What is DeFi?

DeFi is attracting a great deal of attention as a completely different financial system from the conventional ones. We will explain its fundamentals, advantages and disadvantages, and available services.

DeFi means decentralized finance

DeFi stands for Decentralized Finance. It is an unconventional financial system and a blockchain service based on Ethereum (ETH), a crypto asset (virtual currency). In addition to being used for payments with crypto assets, it is also attracting attention as an investment platform for asset management and has a number of key points.

Financial system without administrators like banks

Traditional banking is known as "centralized finance," in which banks act as central managers, earning fees and managing assets under the trust of their users. DeFi is unique in that it does not have a central administrator, but rather allows users who participate in the blockchain to perform transactions directly with each other.

Because blockchain technology does not consolidate information in one place, but shares it among many participants, the accuracy of the recorded information is assured. In addition, smart contracts can execute contracts on the blockchain automatically causing certain actions when predetermined conditions are met, allowing for fraud-free transactions without the presence of an authoritative and trustworthy administrator such as a bank or credit card company. These elements allow DeFi to provide secure, fraud-free transactions. It is these elements that allow DeFi to function properly.

More information on smart contracts can be found here.
Smart Contracts

DEX (Decentralized Exchange) is a crypto asset exchange where there is no administrator. People who want to buy and sell crypto assets can trade directly with their own wallet addresses. As described in more detail below, DEXs also have specialized applications for payments, investments, and gambling.

Advantages and precautions for DeFi

As with many services, DeFi has some great features, but there are also some aspects that you need to be aware of when using it. Let's take a look at some of the benefits and caveats of DeFi.

Benefits of DeFi

Many of DeFi's advantages stem from two things: it is based on blockchain technology and it has no administrator. Unprecedented advantages include the following.

・Low transaction fees

Many services around the world take additional time and effort due to the number of intermediaries between the provider and the user. This is often in the form of a fee, which is paid by the user of the service.

However, in the case of DeFi, since it is a mutual transaction between users, there are no commissions. This makes it fast and inexpensive, which is a major benefit.

・No geographic restrictions, available worldwide

In the conventional financial system, transactions across national borders required a large amount of time, effort, and fees. Differences in legal systems tend to limit the regions that can be serviced.

In addition, in many developing countries, cash management systems and financial infrastructures are not well developed, and financial services that should be common in developed countries are not available in some areas.

However, with DeFi, as long as you have access to the Internet, you can receive the same service anywhere in the world, which is a big advantage.

・No need to present personal information and identify yourself

Conventional financial institutions require verification of personal information when opening an account. With DeFi, however, there is no need to do this because there is no administrator. All you have to do is connect your wallet to DeFi and you are ready to use it.

Many crypto asset wallets can also be used by simply registering an email address and setting a password, which means that there is a low risk of personal information leaks.

DeFi Notes

While DeFi has many advantages, there are also some points to be aware of. Since it is still a new and developing service, it is important to pay attention to the relevant information before using it.

・Fraud and other problems are rampant.

Fast-growing fields tend to attract large numbers of novice users, and scams targeting them tend to be rampant. DeFi has also experienced phishing scams and fraudulent projects that were intended to defraud people out of their funds.

Since DeFi has no administrator, there is no concept of consumer protection, and the service is not licensed by the Financial Services Agency. Please note that if you make a mistake on a remittance or get scammed on a fraudulent website, you are entirely responsible for the consequences.

・There is a risk of variable loss associated with a crash of crypto assets

Since DeFi is a financial service that uses crypto assets, crypto assets must be prepared in advance.The value of crypto assets is constantly fluctuating and can move significantly even within a single day. Therefore, a crypto asset crash could result in a significant loss.

・Gas costs

Blockchain-based services require the transfer of assets and transactions to be recorded on the blockchain. As a reward for this work, users pay a fee called a gas fee.

This gas fee does not have a set price. You can assume that faster processing is more expensive. In Ethereum (ETH), where many services are offered, this processing can have a large queue. This causes priority processing to become more competitive, thus the gas price skyrockets.

Sometimes, a single transaction can cost several thousand JPY or even more in gas bills. It is necessary to be creative, such as aiming to process at times of the day and times of the year when it is not crowded.

・Many DeFi products do not have language support

There are many DeFi services available, but most of them are in English. Users who are not comfortable with English will have to make use of Google Translate and other tools. However, it is easy to make a mistake in this way. Please be careful.

Searching by the name of the service may also lead to fake and fraudulent websites. To avoid this, it may be a good idea to follow links from the official X (formerly known as Twitter) feed of the service.

DeFi's Future

For the healthy development of DeFi, and for it to be recognized and used by many people, some kind of regulation is necessary. However, the traditional framework cannot be applied to DeFi without an administrator, and cross-border transactions are already taking place through DeFi. Cooperation among countries is also necessary to make it a stable financial service while taking advantage of this momentum.

The Vice Chairman of the U.S. Federal Reserve Board has proposed a regulatory framework for DeFi, expressing the view that while there are high expectations for the future of DeFi, regulations should be established while the scale of activity is still small. The Japanese government has already established the "Web 3.0 Policy Promotion Office" in the Minister's Secretariat of the Ministry of Economy, Trade, and Industry to develop a Web 3.0 environment, and is moving forward with the development of a new digital environment that includes DeFi. With these moves functioning, DeFi should be able to develop in a healthy manner while maintaining a high degree of freedom.

How to make a profit with DeFi?

There are several ways to use DeFi for asset management. Each has its own characteristics, and the annual interest rates you can expect vary considerably, so be sure to fully research and understand what they are before you begin. Here we will look at a few ways to profit from DeFi.

Yield farming

Yield farming is a mechanism whereby participants deposit their crypto assets into a DeFi service to provide liquidity and earn interest and commissions. Originally, DeFi had the disadvantage of having no administrator, making it difficult to prepare large amounts of assets and to make large transactions. In other words, low liquidity.

Therefore, a "pool" was created on the DeFi platform, where participants deposit their crypto assets and receive a portion of the fees paid by borrowers as interest. While acting as a bank that collects funds from many participants, it receives more interest because there is no administrator.

Liquidity Mining

Liquidity mining is a mechanism whereby crypto assets are deposited into the DEX, a financial application required to perform DeFi, and a governor's token is issued in proportion to the amount deposited. This is like a stock certificate. The DEX's reputation grows, so does its value, and if it is subsequently sold, it can be sold for a large profit.

This is called liquidity mining because it mines governor tokens by providing liquidity to the DEX.

Lending

Lending is the deposit of assets on the DeFi platform for a predetermined period of time, which are returned with interest at maturity.

Lending is also available on crypto asset exchanges, but while most exchanges offer an annual interest rate of around 1-5%, you can expect a higher yield if you use a service that specializes in lending.

Staking is a system in which you are rewarded for depositing a certain amount or more of a particular crypto asset and participating in the blockchain. The amount of reward depends on how much of a crypto asset is held and for how long.

This method allows for investment without moving assets, but if a lock period is in place, the deposited crypto assets cannot be moved for a certain period of time. If there is a price collapse during this period, there is a possibility of a significant loss of principal. This is a method that aims for long-term positive returns rather than short-term gains.

Staking

Staking is a system in which you are rewarded for depositing a certain amount or more of a particular crypto asset and participating in the blockchain. The amount of reward depends on how much of a crypto asset is held and for how long.

This method allows for investment without moving assets, but if a lock period is in place, the deposited crypto assets cannot be moved for a certain period of time. If there is a price collapse during this period, there is a possibility of a significant loss of principal. This is a method that aims for long-term positive returns rather than short-term gains.

Typical DEXs you should know about to get started with DeFi

To get started with DeFi, you will use a DEX. The DEX does not provide financial management services like a crypto asset exchange, but is a financial application that connects users to the DeFi network.

Each DEX has its own features as shown below.

・Uniswap

Uniswap is a DEX that launched in 2018 and was one of the first DeFi applications. As of September 2022, it is the most popular DEX with the highest volume of transactions per 24 hours among all DEXs.

Although the development is carried out by a company, it also has an aspect of a DAO (decentralized autonomous organization) in which each participant cooperates to advance the project, and decisions are made through community voting.

Another important feature of Uniswap is that it allows trading of more than 1,500 types. This is a recommended DEX for those who want to try trading minor crypto assets.

・Aave

Aave is a lending platform that supports more than 30 different types of crypto assets. In addition to lending, which earns interest based on the amount of currency deposited, the platform is equipped with unique features such as flash loans, which allow users to borrow crypto assets without collateral, and credit mandates, which allow users to receive interest on the deposited currency as well as lend it out and earn interest on it.

Aave's lending service has a reputation for being a relatively low-risk investment method.

・yearn.finance

yearn.finance is a service that automatically searches for and invests in the best crypto assets through lending.

There are already a large number of crypto asset lending services in existence, making it difficult to manually select the most lucrative ones. yearn.finance reduces this workload.

YFI, the native token of yearn.finance, attracted global attention when its price spiked, albeit temporarily, in May 2021. It is one of the DEXs to keep an eye on in the future if you are looking to trade with high yields.

・Stargate Finance

Stargate Finance, the issuer of the crypto asset Stargate is unique in that it is cross-chain compatible. Many crypto assets are not compatible with the blockchain itself. As a result, direct money transfers between different currencies are no longer possible. Cross-chain, however, makes it possible to transfer currencies between different chains. As of September 2022, seven currencies are supported, including Ethereum (ETH).

Although Stargate Finance is a project that just started in March 2022, many investors and traders have already declared their investment. It is ideal for those who want to challenge the emerging DEX.

・Instadapp

Instadapp is a somewhat unusual service. It allows you to use the multiple DEXs introduced so far in a single interface. This is useful when you want to change the DEX used depending on the contents of the transaction or the situation at the time, and it also has a convenient function that allows you to perform tasks that require multiple steps to be performed at once. It is also useful for improving work efficiency and reducing network fees. It is recommended for those who want to manage various DEXs at once and trade efficiently.

How to get started with DeFi

Since DeFi does not accept JPY as-is, you must first open an account with a crypto asset exchange and purchase crypto assets.

Using bitFlyer as an example, here is the general process of using DeFi.

1. Register with bitFlyer or another crypto asset exchange

Open an account with an exchange. The specific procedure for opening an account varies slightly from exchange to exchange, so please follow the instructions.

It may take some time to complete identification and bank account verification.

2. Purchase the crypto asset of your choice

Deposit JPY into your exchange account and purchase the crypto asset of your choice. We recommend that you use your disposable funds and not overdo it until you get used to it. Ethereum (ETH), which many DeFi are based on, will be easy to use.

3. Prepare a wallet

There are various wallets available, but MetaMask is recommended if you want to use an Ethereum (ETH)-based DeFi. Also, if you connect MetaMask to bitFlyer, you can send money directly from your wallet.

More information on MetaMask can be found here.

What is MetaMask? Explaining Wallets for Storing Crypto Assets

4. Connect to the DeFi you want to use

Connect your wallet to the DeFi service you use, such as DEX, and begin trading.

If you want to start using DeFi, open an account with bitFlyer first!

DeFi is still a new financial service, and for that reason it has a promising future. Although there are some difficulties, we recommend that you first learn the basics and actually try trading.

Why not start by opening an account with bitFlyer and getting your hands on crypto assets?