Getting started with DEFI

What you’ll learn

• What DEFI is
• What you can do with DEFI
• The practical steps involved for the main DEFI functions
• The risks & drawbacks

In its basic form, Decentralised Finance (Defi), gives you access to a range of financial services, from the simple kind that would normally be provided by your high street bank, to the complex instruments used by Hedge Funds and Investment Bankers; all you need is a browser wallet and vigilance.

By locking your cryptocurrency into Smart Contracts, in a process known as staking, you can earn interest, denoted as an Annual Percentage Yield (APY) – a term familiar to traditional finance (tradfi). 

As a reward you for staking funds – providing liquidity – you also get rewarded in a token specific to each Defi project. That token gives you voting rights in any discussion of changes to the way its system works, and has speculative value.

DEFI tokens have shown remarkable increases in value since 2020.

How DEFI uses Smart Contracts

A Smart Contract is essentially an agreement to fulfil certain terms expressed in computer code. Right now your bank account might give you the right to a certain amount of monthly interest, cashback on direct debits at the cost of a monthly fee. 

That agreement is reached through a formal application process – which may take several days – is managed through a mixture of people and software and recognised in writing.

By contrast, a Smart Contract uses programming language (Solidity on Ethereum) to express the mathematical parts of an agreement – how much interest, when it should be paid – and the underlying Ethereum blockchain executes the agreement so it is transparent and cannot be amended, at the cost of a fee, paid in Gas (denominated in ETH).

In this basic respect, Defi recreates the sort of saving and investment opportunities that were once the preserve of traditional finance (tradfi) with the crucial difference that it entirely cuts out the middleman. 

You interact with code, not people, and there is no formal process – no forms or KYC. This new permissionless model democratises wealth generation and is an antidote to the closed network way that financial networks currently operate. 

It does mean, however, that there is no guard rail, so you’ll need to be comfortable with the level of autonomy in order to enjoy the potential rewards which don’t stop at earning interest and tokens.

Advanced users can stake cryptocurrency A and mint (generate) a new synthetic currency B, which they can then use elsewhere in the Defi ecosystem, wherever it can generate the best yield in a process known as Yield Farming. 

If this seems daunting, you can always earn passive interest on your crypto but with the comfort of working with people (CEFI), not Smart Contracts. We explain the difference between CEFI and Defi in a separate article.