The Role Of DeFi In Web3
Welcome to the 2nd edition of Web3 and More. Last week, we looked at the definitive overview of Web3 and I had prepared to dive deeper into each concept of Web3 such as the Metaverse and GameFi, but, I remembered most of my subscribers are crypto first-timers and would get confused if the role of DeFi in Web3 is not adequately explained and practiced.
Almost everything about cryptocurrency, the metaverse, NFTs and Web3 is connected to DeFi, yet many do not understand what it actually means in practice.
Hence, in this edition, we’re going to explain the role of DeFi in Web3, in the most practical words possible.
In order to do justice to this topic, we’re going to explore the following questions:
- What is DeFi?
- Essential DeFi Terms
- What Are The Benefits And Challenges Of DeFi?
- How Can You Protect Yourself In DeFi?
- What Is The Role Of DeFi In Web3?
- What Is The Best Way To Get Started In DeFi Now?
- What Next?
Note: This guide is written to help beginners make informed decisions in DeFi.
WHAT IS DEFI
The word DeFi stands for Decentralized Finance which is widely known as Open Finance in the world of crypto. Decentralized Finance in its simplest form is the gateway to accessing traditional banking services in an unregulated and unrestricted economy which is powered by smart contracts.
In other words, DeFi is the blockchain component that gives access to anybody, at any time with an internet connection to save money, lend money, borrow money, donate money and invest for higher earning rates without going through any authority.
With DeFi, the world’s unbanked population can now access and enjoy financial solutions that they were previously deemed unqualified for and in addition, they can engage with these platforms from any device and without registrations – just ‘plug’n play’.
For example, if you wish to lend money as an individual to someone you’ve never met, you can simply visit a DeFi lending protocol like Compound Finance, connect your crypto wallet, choose a currency you want to lend, enter the amount and approve the transaction and that’s it. You’ll start earning interest in the form of crypto tokens on a regular basis (per minute, hour or day) and you can still withdraw your funds or borrow against them at any time.
ESSENTIAL DEFI TERMS
While there are countless DeFi terms to understand, listing them all can easily get us confused, thus, we’ll be considering only a handful that are essential to this guide and subsequent editions on Web3 and More.
Smart Contracts & Smart Chains
Smart contracts are the life-line of every DeFi product out there. They refer to the written set of code that determines exactly how a decentralized platform or protocol works.
Smart Chains on the other hand are blockchain networks built for running or deploying smart contracts. For example, the Bitcoin network is not a smart chain and can’t run a DeFi application, while the Ethereum blockchain is a smart chain, hence, permits developers to build and deploy all kinds of decentralized applications on it.
DApp is the short form of ‘Decentralized Application’ referring to a blockchain software application that utilizes a DeFi framework. As you must have guessed, for an application to be considered a DApp, it must be powered by smart contracts and deployed on a smart chain.
DEX & AMM
DEX is the short form of ‘Decentralized or Distributed Exchange’. DEX is a type of cryptocurrency exchange that securely allows direct person-to-person crypto transactions online and mostly has no physical address, thus, is not bound by applicable laws or regulations.
AMM on the other hand, is the short form of ‘Automated Market Maker’ referring to a decentralized asset trading pool that enables the buy and sell of cryptocurrencies. AMM is most times used interchangeably with DEX since most AMMs are DEXs(pronounced DEXes) and vice-versa. For example, Uniswap and PancakeSwap.
APY is the abbreviation for ‘Annual Percentage Yield’ referring to the rate of return on your crypto investment on a yearly basis. APR which stands for ‘Annual Percentage Rate’ is the term for traditional finance interest rate but it is used interchangeably with APY.
TVL simply stands for ‘Total value Locked’, which means the amount of money or assets that is locked (staked) on a decentralized exchange or application.
Liquidity Pool (LP) is the life-blood of any cryptocurrency. It is a pool of funds being deposited by different individuals or entities to enable the buy and sell of a token on DEXs. Since tokens depend on these deposits to keep trading, they mostly offer high incentives for those willing to deposit their tokens to the pool of funds.
Each time you deposit into an LP, you’ll receive LP tokens which signifies the amount of share you hold in that pool.
This is the act of providing liquidity to a ‘liquidity pool’ in order to earn(mine) rewards in form of tokens.
Stake/Staking: This is the act of depositing your tokens on a DApp or CEX in order to earn additional coins for free. Interest rates are commonly stated as APY/APR.
Yield farming is the process of token holders maximizing their rewards across various DeFi platforms. For example, a yield farmer can deposit into 3 different liquidity pools, he can also take his assigned LP tokens and stake them on a DEX or yield farming platform like Aave, Uniswap, Beefy Finance etc.
Slippage simply refers to a difference in price between buyer and seller expectations. The slippage can range from 0.1 to 1%.
Every crypto transaction requires a Gas Fee (transaction fee) which is paid to crypto miners who are supporting that network. The amount of this gas fee will vary in cost depending on the network you’re processing the transaction.
Pause, take a second glance at the terms we just explained, especially the abbreviations, as they’ll be regularly used in later editions.
WHAT ARE THE BENEFITS AND CHALLENGES OF DEFI?
BENEFITS OF DEFI
- Openness: You don’t need to apply for any account or wait to be approved before using DeFi products, all you need is an internet connected device and a Web3 wallet like MetaMask.
- Accessibility: DeFi is effectively decreasing the wide gap in traditional financial inclusion, by giving people who weren’t granted access to open bank accounts to now process all kinds of financial transactions at their own convenience.
- Speed: Traditional money transfers can take up to days due to slow processes, but with DeFi, you can transfer funds in seconds or minutes.
- Autonomous: Financial institutions can block your bank account and freeze your funds for whatever reasons, but you are in complete control of your wallet in DeFi and are not restrained by time zones or working hours.
- Lower Fees: DeFi transaction fees are generally much lower than traditional financial transactions with fees costing just a few cents in USD (except on Ethereum) etc.
CHALLENGES OF DEFI
While it’s exciting to talk about the benefits of DeFi, there also exist a number of avoidable challenges that have cost many people lots of money, including myself.
The ability to learn from the mistakes of others rather than yourself, can best be utilized in DeFi.
Given that decentralized finance is still in the early stages, it has a steep learning curve that makes it harder for broader adoption. You’ll need to read or watch a number of tutorials and still hope that you got it from a trusted source, just to get started.
Also, some of DeFi’s advantages such as openness and absence of regulations can and are being used by malicious individuals to scam others.
For example, when a smart contract is deployed or live for you to interact with, there could be errors in that code, which hackers can take advantage of to access your funds.
Other times, it is the developers themselves that intentionally add a malicious command in the code that hacks into the wallet of anyone that interacts with their platform. Yet, there’s no regulation to make them pay, so it will likely go on for some time.
HOW CAN YOU PROTECT YOURSELF IN DEFI?
I must disclaim that I’m not a security expert, but over the years, I’ve researched and applied a number of security measures to protect myself in DeFi, some of them worked, while others were complete waste of time.
Here’s my top security (not investment) tips from those that worked:
Always Do Your Own Research (DYOR)
It is very easy to get carried away by the hype and FOMO (Fear Of Missing Out) but always pause for a moment to find out more about a project or platform before deciding to go forward with it. A very critical area to pay attention to is the founding team, are they credible, are they anonymous and if they are anonymous are there reputable figures backing them?
Opt For Audited Smart Contracts
While it is important to have basic coding skills to help you read codes and avoid projects with redflags, honestly, that is not possible for everyone. So, no matter how enticing a DeFi application might seem, if their code is not audited by a reputable firm, then don’t interact with it. If you must, then use the next tip.
Use Bunner Wallets For New Apps
This is one that I frequently use. Having a primary wallet where most of your assets are stored and having 1 or 2 more separate wallets which you can use to explore new platforms can greatly reduce your exposure to hackers.
For example, If you have $10,000 in your wallet and you wish to connect to a new platform, it is advisable that you create a new wallet, and transfer a dispensable amount from the old to the new wallet, then interact with the platform using the new wallet. If things go wrong, you’ll only lose the amount in the burner wallet and if things go right..well, to the moon you go.
Get a Hardware Wallet or MultiSig
Depending on how much value you’re holding, it is best to invest in a hardware wallet like Ledger Nano, Safepal and others. This will ensure that your valuable assets will be securely locked away from common software wallet compromises.
If you’re not in a good position to buy a hardware wallet, then a Multi-signature wallet like Gnosis which requires approval from more than one wallet to process transactions could be a good alternative.
Avoid Random Airdrops
Crypto airdrops are popular means for many beginners to get free coins or NFTs. For example, the world’s most expensive NFT collection ‘CryptoPunks’ was given out as an airdrop and we’ve equally seen token airdrops that crossed the $100,000 mark.
As good as this seems, it has quickly become the easiest method for hackers to drain investors assets. So please, do not click or connect to unverified airdrop offers.
Always Ask Questions
No one person knows it all when it comes to DeFi and you’ll be doing yourself more harm than good by not asking questions. No matter how embarrassing it might look, if it’s worth your money, then make sure to ask until you get the right answer.
WHAT IS THE ROLE OF DEFI IN WEB3?
Web3 has positioned itself as the decentralized version of the internet which utilizes blockchain technology, in practice, DeFi is the main component of blockchain that it utilizes.
Hence, DeFi is the primary framework of the Web3 economy.
In order to succeed in Web3 as an investor or creator, you’ll need to understand DeFi and how to interact with different DApps in order to use the Metaverse, buy and sell NFTs, play games to earn, create and monetize content and so much more.
HOW CAN YOU GET STARTED NOW?
First things first, get registered on a CEX (centralized crypto exchange) like Binance that offers most of the DeFI benefits that you could find on a DApp.
It is the easiest and safest method for beginners to test the waters and start earning from stable USD coins rather than jumping into high-risk high-rewards DeFi tokens.
Besides, almost every DeFi investor out there also hold an active account on centralized exchanges since they offer easier methods for us to fund our crypto wallets, withdraw our yield farming earnings to physical cash and they are also fully responsible for the security of the accounts, thus, take extreme measures to take that burden off our hands.
Here is a screenshot of some of the DeFi staking options Binance offers.
While they offer higher staking rewards for more volatile tokens, these are for stablecoins and the process of staking is more streamlined for beginners than on DApps.
However, the biggest scoops and earnings lies within DApps with APY ranging from 10s to 1000s per year.
In the coming edition, we’ll go through the process of setting up our first Web3 wallet, fund it using a debit card, interact with our first DApp, make a trade, deposit into a liquidity pool and start our first yield farming.
DeFi is a powerful blockchain component that is changing how financial services are provided and accessed. Even at this early stage, we’re already seeing the decentralization of almost every traditional financial service out there and yes, this is just the beginning.
If you forgot everything else, please, always remember to do your own research (DYOR) before engaging with any platform or applications, including the content in this guide.
I’m not a guru of any kind, but I hope that I can help you and others to make informed choices in Web3 and More.