You can think of DeFi as the “crypto way” of doing traditional finance services. In the familiar world of banks (TradFi), you go to the bank to save, invest, borrow, or get insured. They act as middlemen, managing your money and charging fees for their services.
DeFi cuts out the middleman with the power of technology. Instead of banks, DeFi uses protocols that run smart contracts on the blockchain. Here’s a simple breakdown of how each piece of technology works in the DeFi ecosystem:
- Blockchains are like giant, public record books for crypto. Every transaction is stored securely and can't be changed. Think of them as the unbreakable foundation for DeFi.
- Smart contracts are self-executing agreements written in code. They lay out the terms for financial interactions, like borrowing or lending, in a clear and transparent way. Once set, these contracts run automatically on the blockchain, removing the need for a trusted third party like a bank.
- Protocols perform financial services using these smart contracts. For example, a lending protocol uses a smart contract to interact with borrowers, secure their collateral, and charge interest. At the same time, another smart contract interacts with lenders, holds the lent funds, and pays interest.
- Liquidity pools are digital pools of crypto that function similarly to a giant savings account. These pools fuel activities like lending, borrowing, and trading within DeFi. Users who contribute to these pools, known as liquidity providers, help keep the system running and earn interest in return.
The beauty of DeFi is that it removes the need for trust in middlemen. Smart contracts ensure everyone follows the agreed-upon terms, making DeFi a revolutionary way to participate in the financial world.
DeFi might seem radical, but it's part of a long human tradition of adapting financial systems to new realities. Remember the days you relied on the postal service for every message? Email, powered by decentralized protocols like SMTP, changed that game. DeFi is the email revolution for finance, offering a faster, more transparent way to manage your crypto.
Now that you have an understanding of who’s who in DeFi, let’s dig into how you can make money with DeFi. Next, we’re breaking down what DeFi yield is, and where it comes from.