Step by Step Guide on Investing in Decentralized Finance (Defi)

Discussing step by step guide on investing in decentralized finance (Defi) requires a lot. We shall start with beginner’s guide in DeFi. Then, talk on Ethereum and smart contracts. Also, talk on automated market makers. Decentralized applications & Terminologies in DeFi will also be studied.

Waves are created by DeFi. It is done in a way that, it fundamentally changes how both local and multinational businesses operate. In the world of crypto, decentralized finance has become a popular topic to discuss. It is so, due to the way it has grown.

Since the era of software engineering, human survival has hoped on authorizing draining tasks to our machines. It has helped them to improve very well. The ability to adapt to environments aid humans dominate the planet.

Decentralized finance is constantly evolving the financial markets. This evolution is displacing intermediaries in terms of power. It is distributing it across fundamentally unrelated people. It is the most common evolution in the industry.

In recent times, we can transact in a peer-to-peer ecosystem. Trading is also made available, all being the work of DeFi. Nobody knows what the technology will be capable of in the future. Its potential is shocking. Now let’s look at the step by step guide on investing in decentralized finance (Defi). We shall start with Beginner’s guide on DeFi.

Beginner’s Guide on DeFi

Beginner’s guide on DeFi is on the primary level. There is an establishment of a third party. It is usually a bank or financial institution. From it financial transactions are performed. Although, there is an incredibly efficient operations, but it is highly prone to hackers. In beginner’s guide on DeFi, it is better to learn about decentralization before decentralized finance. It is followed step by step.

Nobody is happy when money is taken away from them. The most common traders worry about security, though concerned investor has a lot to worry about. The point is that security is a priority.

Beginner’s guide on DeFi will assist you, to understand the basics of DeFi. No central body is in charge of the network. It is now the role of decentralization to prevent censored actions. Also, keeps all the funds safe and network still functioning. It doesn’t get affected even if a single point on the network is attacked. This is done through a majority consensus between other people.

Bitcoin is still one of the most basic cryptocurrencies in existence. It gives access to peer-to-peer transactions. It alsoo has other work in finance despite being popular. Bitcoin is currently the most popular decentralized network and cryptocurrency. It operates on a blockchain technology, which simply means a distributed ledger of transactions.

Ethereum blockchain is the power house of most decentralized finance application. There are other options out there too but Ethereum blockchain is preferable. It gives DeFi features, like running decentralized applications. This is why DeFi chose Ethereum at the expense of others.

We just introduced the beginner’s step by step guide on investing in decentralized finance (Defi). Now let’s continue.

Discussion on Ethereum and Smart contracts

Ethereum and smart contracts operates by automating financial processes. Also, it encodes financial contract terms into a transaction. Smart contracts were launched and introduced in 2015 by Ethereum.

A runtime environment for decentralized Blockchain applications is what we refer to as “smart contract”. If Ethereum and smart contracts are not built on blockchain, the won’t function properly. They are snippets of code running on the Ethereum Virtual Machines. Generally, Ethereum and smart contracts work hand-in-hand.

Ethereum has been recorded as the world computer. It is because, it gives applications the access to work on the basis of a decentralized network. As long as Ethereum continues to exist, the DeFi space will continue to thrive. It will always live up to the name it has been recorded for.

Developers have succeeded in creating all kinds of decentralized applications (DApps) through smart contracts. The only difference is that they run on a network of distributed computers. While the other runs on a central server.

Brief Touch on Decentralized Applications

Decentralized applications (dApps) is a type of distributed open source software application that runs on a peer-to-peer (P2P) blockchain network.

ERC-20 tokens are numerous on Ethereum. Though, practically anyone can create them. The utility and the DApps they serve gives them value. Ethereum network allows DApps to issue their own tokens for in-app payments, while Bitcoin doesn’t. The ERC-20 token standard is highly obeyed. This is for the issuance of token to take place.

There is a transaction fee attached to any action performed on the Ethereum blockchain. It is known as gas fee, it essentially covers the cost of computation for the code being run. It’s in form of ETH native token too.

Decentralized finance is a subset of DApps. It deals with any transaction of a particular digital asset. It is also used for trading and staking tokens. DApps ranges from gambling machines to development platforms.

DeFi has a decentralized nature. It doesn’t have a single point of failure. It resists censorship, and fundamentally distributed control frameworks are present. All these are the different limitations of centralized financial services. Access to banking services is approved by DeFi. You just need to have a smartphone and internet connection.

A Blockchain network is resistant change. It doesn’t give fake transaction records. DeFi activates all kinds of use-cases. Even the ones that seemed impossible earlier on blockchain networks.

If DeFi’s growth keeps increasing, we might experience a decentralized future soon.

Frequent research and development on DeFi, should be conducted. This will convince a lot of people. DeFi has the ability to transform the function of our global economic systems. This is achievable by providing more efficiency, security and access.

Terminologies in DeFi:

Decentralized Ledger Technology (DLT)
Ether
Smart contracts
Decentralized application (DApp)
Gas

At this point, we shall study the intermediate sep by step guide on investing in decentralized finance (Defi)

Intermediate Guide for DeFi

Decentralized finance is a system that operates with the absence of middlemen in trading between two parties. The middlemen can be banks, transfer services and other financial institutions. They actually gain a commission for each transaction that you make. these lower overheads enable a more accessible and affordable experience for end-users.

DeFi and Blockchain are almost tackling the same issues together.The difference is, users communicate with DeFi. The infrastructure used to distribute financial services to a decentralized user-base, is provided by blockchain.

For instance, if blockchain represents the Internet, then DeFi represents online services like PayPal, Lending Club, etc. One can also replace blockchain with bank, having DeFi protocols as the bank services. It’s as simple as that.

In stock exchanges, investors, brokers, and traders place bids and requests interaction with the market. This is similar to digital assets that operates on a centralized basis. All these happen despite the heavy focus on decentralization.

There are some issues people have with a centralized exchange. One of them is opening the market up to a single point of failure. Sometimes, huge amounts of capital embezzled from exchanges through attacks, hacking and exploiting other vulnerabilities leaves us blank. It’s problem isn’t just theoretical. Systems in charge of big transactions, should be considered highly efficient.

Definition of Decentralized Exchanges

People hardly knew about DeFi when it was first introduced to the world a few years ago. Centralized exchanges use an order book to keep track of the multitudes of market orders conducted on the platform. The biggest advocates of blockchain didn’t fancy emulating this model in a decentralized environment. It seemed inefficient and non-profitable. The concept of a decentralized exchange was more like a novel, rather than drama.

Since last year, decentralized platforms have been more active with the introduction of Automated Market Makers (AMMs). Some difficulties that occurs are mainly because decentralized exchanges (DEXs) lack the liquidity offered by their counterparts(centralized exchanges). There is a list of Market makers that profit from filling gaps in the order book.

Automated Market Makers are smart contracts managing a liquidity pool of two or more tokens. Unlike the regular market makers that are individuals or firms. Automated market makers-based DEXs function in a unique way, they allow users to deposit and withdraw tokens into liquidity pools. Prices are based on the ratio of the tokens in the pool. They don’t need to look for gaps to profit from within the bid-ask spread of an order book.

The DEXs are much more attractive proposition. It is a wide range of services. It was assumed to fail. Examples like lending and borrowing. Also services that have no parallel in the centralized world like flash loans, were all enabled. Liquidity providers or LPs are individuals that contribute to the team. They keep providing liquidity including a cut of the platform’s trading fees.

Risk To Encounter in DeFi

The total value of all the stocks, bonds, and other assets sold in financial markets currently sits at around $80 trillion. This is the market capitalization of the global stock market. It is still 40 times larger than the total cryptocurrency market capitalization. The total value of ETH locked into DeFi is over a thousand times smaller than the market capitalization of the global stock market.

What is investment without risks? There are risks in DeFi. For liquidity providers on automated market makers-based DEXs, volatility can lead to impermanent loss. This poses a bigger problem. Digital assets are notoriously volatile. This means that the possibility of losing your entire investment is equivalent to making a small fortune from it atimes.

Sometimes it is even better to hodl. The reason is that sudden drops in price can drastically cause huge losses owning to the way Automated market makers find the value of a token. They use the basis of ratio of paired tokens in the same pool.

There is a risk of newbies being scammed. The invest in the volatile market. When those beginners loose, they start having bad perception about the DeFi space.

Terminologies:

Automated Market Makers (AMMs)
ERC-20 tokens
Stablecoin
Impermanent loss
Smart contract audit

Research More On:

Pegged Currency
How to Wrap Bitcoin for DeFi
A Dive Into Staking

We are about to enter the last level. This is the expert level to step by step guide on investing in decentralized finance (Defi).

Expert’s Guide for DeFi

Governance is a large part of DeFi protocols. It lets the people involved to determine various network attributes, including interest rates, staking parameters, etc. The real power of decentralized finance lies in how it affords control over the network’s market characteristics to its participants. However, it may allow people to trade with each other in an environment that lacks trust entirely.

In In April 2022, there’s close to $81 billion in assets locked into decentralized platforms. This is a huge growth compared to March 2020. When the total value of ETH locked (TVL) into DeFi platforms was just an amount of $700 million. The huge growth was due to the hype generated by “yield farming”. It is a method exclusive to the decentralized finance space that can make you a lot of money when done correctly.

The journey of yield farming (liquidity mining) began as the Compound DeFi credit market started distributing its native COMP token to both borrowers and lenders on the platform around June 2020. People understood that loaning out this COMP token could lock more profits and cause huge pump in the token. Liquidity is the source of profits.

Explanation of Yield Farming or Liquidity Mining

On AMM-based decentralized exchanges, anyone can create a pool using a pair of tokens by depositing an equivalent value of both tokens into the pool. To get a better view, let’s put the concept of liquidity pools into consideration.

Furthermore, let’s say there’s a pool for the ETH/USDT pair. This simply means the pool would contain equal value of USDT and ETH, meaning if you wanted to buy 1 ETH, you would have to deposit USDT that has equal value with 1 Ether token.

Pools are bases for Arbitrage opportunity. Its liquidity is relatively small. This is the reason behind the encouragement provided by AMM-based DEXs to liquidity providers. The initial value of Tether token increases slightly. Its value is small, compared to ETH. Therefore, on a small scale USDT increases the pool’s value in return.

Larger liquidity pools have effects on token prices even from a single purchase done by whales. This is because whales hold more significant positions, but this also depends on the size of the liquidity pool. To normal traders, reverse becomes the case. Governance tokens enables DeFi platforms to motivate their users positively. This provides liquidity for the platform.

Meaning of Governance Tokens and DAOs

Users propose changes to the protocol, and as well create Decentralized Autonomous Organizations (DAOs) through governance tokens. They also grant holders voting rights to proposals made on a particular platform. Since 2017, governance tokens have been in use. They are equally not new to the game.

With regards to DAOs, participants can vote on how a treasury allocates a network’s money. The DAO itself can contract work from other individuals, private companies, or even other DAOs. Decentralized networks that hold a treasury of capital, similar to a fund managed by a group of distributed and unrelated individuals is what we call DAOs.

All the capital in DeFi platforms is on a single network. I don’t see any reason to put much focus on it, since Ethereum doesn’t have a cross-chain communication with other blockchains. The expansion of the DeFi ecosystem is getting out of hand. However, as the competition goes on, almost every DeFi platform has a better advantage. Ethereum network is the base.

Interoperable Communication in DeFi

Cardano, Polkadot and Polygon are projects that do not require a trusted third party before passing information and value through decentralized networks. Our next research topic is for DLT being interoperability.

The function of an interoperable web of blockchains is to help distribute capital across multiple networks and protocols. This distribution makes the market more accessible and decentralized. Any effort made for DeFi platforms to be interoperable, gives the problem a different approach.

In order to provide internet access for computers, TCP/IP created a standardized protocol. The online products and services we know and love today has increased owning to this access. However, to make DeFi the dominant platform for financial transactions and services worldwide, interoperable standard is nothing but the start. Interoperability will eventually find its way into blockchains because it’s very important.

CONCLUSION

I hope you impressed by the step by step guide on investing in decentralized finance (Defi). Things you should study more are: Beginner’s guide in DeFi, Ethereum and smart contracts, Decentralized applications and Automated Market Makers.