How DeFi Works

The world of cryptocurrency investing involves far more than just buying an amount of a coin or token and waiting for its value to rise in the market. While the same represents the basic start in crypto investing, the digital coin and token world involve a lot more. Decentralized finance, or DeFi, provides an advanced approach to crypto gains, including how to leverage profit off the activity of many others every day with exchanges and liquidity support.

What Exactly is DeFi?

DeFi is a term used to categorize smart contract protocols that replace traditional financial institutions in a decentralized manner. The tools primarily focus on advanced financial needs including liquidity pool support, lending and borrowing, staking, and trade exchange support. Users don’t need pre-approval or identity requirements; instead, use is confirmed with a web3 wallet and the approval of the user to execute the tool’s actions.

Operational Architecture Based on Smart Contracts

Every DeFi project uses what is known as a smart contract to operate and provide its benefits for users. These are automated programs that are executed by the user to initiate specific, predetermined actions. Users see these actions as transactions and the movement of crypto for different purposes. However, on the blockchain, the tool executes the given contract with a series of code exchanges that execute scripts. The compliance of the script’s actions is then confirmed by the given blockchain validation processes that check the execution is correct and enforced as expected. The best DeFi projects to work with have completed an audit with third-party validation.

The Key Advantages of DeFi

First, DeFi protocols operate without central control. That allows them to exchange and move assets without any censorship. They can trade and exchange crypto as needed without additional control beyond having a sufficient balance to do so and available coins or tokens. Algorithms and software manage the trades and keep transactions tied to real-time market values.

Secondly, DeFi allows users to leverage their crypto for additional financial power through borrowing. Alternatively, users can grow their assets by lending them out to others via DeFi as well. Lenders gain through interest, and borrowers get additional crypto assets they pay back over time.

DeFi also supports stablecoins. These are crypto assets pegged to specific fiat currencies. This is particularly helpful when users need to exchange their crypto into a temporary format that retains their current value until market changes become more favorable to enter into again.

For those looking to make big gains, DeFi yield farming is possible either through staking or liquidity pool support, helping exchanges work better with crypto balance liquidity. Both are rewarded with additional crypto of the same type invested, which can be very lucrative over time.

Risks to be Aware Of

DeFi is not the perfect investment option; many projects have large risks, and some have been hacked despite their security protection. In many instances, the security failure was due to a loophole that a hacker found and took advantage of. In some cases, these hackers end up returning the funds to the DeFi administrators for a reward, mainly to get credit for the hack and to convince the project to improve its code for a more hardened defense. However, some have outright stolen the assets entirely. For the user, the above essentially means assets invested are at risk without a safety net. Understanding this aspect, many only invest what they are willing to lose in DeFi should something bad happen.

The other big problem is blockchain network congestion. When this occurs, transactions don’t go through or, worse, they are extremely expensive to affect. This was a big problem in 2020 and 2021 when Ethereum-based DeFi users had to deal with expensive “gas” fees, charged by miners to process a transaction. While the DeFi tools work fine, the gas fees make actions too expensive for the common user to benefit from without moving sizable values at a time (i.e. over $5,000). Gas fees have dropped significantly since, but they can be a risk again.

Finally, regulation may eventually put the DeFi industry at risk, especially financial activities like borrowing and lending. No one knows yet how that will change, but regulators are clearly paying attention to DeFi along with crypto in general.

DeFi is powerful and useful, but it does take a bit of learning to understand. However, if you put in the time to investigate the industry, it may prove to be a powerful and transformative opportunity.