Decentralized finance and decentralized apps are simply services that are able to operate without a single, centralized governing body. This type of structure promotes a more trust-less ecosystem and circumvents the risks associated with a centralized entity controlling your funds for you.
Below are some common DeFi activities that offer extended utility to cryptocurrency assets and incorporate blockchain technology in their financial solutions.
Staking
Users can contribute funds to a validator pool in Proof of Stake (PoS) blockchains to participate in the process which secures the network and produces blocks. The pool receives block rewards from the network (see What are Gas Fees?) for the contribution and distributes these rewards to pool participants. Depending on the blockchain network, staking funds typically introduces another layer of risk (ex. counterparty and slashing). Stakers will often receive a liquid staking derivative (LSD, LST, LRT - see Alternative Asset Types) to represent their holdings in the stake pool and to be used in other decentralized finance activities.
Ex. Rocket Pool
Governance/Voting
Many decentralized organizations (DAO) and DeFi protocols will create governance tokens to invite holders to participate in the official decisions and vote on various business activities. These strategies are providing ways for decentralizing governance and putting the power into the hands of the holders, users, and traders.
Ex. Chainlink
Liquidity Provision
Investors can earn a share of the fees generated by an exchange for swapping between cryptocurrencies by contributing funds to a “liquidity pool.” Deposits typically include two currency assets and improves the trading experience of the platform by allowing users trade your funds back and forth. Rewards received are dependent on the amount of volume that is traded and your potion of the total pool size. Providing liquidity exposes risks of impermanent loss and should be considered carefully (see investment risks).
Ex. Uniswap
Borrowing/Lending
Users may deposit cryptocurrency assets onto lending platforms in order to both receive “yield” rewards and/or for use as collateral to borrow other cryptocurrency. This type of functionality improves user liquidity by allow for easy short-long term loans and access to capital without requiring the sale of your current holdings. Commonly, a cryptocurrency asset (such as ETH or WBTC) is deposited and a stable coin (USDC) is borrowed and will need to be repayed in order to retrieve the collateral (see rehypothecated). Additional strategies include “looping” your deposit by using the borrowed asset to purchase more of the original collateral, to then deposit and borrow against again - further increasing the risk/reward.
Ex. Aave
Derivative Futures & Perpetuals
Advanced functions include using various cryptocurrencies as collateral for futures positions, allowing you to “long” and “short” selective assets. This also introduces leverage to increase risk/reward multiplicatively, but beware of extreme volatility which may lead to liquidations - complete loss of your collateral.
Ex. Hyperliquid
Important:
Always ensure you are interacting with reputable projects and protocols by referring to official resources such as those below - we encourage checking multiple sources before connecting with any websites for the first time
Resources:
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Catalog of cryptocurrency protocols
- Expansive list of assets and blockchain projects
- Exhaustive listings of tradable assets on variety of networks
- Use community engagement and mutual connections validate protocol profiles
Warning: Decentralized finance platforms are a completely new industry and it may be difficult to differentiate the legitimate organizations from the scammers. Please exercise extreme caution when exploring new websites and new protocols. There are bad actors everywhere who are trying to steal your coins and it is our responsibility to avoid them as best we can. Please see common scams for more threats to avoid.
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