excellent resources dedicated to its history, I will make sure to provide resources for further reading below.
Centralized finance
To fully understand the applications of DeFi, it’s important to be able to distinguish the difference between centralized finance (the current system) and decentralized finance.
Centralization: An organization or system which is controlled by one or few select individuals or governing bodies. In the context of technology, centralization refers to a system where data and operations are controlled by a single entity or organization and is the opposite of decentralized systems.
Traditional finance (TradFi) is a closed and private centralized system of banks, institutions, payment processors and third party intermediaries, which are managed and governed by only a small number of stakeholders. These stakeholders are responsible for overseeing how trillions of dollars of wealth is stored and navigates throughout the financial system safely and frictionlessly.
Due to its centralized nature, these institutions are able to service the financial needs of society efficiently. Whether it be by storing wealth as a custodian, financing loans as a lender or securely processing payments between parties, the system works well for the majority of the developed world.
The main problem with this is that the interests of TradFi stakeholders need to remain aligned with that of wider society and there is a certain level of trust required;
You trust that you will always have access to the money in your bank account
You trust that your bank will process the payments for goods and services you purchase
You trust that your bank is responsible and will manage risk effectively
You trust that your bank adheres to regulations and laws in their local jurisdictions
Regardless of how interwoven the financial system may be with governance and the global economy it is not too big to fail. With any kind of system, if there is any element of trust needed, it means there is always a risk that it can be compromised due to self-interested bad actors, those with ill intent or just through negligence.
Up until now, we have had no other choice but to believe the system will continue working, but as many of us have experienced it shows its weaknesses and cracks a little too often for comfort.
This is where DeFi comes in.
What is DeFi?
DeFi is an independent and trustless financial system, distinguished from its older, centralized counterpart in several key ways.
Decentralization: The distribution of power or control among multiple individuals or entities, rather than being concentrated in a single central authority. It is often used to describe systems or networks that operate on a peer-to-peer basis, where each participant has an equal role in decision-making and governance.
One of the main distinctions is that DeFi is built on top of blockchain technology, which at its core, is an immutable and censor-proof digital ledger. This means that once a transaction is recorded on the blockchain, it cannot be altered or deleted, and it is resistant to attempts at censorship. Additionally, DeFi is permissionless and non-discriminatory, meaning that anyone and everyone can use it without the need for approval or permission.
The core component of how this is achieved is though so-called ‘smart contracts’, which are self-executing contracts with conditions and terms of the agreement written directly into code. Because of this DeFi does not require third-party intermediaries to process transactions. Instead, coins and tokens can be programmed to power individual protocols, networks, and ecosystems. This allows for greater efficiency and cost-effectiveness, as well as increased security as there is no single point of failure.
A common occurrence in the world of crypto is that code is usually open-source, allowing anyone to build with, test on, and scrutinize for weaknesses. This openness and transparency extends to the transactions themselves, which are visible on blockchain explorers for anyone to see. This allows for greater trust and accountability in the system, as all network participants can see what is happening. This is in stark contrast to the traditional banking industry which is strictly closed and private.
In terms of governance, rather than being controlled by a select few decision-makers, DeFi applications can be governed by all network participants. This creates a more democratic system, where users have more control over the direction and development of the platform.
Some real-world problems that could be solved through the introduction of DeFi:
Restrictions on how much money you spend or withdraw from an ATM
Currency debasement through significant money printing and poor fiscal policy
High costs of transferring wealth between borders
Loss of wealth or possessions by being displaced due to geopolitical strife or war
Inability to take out loans or mortgages due to poor credit or lack of access to a reliable banking system
If you’re reading this in the comfort of a developed democratic country with easy access to financial instruments, the internet and single digit inflation, its likely that many of the above may seem unrelatable, but these are significant issues in certain developing regions around the world.
As one of the first countries to roll out a central bank digital currency (CBDC), Nigeria is itching to see good adoption of its eNaira, but since its inception in October 2021 its said that less than 1% of the country are actively using the new currency. As a way to motivate more people to switch, a controversial, and arguably oppressive approach has been taken to limit cash withdrawals from ATMs to the equivalent of $45 per day or $225 per week. Tactics like this have had the adverse effect intended as Nigerians have consistently ranked one of the highest countries for crypto adoption, Chainalysis recently placed Nigeria 11th on their global adoption index. It’s likely that people are choosing to opt for a less restrictive financial system in DeFi.
One of the impactful problems, and more widespread, is the need to transfer wealth and money across borders. This refers to the millions of citizens around the world working abroad, who are required to send remittance payments back to the country they call home. This not only has a huge impact on the individuals who forgo a high percentage of these payments due to huge processing fees, but also on a larger scale, the recipient countries and their overall GDP are impacted by this over time. It’s not speculation that a lot of people who depend on these remittance processors are from poorer developing countries.
Financial intermediaries and remittance processors take a huge cut for their role in moving payments between borders, and they take their sweet time doing so. Cryptocurrency is practically instant, borderless and has no requirement for third-party interference to move wealth safely from one account to another.
Here is an absolutely mind-blowing graph which shows how important remittances are to these countries:
If you’re not already aware, I’d recommend checking out how El Salvador adopted Bitcoin as legal tender and how its leveraging this to spearhead financial independence. One of the main drivers for this push from President Bukele was indeed due to their reliance on oversee remittances.
These are just a couple of high level examples on some of the issues faced. It’s possible that if DeFi is introduced in the right way in these regions and others, it could be revolutionary.
How do I use DeFi?
Now that you know a little bit more about the technical nature and the reasons behind it’s inception, to understand the applications of DeFi more wholly I’d recommend spending some time using it.
Contrary to the idea that a lot of cryptocurrencies have no intrinsic value or use case, there are now hundreds of different DeFi applications and protocols which anyone with an internet connection can use. Some of the most common types are;
Decentralized Exchanges (DEXs): Platforms that allow for the trading or swapping of cryptocurrencies and other digital assets.
Lending and Borrowing platforms: Permissionless platforms to lend and borrow digital assets, without the requirement for a credit social credit score.
Yield Farming: Also known as liquidity mining, is the process of providing liquidity to a (DeFi) protocol in exchange for a return on your stake, similar to putting your money into a bank and returning interest over time.
Governance: Although not strictly unique to DeFi, Decentralized autonomous organizations (DAOs) are forms of decentralized governance that allows the community to make decisions about protocols or projects.
To begin using some of the different applications, you first need to obtain some cryptocurrency. However, before you even begin to think about doing this, I’d recommend reading my guide on ‘What not to do’ when you’re getting started with crypto so you can understand how to avoid some early mistakes and pitfalls:
At this point I am obligated to remind you that you should be hyper careful with any investments you make, always revert to consulting with a trusted financial advisor before making any investment decisions. Crypto is volatile and risky, so always proceed with vigilance and caution. I am not a registered financial advisor, just someone who is passionate about the space and looking to help people avoid some easy mistakes.
For those of you who are keen to give it a bash, you only need a very small amount of money to deposit to play around with your selected applications. This is because over time you’ll become a lot more confident with the different procedures, in the meantime you don’t need to risk losing any money. This also means you can then learn to understand whether you want to pursue using crypto further, there’s always the possibility that you don’t feel comfortable doing so and that’s fine. It’s not for everybody after all.
Some of the main steps for getting started:
Get a Wallet: First, you'll need a digital wallet that supports the cryptocurrency you want to use for DeFi. Some of the most well known are; MetaMask, Trust Wallet, and Coinbase Wallet. These can ordinarily be accessed via browser extensions.
Choose an exchange: There are many ways to purchase crypto and a lot of the time you can purchase different coins and tokens from digital wallets directly, but one thing to be mindful of early on is how fees stack up and can become costly over time.
Choose a DeFi Service: Each service will have its own set of rules and features, so be sure to read the details and you know the ins and outs of the protocol before making a decision - you cannot do enough research on this, and I’d recommend sticking with the more well known names in the space. Uniswap, Compound and Aave are some of the largest on the Ethereum network.
Deposit Funds: Once you’ve chosen an application, you’ll need to deposit the funds you bought from the exchange into the platform. Make sure you copy the correct address and you're depositing the correct cryptocurrency network, as some platforms only support specific coins or tokens. Some examples are Ethereum, Solana and Cardano, all of which have coins native to their ecosystems.
Connect Wallet to the Platform: Once you feel confident that you’ve chosen a good and safe platform to use, you can use your digital wallet to connect and interact with the protocols and smart contracts.
Withdraw Funds: When you're ready to exit the service, you can withdraw your funds and any interest or profit you've earned. Keep in mind that you may need to close a loan or unwrap your cryptocurrency before withdrawing.
Summarizing the areas to research:
Wallets: The differences between hot and cold wallets and how to keep your crypto safe
Exchanges: Which have a good selection of cryptocurrencies you want to purchase, what are the costs and fees and understanding whether your bank will allow you to deposit to the exchange
Networks: Understand the different native coins and tokens of the protocols you want to use
Known risks: As with all crypto activities, it's important to be aware of the risks involved, such as potential losses from market volatility, hacking or phishing attempts, and smart contract bugs. Crypto is still evolving as a technology and there are still areas which can be compromised by those with ill intent.
Wrapping up
I hope this was useful to walk through and you learned something from some of the steps to getting started with DeFi. My comments are always open below for any feedback or even if you have further questions on any of the things covered you can add me on Twitter and DM me (provided you don’t look suss).
Let me know if there’s anything which doesn’t make sense, I’m keen to learn how to present this kind of information in the simplest way.
To understand more about the fundamental value proposition of decentralized finance I’d recommend reading or listening to The Bitcoin Standard by Saifedean Ammous, it’s considered the bible to many for how it outlines the fundamental value proposition of Bitcoin. A must if you have a desire to understand the technology properly.
Coming next
Next in the ‘simplify’ series will be NFT’s, an area of web3 which I’m passionate about and can’t wait to share with you.
Thank you for reading, see you in the next one!
f.
Resources used for reference:
https://bitcoinwhitepaper.co/
https://bitcoinmagazine.com/legal/nigeria-pushes-cbdc-usage-atm-limits
https://medium.com/@bemnetmerete/what-is-blockchain-technology-and-how-does-it-work-55f2548c16b5
https://ethereum.org/en/developers/docs/smart-contracts/
https://cointelegraph.com/magazine/wtf-happened-in-1971/
https://blog.chainalysis.com/reports/2022-global-crypto-adoption-index/
https://www.visualcapitalist.com/cp/remittance-flows-gdp-impact-by-country/