Decentralized Finance, or DeFi, refers to a financial system built on blockchain technology that operates without traditional intermediaries like banks, brokers, managers or even the government. Instead, DeFi uses what are called smart contracts on decentralized platforms to facilitate financial transactions and other services. While traditional finance (TradFi) has its own well known advantages such as having access to your local legal system and security enforced through regulatory frameworks subject to audits and compliance requirements it also has its limitations.

DeFi was designed to be robust conceptually and technically. The decentralized architecture combined with concepts such as gas, validators, proof of work, proof of stake, the consensus system, bridging, the virtual machine besides other resources allow such networks to operate at global scale and not be subject to any particular authority.

It provides accessibility, transparency, resilience and makes it impossible for external agents to block or freeze your assets giving users the power of irrevocable self-custody and the freedom to transact anytime and anywhere in the world in a permission-less fashion.

With Great Power comes Great Responsibility

You are the only authority controlling your assets in DeFi, this means external agents can’t interfere with your portfolio but it also means they can’t help you either which is why doing your own research is the most important habit to survive in this ecosystem.

Here are some essential terms everyone should learn about the DeFi context:

Self-Custody: By far the most important concept in DeFi! Have you ever heard the phrase “Not your keys, not your crypto”? It refers to the fact that any cryptocurrencies you own inside a CEX (Centralized Exchange) do not actually belong to you meaning if anything happens to that Exchange you might lose it all!

DeFi solves this problem by allowing you to move your assets to a private digital wallet where the only way for anyone to access your money is by owning the cryptographic keys belonging to that particular wallet, which ideally only you have access to.

Digital Wallets: Unlike what most think, your assets are not stored in your digital wallet! Everything, including your transaction history is stored in the blockchain. Your wallet gives you access to anything in the block chain that belongs exclusively to you.

The so called Hot Wallets allow users to connect to applications on the Internet where a large variety of services are available such as trading, buying coins, P2P market, swapping, lending, etc. Alternatively the Cold Wallets are intended for maximum security. They allow you to isolate your private keys from the external world and they are only used to sign/authorize transactions.

BlockChain: A system that records every operation executed by the network in a consistent way so transactions can be verified for legitimacy and data can be stored. This concept was introduced by Bitcoin which is a coin with its own network. Ethereum (ETH) uses a different network capable of supporting multiple coins.

Tokens: Tokens serve a large variety of purposes. They can be coins such as Bitcoin (BTC), Ethereum (ETH), Solana (SOL), etc. as well as NFTs (Non-Fungible Tokens). They have market value and they can be traded. On centralized exchanges (CEX) they represent the assets you own.

NFTs: Non-Fungible Tokens are unique digital assets that represent ownership or proof of authenticity of a specific item. They can be used for digital art, as collectibles, domain names, or to represent the ownership of something in general.

Nodes: Machines participating in the network. When a client requests a transaction the request is sent to multiple nodes in the network responsible for processing the request, validating the operation and recording the data on the block chain.

Validators: Validators verify every operation in the network using cryptography and the consensus system. Validators might be required to stake the network’s token used as gas and they get rewarded this same token as payment for the services provided to the network which makes decentralization viable.

Gas: Every operation has a cost, this is how node operators get paid for their time and energy spent maintaining the network operational. Gas represents such operational costs. Some networks allow users to pay more or less gas depending on how fast they want their transactions to be processed. Example: The Ethereum network has multiple coins but every transaction is paid in ETH, the native gas token.

Smart Contracts: Smart contracts are pieces of code that get executed by the nodes to allow functionality to be accessed automatically. Example: A user might want to swap some ETH for USDT, in this case the smart contract will check the ratio between the coins, check if there is enough funds in the user’s wallet, check if enough liquidity is available in the exchange and execute the swap if all conditions are met.

dApps: Decentralized Applications are applications on Web 3.0 available for anyone who wants to interact with DeFi services. Protocols use dApps as an interface between users and the platform's multiple smart contracts.

Stablecoins: Unlike most cryptocoins subject to arbitrary volatility, a stablecoin's job is to keep its value always the same. A stablecoin's value is pegged to a Real World Asset (RWA) such as the US Dollar, Euro, etc. They work as synthetic versions of fiduciary money (and it’s partially backed by it) but made available as cryptocurrency.

Liquidity Pools: Liquidity pools are funds locked in a smart contract on a decentralized exchange (DEX) or other DeFi platform. These funds are provided by users, known as liquidity providers, who deposit tokens into the pool so that they can be used by others without the need for a middleman. Liquidity Providers are incentivized by earning fees every time someone swaps between the assets they provide.

Staking: Validators can stake large amounts of money in the network in order to participate in the consensus system. If a validator is somehow corrupted the network can execute a process called slashing where the money at stake is subtracted from the validator as a penalty and the validator loses its reputation. The risk of staking is compensated with fees generated by the network. Retail users can also stake their own coins or delegate part of their assets to specific validators in exchange for shared profit.

Bridges: DeFi is not just one big network. It’s closer to a network of networks! Most of these networks are completely independent relative to each other. Bridge protocols provide a way for people to move assets from one network into another. Example: You have some USDT on the Polygon Network but you want to use it on the Solana Network, you’re gonna need a bridge to do that for you.

Governance: Immutability is highly valued aspect in DeFi but when changes need to be made some protocols make a voting system available. Decisions are taken based on votes accounted for by special tokens minted for this specific purpose and they are called Governance Tokens. Governance systems use such tokens to help approve changes of common interest to protocols.

DEX: Short for Decentralized Exchange. Some of them provide simple services such as swapping and bridging coins while others offer a fully featured set of tools such as perpetual futures trading, limit orders, liquid staking, Automated Market Makers (AMM), etc.

P2P Market: The Peer to Peer market allows retail investors to exchange coins directly. You can buy some Bitcoin directly from a trusted friend using fiat money or straight up trade crypto currencies with another person using your hot wallets connected to blockchain networks.

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Mastering the Decentralized Market

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TradFi relies on centralized institutions, intermediaries, and regulatory frameworks to provide financial services and shield users as well as its infrastructure from potentially dangerous activities.

DeFi represents a transformative shift in the financial industry, leveraging technology to create an open, transparent, and accessible financial ecosystem. Many investors still see DeFi as a system in its early stages, packed with highly profitable opportunities, huge potential for innovation and of course risk to be managed.

The most important lesson every investor learns with DeFi is that doing our due diligence pays off and taking responsibility in your own hands is the best strategy to win.

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