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DeFi: what it is, the main services, and how to make money from it

DeFi: what it is, the main services, and how to make money from it

Although the DeFi sector is quite new, it has already succeeded in competing with the outdated and sluggish banking system. The list of new services already makes it possible to shift from banks that use fiat money for loans and deposits towards cryptocurrencies. Given the rising rate of inflation with each passing year and the devaluation of monetary units in most countries of the world, the number of DeFi's supporters is only increasing.

What is DeFi

Decentralized finance (DeFi) is replacing traditional banking and the financial sector, offering an alternative to fiat money in the form of cryptocurrencies. Basically, the DeFi sector provides the same banking services, but more efficiently: smart contracts reduce the risk of fraud, low fees help generate higher profits, and affordability makes the services available to all Internet users, bypassing legal restrictions.  However, we should note that all services are paid only in digital coins, which you still need to withdraw in the real world.

DeFi services:

Liquidity provider

Anyone who wants to generate passive income can become a liquidity provider by contributing free funds to liquidity pools. The liquidity pools can be compared to a typical currency exchanger, which is a place where some cryptocurrencies are exchanged for other cryptocurrencies. However, they differ as well: in case of lack of currency, banks deliver the lacking money directly, while replenishment of liquidity pools is done through individuals, i. e., the very providers. In return for providing their funds, each provider receives LP-tokens (which can be changed back to own funds at any time) and a small percentage of each pool trading operation (or a fixed payment for each week, month, or year). Some pools offer different bonuses to attract funds, such as higher percentages when depositing large amounts, mini lotteries among participants, granting extra privileges, etc. 

Yield farming

This method is directly related to the previous one. Once you become a liquidity provider and get LP-tokens, you can use them for farming, another type of passive income generation. The point is that the owners of the liquidity pool cannot predict when exactly you will want your funds back. This creates a constant risk of fund shortages. In order to solve that, they offer you to freeze the received tokens for a certain period of time, like for 3, 6, 12, or more months. In return, you receive an annual percentage of the token's value. By analogy, farming is a long-term bank deposit with a high interest rate.

Staking

Staking can bring the highest interest income, with rates that can reach fantastic amounts, of up to 200%-600% per annum or even more. In contrast to liquidity pools and yield farming, where digital coins ensure the performance and security of a particular project, the staking of coins helps ensure the security of the entire network of a particular blockchain. The logic is simple: cryptocurrencies are bought with real money and operate on a specific blockchain network. If the owners of a particular cryptocurrency decide to sell all of their savings, the value of the coins will instantly collapse, which will lead to an even greater outflow of real money from the blockchain, causing bankruptcy. To avoid this, blockchains offer owners to "freeze" their coins inside the network, which means they cannot be used. But stakeholders are rewarded for ensuring security whenever new coins are issued on the network. Moreover, they also get a chance to participate in blockchain development as the ‘frozen’ coins give you a vote on polls for changes in the operating rules. The more coins you have, the more powerful your vote is in polls. 

Stack drops are an additional source of profit. It is an additional free distribution of digital coins among all stakeholders.

Lending

In addition to passive income, DeFi also offers a lending service. Once you pledge your cryptocurrency, you can get a loan. The advantage of getting a loan is that there are no checks, no need for a guarantor or a good credit rating. A major advantage is the absence of borders, which means that you can get a loan in any part of the world where there is an Internet connection. Such lending is highly demanded by residents of countries with high interest rates on bank loans.

Some decentralized lending protocols provide access to borrowed funds without collateral in cryptocurrency but secured with real funds. Most of them are in their early stages of development. This is because without legal collateral agreements, it is not possible to obtain a refund of the loan or to appropriate the collateral. 

Analogy

Advantages and disadvantages

The advantages of DeFi include:

  • Accessibility. Any Internet user can benefit from banking services. 
  • Absence of supervisory bodies. Most governments cannot tax cryptocurrency owners because they are anonymous. However, all developed countries are working on its regulation.  
  • Decentralization. Most DeFi-services are non-custodial (do not store user assets) and allow transactions directly between investors using personal cold wallets. 
  • Smart contracts. All transactions are conducted using smart contracts. This eliminates the human factor, corruption, or influence of ‘third parties.’
  • Transparency. The protocols and software are based on open-source code. All transactions can be verified in the public blockchain, and any user can benefit from it.
  • No intermediaries such as commercial banks or central banks. Financial services are processed online in a few clicks, and all parties' obligations are guaranteed by smart contracts. There is no bureaucracy, credit ratings, and drastic bank tariffs.

The disadvantages include:

  • Difficulty when withdrawing cryptocurrencies as fiat money. Rapid fluctuations in digital coins can lead to significant financial losses when withdrawing funds.
  • High commissions in the Ethereum network, where most DeFi projects are concentrated.  Fortunately, there are plenty of other blockchain-based alternatives on the market.
  • Hacking smart contracts. Attackers can hack smart contacts or protocols and withdraw some funds. Everything is the same as in the case of robbing bank branches or hacking into their computer systems. Many DeFi platforms try to compensate for losses and are constantly working to improve the security of their solutions.

Examples of successful DeFi platforms:

MakerDAO

MakerDAO is one of the most famous platforms. More than half of all frozen Ethereum digital coins are on this platform. It lends secured crypto-assets to anyone who passes approval, acting as a crypto-bank. The borrower uses a smart contract to send ETH coins as collateral, and in return receives a certain amount of DAI stablecoins. The value of the collateral is always higher than the amount of the loan granted so that in case of non-payment of debts, the platform won't incur material losses.

InstaDApp

Instadapp is a blockchain protocol that enables various financial transactions, including lending, margin trading, staking, etc. In fact, Instadapp has formed an entire ecosystem of financial services based on Ethereum smart contracts. It actively cooperates with MakerDAO in terms of lending. The main advantage is the convenience and good visualization of all functionalities. 

BlockFi

BlockFi is a service dedicated more to institutional investors. It issues loans in US dollars or in stablecoins for large amounts of money secured by cryptocurrencies (BTC, ETH or LTC). It also accepts deposits in BTC, ETH, LTC, USDC, GUSD, and PAX with a monthly interest payment. BlockFi is fully compliant with U.S. laws and regulations, which increases its credibility. 

 

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