Basic Guide for DeFi Investment

by Heybit
Basic Guide for DeFi Investment

What is DeFi (Decentralized Finance)?

DeFi (Decentralized Finance) is a financial system that operates in a decentralized manner, unlike traditional financial services that involve intermediaries. Traditional financial institutions like banks and brokerage firms have centralized entities that manage their operations. However, DeFi allows users to access services without a centralized authority.

Centralized financial services can cause various issues, such as expensive intermediary fees, manipulation of loan documents, or failure to disclose critical financial problems within the institution. DeFi was created to address these issues and has a significant presence in the cryptocurrency investment market.

It is true that DeFi is still not completely immune to risks such as embezzlement, fraud, and hacking, which can be partly attributed to centralized methods. However, various technologies and services are continuously evolving to address these challenges and improve the overall security and functionality of the DeFi ecosystem.

Centralized Finance vs Decentralized Finance

Banks are the most representative institutions dealing with finance. Typically, we go to a bank to borrow money (loans) or deposit money to earn interest (savings or fixed deposits). Banks directly intermediate and manage our money, providing financial services that can be considered as centralized finance.

Decentralized finance does not rely on entities like banks. Instead, services are automatically carried out by a system. This is called a smart contract, which can be simply described as a "predefined agreement on the blockchain." This contract is implemented in programming code and acts as a command that ensures the contract is fulfilled when specific conditions are met.

Let's take a vending machine as an example. Normally, when you insert money into a vending machine and press the button for the desired drink, the drink is dispensed. The vending machine manufacturer creates an algorithm (smart contract) and inputs it into the vending machine. This algorithm automatically checks the money inserted and dispenses the drink without human intervention. Smart contracts work on a similar principle.

However, the most significant difference is that smart contracts cannot be changed once written. Contract conditions must not change suddenly (although it rarely happens). In centralized finance, contract conditions can be changed by the involved parties, but this is not possible in DeFi. Of course, you can add a new contract to update the existing one in a sequential manner.

Types of DeFi

DeFi provides services similar to centralized finance. Just as we deposit money or take out loans at a bank, these services are also available in DeFi. The main difference is that centralized finance uses fiat currencies like the Korean won or US dollar, while DeFi uses cryptocurrencies.

There are various DeFi services, but they can be broadly categorized into swaps (exchange), yield farming (staking), and lending & borrowing. These services can be accessed through DeFi protocols. A protocol can be understood as a kind of DeFi service provider. We can use various DeFi services through these protocols.

  1. Swaps (Exchange): Swaps are decentralized exchanges (DEX) that allow users to trade cryptocurrencies without the need for an intermediary like a centralized exchange. Popular swap protocols include Uniswap, SushiSwap, and PancakeSwap. These platforms utilize liquidity pools and automated market-making algorithms to facilitate trading.
  1. Yield Farming (Staking): Yield farming is the process of staking or lending cryptocurrencies to earn passive income in the form of interest, additional tokens, or both. Users can deposit their assets into liquidity pools or staking platforms to earn rewards. Popular yield farming protocols include Yearn.Finance, Aave, and Compound.
  1. Lending & Borrowing: DeFi lending platforms allow users to lend or borrow cryptocurrencies without the need for a traditional financial institution. Borrowers can access funds by providing collateral, while lenders earn interest on their lent assets. Popular lending platforms include MakerDAO, Aave, and Compound.

By using these DeFi protocols, users can access a variety of financial services without relying on centralized financial institutions, reducing fees and increasing accessibility for those who may not have access to traditional banking services.

DeFi Investment

So, what kinds of investments can be made through DeFi? There are generally two types: 1) Earning profits through the service itself, or 2) Investing in DeFi protocol tokens.

If you expect the dollar to strengthen, you may exchange your Korean won for dollars or pursue interest income through a dollar deposit. The same applies to cryptocurrencies. If you think cryptocurrency A will increase in value, you can exchange your cryptocurrency B for A. Then, you can deposit the exchanged cryptocurrency A into a protocol to earn interest.

Let's take loans as an example. Traditional financial institutions like banks lend us money through deposits and provide loans while collecting fees. DeFi works similarly. You can borrow cryptocurrencies from protocols to engage in leveraged investments or lend your cryptocurrencies to the protocol to earn interest on loans.

There are countless DeFi protocols in the cryptocurrency market today. These protocols issue their tokens, which can be used to participate in decision-making or receive high-interest rates when deposited. Although the structure and concept are entirely different, there are similarities since the token's value increases as the protocol grows.

However, since protocols are decentralized, there is no obligation to maintain the service or the token's value, which means the risks are higher. It is crucial to always be aware of this aspect when considering investing in DeFi.