DeFi (Decentralized Finance) For Beginners: Introduction, Wallets & Trading
Key Questions Answered
DeFi refers to a thriving ecosystem of applications and protocols focusing on revamping the existing financial infrastructure. DeFi projects build their technology on top of layer one protocols like Ethereum, Cosmos, and Polkadot, with the vast majority of the current DeFi development occurring on Ethereum due to its extensive network effects.
Broadly, DeFi can be thought of as building an alternative financial infrastructure to the legacy system (e.g., banks, insurance companies, exchanges, etc.) from the ground-up. The idea is to disintermediate the trust placed in existing institutions and create decentralized and more inclusive versions of financial plumbing on permissionless networks.
Today, it’s hard to have a passing conversation in the crypto space without DeFi dominating the dialogue. So, what exactly is DeFi, and why should you care about the new craze defining its ascendance – yield farming?
What is DeFi?
Decentralized Finance (or DeFi) is a technological movement that aims to replace traditional financial systems by shifting the flow of money from centralized entities (i.e. banks) to decentralized P2P networks, and using smart contracts to execute code based on predetermined conditions.
DeFi technology offers services such as crypto trading, lending, borrowing, tokenized stock trading, yield farming, liquidity mining, prediction markets, and more. Many services and features that exist in traditional financial markets are replicated in DeFi in a trustless manner.
The DeFi industry is still in its infant stages, but the market surpassed the $100 billion milestone in 2021. The DeFi market soared 400% in a year, and DeFi tools such as MetaMask accumulated over 10 million downloads.
When Did DeFi Start?
Following the ICO mania of 2017, the broader crypto market may have entered an extended bear market in the aftermath, but the limelight of the hype of 2017 caught the attention of the mainstream. Investors, developers, traders, and other professionals poured into the industry as the remnants of capital from the ICO bubble were used as fuel for technological innovation alongside increasing VC investment. Much of that effort and capital has manifested in decentralized finance (DeFi).
How Did DeFi Start?
DeFi started on Ethereum when the founder, Vitalik Buterin, noticed that Bitcoin (BTC) was lacking smart contract functionality that could make blockchain useful for creating financial services and decentralized applications (DApps) on top of existing blockchain infrastructure.
These applications have the potential to replace traditional banking by giving each user full control over their money and enabling fully trustless trading. DeFi removes the need for an intermediary such as a bank and users can trade among each other using P2P technology.
Ethereum was the first crypto that enabled other users to build coins on top of the blockchain under the ERC-20 standard. Any developer with basic coding skills could deploy an ERC-20 token and build their own crypto. Over 300,000 crypto coins were deployed on the Ethereum blockchain alone.
Bitcoin is fully decentralized as a currency, but it lacks smart-contract functionality that allows developers to build features such as their own crypto, borrowing/lending, and decentralized trading services — cutting-edge tech that can take crypto to the next level.
The increase in cryptos being deployed on Ethereum lead to the creation of many decentralized trading platforms. UniSwap was the first DeFi trading platform that became popular, by allowing people to trade ERC-20 coins for Ethereum.
With the rise of decentralized trading platforms, developers began creating a new ecosystem of financial services such as lending and borrowing services, tokenized stocks/precious metals, yield farming services, gaming/prediction markets, and more. The tech later expanded to other competing platforms beyond the Ethereum ecosystem.
How to Use DeFi
What can DeFi actually do for you? DeFi platforms include everything from decentralized exchanges (DEXs like Uniswap) to synthetic assets (e.g., Synthetix), liquidity pools, insurance products (e.g., Opyn), payments, borrowing/lending protocols (e.g., Compound), stablecoins, and more. These platforms function similarly to existing financial services, but in most instances, replace the institution (such as an exchange) with a series of smart contracts operating on a network like Ethereum.
Let’s look into some practical day-to-day use cases:
- Decentralized Exchange (DEX) Trading: Users can trade ERC-20 and other layer-2 tokens to make a profit. Decentralized exchanges (DEXs) work similarly to centralized exchanges, as users can buy and sell crypto, sometimes even with limit orders. These exchanges work on the principle of “swapping” one coin for another, for example, swapping Vlaunch (VPAD) > Ethereum and back.
- Lending/Borrowing: DeFi is comparable to traditional finance because it offers similar features such as borrowing/lending. Users can lend on DeFi exchanges by depositing collateral. Lenders can earn money by charging interest for their crypto assets.
- Stablecoins: Traders can convert their tokens to stablecoins pegged to fiat currencies such as USDT, USDC, DAI, and more. Similar to how traders can cash out in volatile crypto like ETH, they can use stablecoins in decentralized wallets.
- Yield Farming: An investor can charge fees for trading on decentralized exchanges by making their cryptos available for trade. A DeFi platform requires 50:50 ratios between two crypto pairs. If a person has ETH and Shiba Inu (SHIB), they can deposit them as a SHIB/ETH LP token and earn % fees for every swap on the platform.
- Wrapped Crypto: Users can “wrap” other crypto coins that don’t run on the Ethereum blockchain such as Bitcoin — wBTC being the most popular. This allows them to hold a wrapped version of their favorite coin in a DeFi wallet.
- Staking: Users can stake their DeFi coins to earn a certain APY (annual percentage yield). On most coins, the APY % per year could exceed that of traditional financial institutions by a significant margin.
- Aggregation: Users can take advantage of a DeFi app such as 1Inch that aggregates decentralized exchanges and get lower fees depending on the state of the network and the liquidity in different exchanges.
7 Benefits of DeFi
DeFi has numerous benefits over traditional finance. It encompasses the following features:
- Global: DeFi is truly unlimited in its reach. Any person can use DeFi services from any location in the world without restrictions.
- Private: DeFi wallets are private. To use a popular wallet like MetaMask, a user only needs to remember their recovery phrase. They do not need an email, ID, passport, proof of address, or any sensitive information.
- Keys: DeFi users have full control of their crypto keys, and the only way to trade on most popular DeFi applications is to have a decentralized wallet. Users own 100% of their crypto in DeFi.
- Decentralized: DeFi is the true definition of peer-to-peer electronic cash in the original way Satoshi Nakamoto envisioned it in his Bitcoin whitepaper. Users can trade and move their crypto at any time without asking permission.
- Transparent: All DeFi transactions are public and transparent on the blockchain. Using block explorers, users can see their past trades and other people’s trades. However, this data is not tied to the person’s identity — only their crypto address.
- Fast: DeFi transactions are fast and the average swap on decentralized exchanges takes between 5–10 seconds to confirm transactions. This is a lot faster compared to wire transfers in banks that take 24 hours on average and close on weekends.
- Open-Source: DeFi is built on open-source software protocols such as Ethereum (ETH), Uniswap (UNI), and MetaMask. Developers can deploy crypto tokens instantly and they can trade them. Open-source licenses spawn thousands of different dApps.
DeFi Trading & Exchanges
DeFi trading works similarly to centralized trading. The difference between trading crypto on DeFi exchanges and centralized exchanges is that the liquidity needed to make a trade is provided by peers in DeFi using so-called liquidity provider (LP) tokens, while on centralized exchanges it’s provided by the exchange.
DeFi wallets such as MetaMask give people full ownership of Ethereum and ERC-20 tokens in their possession. The MetaMask wallet can be used to make trades on UniSwap by swapping Ethereum for any ERC-20 coin on the network. It can also be used for other layer-1 networks.
On DeFi trading platforms, liquidity providers receive small fees in exchange by adding their crypto pairs and holding LP tokens. Users can add a liquidity pair such as ETH/USDT and earn fees from every trade. Lending services on DeFi work by merging crypto liquidity in large “pools” where lenders can add funds for a % return and lendees can lend funds by depositing collateral.
This technology was adapted from Ethereum to many other competing, smart-contract-enabled, platforms such as Solana (SOL), Cardano (ADA), Avalanche (AVAX), Fantom (FTM), among others. They offer similar features to Ethereum but with much lower fees.
P2P trading technology doesn’t mean that there aren’t any fees on DeFi. Liquidity providers take an automatic 0.3% fee for each trade. For most Ethereum-based swaps, the blockchain gas fees can exceed the fees of centralized exchanges or even traditional financial institutions.
DeFi and Centralized Crypto Exchanges
On the contrary, centralized exchanges like Phemex can process trades using a central orderbook significantly faster than their DEX counterparts. For many traders, the performance limitations of DEXs are prohibitive, and they tend to favor centralized exchanges instead. Jack Tao, CEO of Phemex explains:
“The technology we require to become a DEX is not ready yet. However, we are exploring if a transition to a non-custodial exchange is possible while still maintaining the many benefits and security features that we provide our clients. We believe that the main purpose of an exchange is to help facilitate the exchange of value efficiently. For such purposes, centralized exchanges still have their relative advantages at the moment.”
An immediate problem that arises with many DeFi platforms (e.g., DEXs) is liquidity. DeFi protocols understood that financial instruments and trading would be the first major technological lure of the crypto market, but attracting liquidity remains a challenge.
How do you incentivize investors to deposit assets into a liquidity pool or DeFi platform?
In the case of Uniswap, the fees generated from each trade in the liquidity pool are paid to the investors who deposit or “stake” their assets into liquidity pools of the protocol. By providing liquidity to the protocol, they are rewarded with a passive revenue stream.
However, for more complicated DeFi protocols, the answer to incentivizing liquidity has morphed into another form known as liquidity mining — AKA “yield farming.”
How Does DeFi Yield Farming Work?
Yield farming is the colloquial name for liquidity mining, a method of token distribution and reward incentives for users to provide liquidity to a DeFi platform. At a high level, liquidity mining can be thought of in a similar light as a rewards-based marketing mechanism that dilutes the ownership of early investors over time, hoping to achieve widespread adoption of the token and platform.
Users are rewarded for providing liquidity to the protocol early on. However, liquidity mining differentiates itself from Uniswap’s fee model in both how it is performed (e.g., across multiple pools), and in what is earned — a native governance token of the DeFi platform.
DeFi protocols are often defined as successful or not by their total value locked (TVL), which is the USD equivalent of total assets in the protocol. And TVL has soared in recent months following the first major yield farming opportunity from Compound Finance.
Example of Yield Farming
In June, Compound Finance, a leading borrowing/lending pool built on the Ethereum, announced it was issuing a native governance token — COMP. Every day, roughly 2,880 COMP tokens are distributed to users of Compound Finance, including borrowers and lenders. The distribution of COMP tokens is a method of fairly issuing governance tokens to the users of Compound that provide the service of liquidity to the protocol.
Compound’s TVL skyrocketed following the unveiling, and the token price exploded alongside the surging TVL. Users can use COMP tokens to vote on protocol changes, which is a defining characteristic of DeFi — distributed consensus and community governance/participation. By incentivizing liquidity, COMP lowers borrowing costs and increases yields for lenders, eventually attracting more users and more liquidity in a positive feedback loop.
Unsurprisingly, the immediate success of COMP sparked a suite of DeFi protocols to follow similar yield farming methods with their own native governance tokens. Other examples include Synthetix (a protocol for minting and swapping synths), Balancer (a DEX like Uniswap with a governance token), and Aave’s lending protocol.
Understanding yield farming and how it works is important when entering the crypto market.
Yield farming, still in its nascent phase, represents years of tinkering with incentive models to fairly distribute tokens, govern protocols, and acquire users. The DeFi boom has proven that the revamping of financial infrastructure is one of the most salient early applications of permissionless networks like Ethereum. Now, it’s a matter of attracting more liquidity, ironing out problems with the protocols, and expanding the feature set.
DeFi Smart Contracts
DeFi is an industry that combines different technologies such as crypto trading platforms, wallets, lending services, and more. The main thing they have in common is that they are all powered by smart contracts.
A smart contract is a fancy term for computer code that acts as a digital agreement on the blockchain. Smart contracts allow decentralized exchanges such as Uniswap to connect to the Ethereum blockchain and transmit data to the blockchain in real-time.
Decentralized lending platforms like AAVE utilize smart contracts to enable fast lending and borrowing services without counterparty risk. This allows anyone in the world with a crypto wallet to start lending and borrowing money regardless of their location or credit score.
The most popular smart contract programming language is Solidity, a language developed by Ethereum co-founder Gavin Wood. Using Solidity, developers can deploy ERC-20 coins and program transactions on the Ethereum blockchain. They can add advanced functionalities such as minting, burning, taxation, and more. Smart contracts can also connect the blockchain to oracles to transmit off-chain data on-chain.
In the first version of UniSwap, users were able to trade ERC-20 coins with Ethereum. For example, ERC-20 tokens like SHIB could only trade on the SHIB/ETH pair on UniSwap. In the second version, any ERC-20 coin pairs could be created without ETH such as SHIB/USDT.
How to Invest in DeFi Coins?
To learn how to invest in DeFi, you have to install different tools that make trading possible. The first step is the install a DeFi wallet — often a Chrome extension. You will also need crypto that you can purchase from Phemex and transfer to a decentralized wallet to make trades.
As mentioned, DeFi is not only on Ethereum, other platforms have their own tools and DEXs. Below, we have laid out the top smart-contract platforms with their own DeFi ecosystems. You can install their wallets and purchase these cryptos on Phemex, then send them to your DeFi wallet.
|DeFi Crypto||Total Value Locked (TVL)||Block Explorer||DEXs||Wallets||Trade|
|Terra Luna (LUNA)||$15B||TerraFinder||TerraSwap||TerraStation||LUNA/USDT|
|Avalanche (AVAX)||$11B||SnowTrace (C Chain)||Pangolin||MetaMask||N/A|
|Solana (SOL)||$8B||Solana Explorer||Serum||Phantom||SOL/USDT|
|Cardano (ADA)||$150M||Cardano Explorer||SundaeSwap||Nami||ADA/USDT|
Note: DeFi on cryptos like Cardano is still in the early stages of development, therefore the TVL is lower. On some cryptos like AVAX, there are multiple chains and C-chain is used for DeFi trading.
Where to Buy DeFi Crypto?
Users can purchase coins that are used for DeFi trades on Phemex. Most DeFi trades are conducted using the native coin of the network. To swap ERC-20 tokens, you need Ether and you can purchase ETH on Phemex by navigating to the ETH/USDT pair.
Phemex has listed many coins that started out on DeFi exchanges. For example, Vlaunch was a major success that started out on UniSwap and got listed on Phemex. Users can now trade the VPAD token directly on our exchange without paying high fees on the Ethereum network.
Aside from native coins like Ethereum, we also list top-performing DeFi crypto that is safe for users:
- LINK/USDT: Chainlink is a decentralized oracle marketplace.
- UNI/USDT: UniSwap is the most well-known DeFi trading platform.
- MANA/USDT: Decentraland is a famous NFT game.
- AAVE/USDT: AAVE is the largest decentralized lending/borrowing platform.
- SUSHI/USDT: SushiSwap is one of the best-known Ethereum trading platforms.
- SHIB/USDR: Shiba Inu is the highest-performing dog coin after Dogecoin.
- VPAD/USDT: VLaunch is a new IDO platform for decentralized coin launches.
- ENS/USDT: Ethereum Name Service is a domain name service for .ETH domains.
These coins started out as DeFi coins on Ethereum and other networks, then reached multi-billion dollar market caps. Phemex has since made their tokens tradable on our platform. Users can buy them on Phemex and withdraw them to their decentralized wallets and back.
To truly learn what DeFi crypto is, it helps to learn by doing. Refer to the table above to buy DeFi coins and send them to your decentralized wallet. If you are new to Phemex, learn more about spot trading and buying crypto with a credit card/bank transfer before you get started.
What are DeFi Risks?
DeFi is still in its early stages of development and fully unregulated. Users have to exercise extreme caution when they trade DeFi coins as there are hundreds of thousands of them and estimates say 50+ coins are created per second.
Coins traded on centralized exchanges like Phemex have markets caps in the billions of dollars with proven teams that are safe to invest in. Most of these coins have been around for years and have never been hacked.
There are other downsides such as high gas costs and tax filings. If networks like Ethereum are congested, the gas fees to trade coins can skyrocket to hundreds of dollars per trade. Moreover, it’s difficult to file capital gains taxes when you have to gather records for DeFi trades.
The DeFi movement aims to decentralize financial services by utilizing blockchain technology. The existing services of traditional finance are replicated in a DeFi network, but the technology removes the centralized component that excludes many potential traders.
With the success of Ethereum, many new smart-contract-enabled blockchains were created as competition. The top runner-ups include Polygon, Cardano, Avalanche, Solana, Fantom, and others. These coins can be traded on Phemex, making it easy to start your DeFi journey.