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What is DeFi?

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What is DeFi
Cristian Cochintu
Cristian Cochintu
23 November 2023

Decentralized finance, or DeFi, is fast becoming an important part of the financial services system run in the blockchain network. However, it should not be mistaken for crypto. 

In 2018, an emerging blockchain economy called decentralized finance (DeFi) started to draw investors’ attention. This new financial ecosystem increased the potential for blockchain technology and cryptocurrencies by making use of the smart contracts' functionality provided by programmable blockchain networks such as Ethereum. Today, DeFi is a revolutionary financial system that is open and borderless. It empowers people to communicate directly with each other using cryptocurrency. 

There is quite a bit you should consider as you enter the world of decentralized finance. If you want to get started today, here is a quick guide that can help.

DeFi Key Takeaways

  • Research your DeFi assets – the potential of DeFi goes beyond only investing in the DeFi tokens; you also have the options of ETFs, stocks, and surely, more will arrive as the industry matures.  
  • Define your DeFi investment strategies – There are 4 main strategies to choose between when investing in Defi, but what you go for depends on your risk tolerance.  
  • Take your positioncreate an account with us to trade the native token of a DeFi protocol or to invest in DeFi related stocks and ETFs.    

    

What is DeFi? 

DeFi stands for Decentralized Finance. It is an emerging financial technology that is based on secure distributed ledgers that are similar to those used in cryptocurrencies

DeFi is a peer-to-peer platform that empowers individuals to challenge this centralized financial system. To differentiate between the old financial system, often referred to as traditional finance, and this new DeFi system, you need to understand what the main differences are between the two.  

The rules for central financial institutions such as banks and brokerages are set by the Federal Reserve and Securities and Exchange Commission in the United States. These institutions provide capital and services to consumers. 

Intermediaries are needed to send and receive money in traditional financial systems, such as banks or stock exchanges. All parties must feel confident about the transaction and have faith in intermediaries to act honestly and fairly. 

DeFi eliminates these intermediaries and replaces them with software. Instead of trading through stock exchanges or banks, people trade directly with each other, with blockchain-based smart contracts doing the job of creating markets, settling trades, and ensuring that all parties are fair and trustworthy. Some may say that DeFi is the alternative to the traditional stock exchange.  

Indeed, the trading market is part of DeFi. DeFi also covers things such as prediction markets, options, derivatives, lending platforms, and other services. Crypto traders and investors are creating their own version of Wall Street. It is decentralized, deals only in crypto, and offers crypto versions of many products offered by traditional financial institutions. There is also less regulation than the traditional market must deal with. 

How DeFi works  

DeFi allows any two parties to transact securely and directly without the need for an intermediary or central authority. This means that financial services are available to more people at lower rates and with better interest rates than traditional financial institutions. 

Blockchain technology is used in decentralized finance. Blockchain is a distributed, secure database or ledger. On top of programmable decentralized blockchains like Ethereum, developers may deploy decentralized applications called DApps, which use smart contracts to manage transactions and run the blockchain. 

As a reminder, all transactions are stored in blocks on the blockchain and can then be verified by other users. Once the verifiers have agreed on a transaction, the block will be closed and encrypted. A new block with information about the previous one is created.

  

When it comes to DeFi, you must remember that all of this relies on the ability of a blockchain to execute smart contracts. Developers write smart contracts to execute specific actions when certain conditions are met. Note that DeFi can only exist on blockchains that support smart contracts. Although Ethereum was the first platform to develop smart contracts, many other blockchain platforms use them, including Polkadot, Solana, Algorand, EOS, and Cardano.  

For instance, you could create a smart contract that states you will pay $500 to someone when a certain condition is met. Everyone can read and access the code but cannot change it. This eliminates the need for centralized intermediaries, such as banks and other financial platforms. Smart contracts govern decentralized apps or DApps, which are not controlled or owned by one person or company.  

Benefits of DeFi 

Traditional retail investors may be wary of investing in DeFi, but these platforms often present new features that aren’t available with traditional finance. Some of the most praised benefits of DeFi are: 

Accessibility. Anybody with an internet connection can access the DeFi platform. Transactions are performed without restriction. Low fees and high-interest rates. DeFi allows any two parties to negotiate interest rates directly and loan money through DeFi networks. 
Security and transparency. Anyone can review smart contracts and transactions that have been completed on a blockchain. However, they do not reveal your identity. Also, smart contracts and blockchain codes cannot be modified. Autonomy. DeFi platforms do not rely on any central financial institutions. They are also not vulnerable to bankruptcy or adversity. This risk is mitigated by the DeFi protocol's decentralized nature. 

Downsides of DeFi 

As with any recent technology and innovation, the DeFi phenomenon comes with many risks. Decentralized finance has not been extensively used or tested. National financial authorities are also looking at the systems they're putting in place with an eye toward regulation. Some of the most mentioned risks associated with DeFi include: 

There are no consumer protections. DeFi thrives in the absence of rules and regulations. However, this means that users may not have recourse if a transaction goes wrong. For example, in the US, in centralized finance, the FDIC reimburses deposit account holders up to $250k per account and per institution if a bank goes under. Banks are also required by law to keep a certain amount as reserves to ensure stability and allow you to cash out your savings account whenever you need to. DeFi does not offer similar protections. Collateralization. Collateral is an item of value that can be used to secure a loan. For example, a mortgage loan is secured by the property you are buying. All DeFi lending transactions require collateral equal to or greater than 100% of the loan's value. These restrictions severely limit who can apply for DeFi loans. 
Hackers pose a threat. Although a blockchain is indestructible, other parts of DeFi can be hacked. This could lead to funds theft and loss. All uses of decentralized finance rely on software systems that can be hacked. You must protect your wallets that store cryptocurrency assets. Private keys are long, unique codes that are only known to the wallet owner. You lose your private key, and you cannot recover it. 

DeFi vs crypto  

New blockchain investors may be interested in the difference between DeFi vs crypto. However, the two topics can’t really be compared as one defines a recent technology for money, and the other is an alternative economy.  

To better understand DeFi compared to crypto, we’ll use the analogy between email and the internet. The internet was initially only available for email communication when it was launched to the public. This super-fast technology allowed people to communicate with one another, which was the idea behind the internet. The email is crypto.  

However, internet technology evolved and spread over the next few decades. Everyone realized that it was not just email but a whole new world with many possibilities. This new world and ecosystem is DeFi.  

Through blockchain, you can make anonymous P2P (peer-to-peer) transfers. Some say that DeFi is the true potential of blockchain technology. 

Blockchain made it possible to make payments faster and more affordable. You could use the entire system to do all things that involve money. It freed individuals from financial institutions and banks. 

DeFi investment strategies   

Before diving into DeFi investment strategies, potential investors need to know what DeFi is used for and how it serves the online community.  

As we've already mentioned, DeFi stands for decentralized finance and refers to financial services that use open-source blockchains. Anyone can access their assets from anywhere in the world using an internet-connected smart device. 

One of the key premises behind DeFi is peer-to-peer (P2P), financial transactions. A P2P DeFi transaction involves two parties who agree to exchange cryptocurrency for goods and services. For instance, DeFi allows individuals to borrow money from others. There are already many protocols that match lenders and borrowers.  

When investing in DeFi, there are several options. Your risk tolerance will determine which strategy you choose. The main investment strategies for crypto investors are: 

  • HODL (Holding) 
  • Borrow and lend crypto 
  • Staking and yield farming 
  • DeFi stocks and indexes 

1. Hodl  

For any new investor in digital assets, the simplest strategy is to buy cryptocurrency and hold it for the long term. Oftentimes, investors refer to this investment strategy using the term "hodl," which became popular after a crypto user misspelled the term “hold” on a forum in 2013. Nowadays, “hodl” is part of the crypto jargon. Whenever you want to describe your DeFi investment strategy of buying and holding, you may also say, “I’m hodling,” meaning that you are holding.  

HODLing may seem like the best way to build your portfolio. But it might not be the smartest. It only depends on your crypto holdings increasing over time and ignores the DeFi opportunities to generate passive income from them. If you don’t want to spend too much time researching new projects, or you are not interested in cryptocurrency trading, then you may choose to invest in DeFi tokens such as Ether (ETH) or Polkadot (DOT).  

DeFi's rule of thumb is that no money should be left idle. With DeFi, any crypto holders can get rewarded for holding crypto and earn a passive income through it.  

2. Borrow and lend crypto 

Just like traditional finance, DeFi allows users to access loans or lend money. However, this comes with some advantages when compared to traditional finance. For instance, the approval of loans is not subject to a credit check by banks. Instead, smart contracts act as an automated digital intermediary that sets rates based on the coins in a liquidity pool. 

Lenders who provide tokens to a liquidity pool often hope to make a profit through interest. Loans are issued by a specialized crypto trading platforms called DeFi protocol. These DeFi loans are usually over-collateralized, which means borrowers provide a guarantee in the form of crypto worth more than the actual loan. 

However, DeFi borrowing and lending differ in many ways. Interest rates can be very favorable. In traditional finance, the best savings rates are a few percent, while most DeFi deposits earn between 1% and 5% annually or more.  

3. Staking and yield farming 

DeFi introduces a wide range of opportunities, and two of the most accessible ones are crypto staking and yield farming.  

If you have decided to invest in crypto for the long run, you may as well hold a cryptocurrency that allows staking. By staking, you may earn a passive income while also keeping your crypto investment. Staking is an essential action for the proof-of-stake (PoS) blockchain, which requires crypto holders to lock their crypto to help secure the network while also validating transactions and generating new network blocks. Similarly, to traditional savings, the longer you stake DeFi assets, the more you earn. 

Yield farming represents a more complicated DeFi investment strategy. This must be done on a specialized lending and borrowing protocol, where crypto holders deposit their crypto into liquidity pools and earn interest on it. Yield farming is one of the most lucrative ways to earn DeFi, but it also comes with the greatest risk. One of the most mentioned risks is impermanent loss, and highly volatile digital assets cannot escape it.  

Crypto staking is safer than yield farming because it does not require you to deposit your funds or trust any third-party smart contract and is not subject to impermanent loss. However, staking may present lower rewards than yield farming. While staking may be a popular choice for some cryptocurrency owners, there are many other ways of generating passive income, including dividend stocks, bonds, or real estate investment trusts (REITs)

4. DeFi stocks and indexes 

If you’re interested in accessing the innovative DeFi and crypto market but like to have broader exposure, then DeFi related stocks and index funds could be for you. 

Index Funds 

Indexes are a trendy way to diversify your investment portfolio

Traditional finance uses exchange-traded funds (ETFs), which track the prices of several assets together. An example of this is an S&P 500 ETF that tracks the price movements of all 500 companies within the USA 500 index. DeFi indexes look similar, except that the assets you are investing in are crypto tokens. In a way are like crypto indexes

Investors love ETFs because tokens in an index are selected based on strict criteria, such as size and volatility. This allows investors to outsource the analysis and research that would normally be required to select tokens for their portfolio to an index provider. 

Most popular DeFi indexes: 

  • DeFi Pulse Index (DPI). It groups the largest DeFi projects. 
  • MetaVerse Index (MVI). It allows investors to bet on future non-fungible tokens (NFTs). It contains the largest NFT protocols in DeFi. 
  • Phuture DeFi Index (PDI). The index contains the top DeFi assets by market capitalization on Ethereum. 
  • Bankless BED Index (BED). Tokens in BED represent one aspect of the future of finance: store of value tokens (Wrapped Bitcoin), programmable money (Wrapped Ethereum), and decentralized finance (DeFi Pulse Index) 
  • ProShares Bitcoin Strategy ETF. The fund tries to track the performance of Bitcoin through the purchasing of Bitcoin futures contracts. As the use of DeFi grows around the world, it will also increase the use of cryptocurrencies. As Bitcoin is the world’s largest crypto it stands to reason that it could benefit from the adoption of DeFi. 

Stocks 

DeFi stocks are companies that are either directly or indirectly involved in decentralized finance (DeFi). Are not vastly different from cryptocurrency stocks, blockchain stocks, metaverse stocks, or NFT stocks. They are providing exposure to companies interested in a new industry. 

For example, companies such as IBM help other companies move operations onto the blockchain. Mastercard plans to use the blockchain to facilitate its current business. Other companies provide access to DeFi platforms for investors to invest in DeFi projects. 

The most popular DeFi-related stocks are: 

  • Riot (RIOT) is one of the most important Bitcoin miners in the U.S. Due to the growing demand for cryptocurrency, Riot is one of the top crypto stocks supporting the Bitcoin blockchain.  
  • Canaan Creative (CAN) is a China-based computer hardware manufacturer. It was established in 2013 by N.G. Zhang. The company specializes in blockchain servers and ASIC microprocessors which are used in bitcoin mining
  • The International Business Machines Corporation (IBM) is an American multinational technology corporation. IBM Blockchain offers transformative blockchain solutions to clients like Kroger, True Tickets, and others. If blockchain-based solutions gain more popularity, the company could see significant growth.  
  • Coinbase (COIN) is the largest cryptocurrency exchange in the world, offering more than 100 cryptocurrencies. There are approximately 73 million users verified in over 100 countries and more than $1 billion of cryptocurrency trading volume through the company's platform. 
  • Meta Platforms (META), formerly known as Facebook, is an American multinational technology conglomerate based in California. The company is a pioneer in virtual reality (VR) and social networking apps, and it is working on launching its own metaverse. The company also launched the Oculus VR headset as hardware to help users get the full immersive metaverse experience.  

How to invest in DeFi-related assets  

As you may notice, getting started in the DeFi space may seem like a huge burden for those not yet familiar with the way blockchain actions function. But that’s not the end of it. Traditional investors can also be exposed to the DeFi space. In the end, to invest in DeFi means to invest in a cryptocurrency that is used to engage in DeFi protocols or companies that have an interest in DeFi space.  

There are two ways to start investing in DeFi: speculating on their prices using CFDs or buying the DeFi assets in the hope they increase in value.  

Trade DeFi coins using CFDs  

A CFD is a contract in which you agree to exchange the difference in the price of a cryptocurrency from when you first open your position to when you close it. You are speculating on the market price rather than taking ownership of the DeFi tokens. If you open a long position and the cryptocurrency does increase in value, you’ll make a profit, but if it falls in price, you’ll make a loss – the opposite is true for a short position.  

 

Buying DeFi-related stocks and funds  

This means that you take ownership of the DeFi-related stocks and ETFs outright, with the intention of holding it with a brokerage and profiting if it increases in value.  

  

Grow your DeFi portfolio with CAPEX.com  

  • Choose which type of account you want to use. Your first concern should be your risk appetite and time horizon. If you want to buy and hold DeFi related stocks and funds, open an investing account. If you want to speculate on the DeFi tokens price movements (including falling prices) with zero commission and leverage, open a CFD trading account
  • Create an account. Regardless of your chosen account, you must register and complete the KYC process to verify your identity. 
  • Fund your account with fiat money. Before buying and trading any instruments, you need to fund your exchange account with U.S. dollars, Euros, or other currencies. 
  • Select your markets. It’s time to decide on your first DeFi investment. We strongly recommend that you thoroughly research the crypto project offering DeFi tokens. Of course, you may choose to invest in stocks and funds that provide an indirect exposure. 
  • Place your order. Follow the steps required by the trading platform to submit and complete your order. From market order to pending orders like Limit and Stop, you have multiple options. 
  • When trading DeFi tokens, the CFDs (contracts for difference) are stored in your account and are far more liquid. However, you should know that CFD trading is fast-moving and requires close monitoring. As a result, traders should be aware of the significant risks when trading CFDs. There are liquidity risks and margins you need to maintain; if you cannot cover reductions in values, your provider may close your position, and you'll have to meet the loss no matter what subsequently happens to the underlying asset. 

    

With CAPEX.com, you can trade CFDs on +2.000 instruments, including 20 major cryptocurrencies and invest in +5.000 stocks with ownership, including the brand-new Bitcoin ETF. 

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Cristian Cochintu
Cristian Cochintu
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Cristian Cochintu writes about trading and investing for CAPEX.com. Cristian has more than 15 years of brokerage, freelance, and in-house experience writing for financial institutions and coaching financial writers.