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Beginner’s Guide to DeFi

guide to defi

What is DeFi?

“I want my bank to have even more control of my life!”
Said no one. Ever.

DeFi stands for “Decentralised Finance”, as opposed to the centralised, regulated kind of finance that rules your life with an iron fist.

The promise is this: you can be your own bank! You can lend! You can borrow! You can trade! No credit rating can stop you!

It’s a big idea that you might find either exciting or scary, depending on your personality. Don’t worry though: there are ways to profit from DeFi that are suitable for beginners, or people just dipping their toe in the Ether.

How does DeFi differ from traditional finance?

DeFi is exclusively digital numbers in a database. The “tokens” that run it don’t exist physically. However, most of the dollars in circulation in the world don’t exist physically either. The big difference is where the numbers are stored. Centralised Finance stores its numbers in its own servers, which it shares with trusted third parties (including Governments).

Decentralised Finance records are stored in public, on a network of privately owned computers, and while the transactions are traceable, the people generally aren’t (there’s no visible database connecting identities to blockchain addresses). The people owning the computers have no control over how the blockchain works.

This probably sounds scary: but blockchain technology was built to operate in the open without having to trust the people doing it (“trustless”), and to let anyone join in (“permissionless”). This makes the technology impossible for Governments to control or exclude people from.

Another big difference is that DeFi doesn’t deal in actual currency! It deals in “digital assets”. In this context, a digital asset is a “token” you can own that lives in a digital ecosystem called a “blockchain”. The tokens act suspiciously like money but are treated by the legal systems of most countries as property. This has some unexpected tax implications!

A “blockchain” is a shared global database on many privately owned computers worldwide. Its primary job is to record transfers of assets between “addresses”. An address is like a mini-wallet that can “hold” tokens, and a blockchain can have an infinity of them.

Building a Smarter Blockchain

Some blockchains do a lot more than just store transactions. Smart blockchains like “Ethererum” function as a self-contained, entirely automated organisation.

Jargon alert: these are called “DAOs” – Decentralised Autonomous Organisations.

How are they automated? Well, if you imagine every employee and function in a company replaced by predictable scripts and computer programs, you’ve pretty much got it. These scripts are called “Smart Contracts”. Stick a user interface on it, and you have a “dApp”.

Tokens Galore

There are thousands of Cryptocurrency “tokens” and a ton of blockchains. The big-hitting Cryptocurrencies are the current leaders, Bitcoin and Ethereum, which are both blockchains and Cryptocurrencies.

Ethereum is the standard in DeFi. Every blockchain has a “native” token that keeps it running (a super-token, essentially), but most newer blockchains can host other tokens. This includes blockchains such as “EOS”, “Tron”, “Binance Smart Chain” and many more. There are thousands of tokens that use Ethereum.

Wrapped Tokens and Stablecoins

In general, blockchains don’t know about each other’s existence unless they’re specifically programmed to provide compatibility.

That’s certainly true for Bitcoin and Ethereum. But Bitcoin is the big gorilla of the Crypto world! If DeFi could access Bitcoin, how would people use it?

This problem was solved by implementing tokens that are placeholders for other things. For instance, a “Wrapped Bitcoin” (wBTC) is a token useful for DeFi that (through smart contracts) represents real Bitcoin.

It’s also possible for a token to be pegged to a real-world value: for instance, there are numerous “Stablecoins” that are linked to the US Dollar, some linked to the Yen, the Yuan, the Euro, etc. These use smart contracts to keep the value of the token stable against its underlying currency.

Moving Money for Profit

The whole point of using DeFi is to generate a profit (passive income). This profit is called a “yield” (it’s like interest).

In DeFi, that usually means moving tokens around to generate yields (usually on the same blockchain), a process called “Yield Farming”.

However, on Ethereum, there’s quite a big, fat problem with that idea if you do it yourself.

Fees fees fees

DeFi promises lower fees than traditional finance, but, at least on the Ethereum blockchain, it hasn’t lived up to that promise. Fees for moving tokens around are currently way too high because the Ethereum infrastructure is creaking at the seams. There is a roadmap for Ethereum 2.0 which fixes this problem and solves the capacity issues. It also reduces the environmental impact of the token. But until ETH 2.0 reduces the transmission fees to sensible levels that don’t make a nonsense of your yield, it makes sense to move your tokens around as little as possible.

So, let’s look at the ways you can use your tokens. What? You don’t have any tokens? No problem, you can buy some to start off with!

Where do I get tokens?

The cheapest price for Ethereum or other tokens would be from a low-cost exchange, though any cost savings might be cancelled out by withdrawal and transmission fees.

You could also use a DEX (De-Centralised Exchange), in which you’re dealing directly with other buyers/sellers. This doesn’t require authentication.

However, the sky-high transmission fees on Ethereum mean that it makes financial sense to buy your tokens as near as possible to where you’re going to use them first. If this is in-app, then it makes sense to do that!

For instance, our AQRU app (that offers interest on your Crypto and tokens), allows you to use trusted provider MoonPay to buy Crypto and Stablecoins in-app. This saves money and hassle.

The good bit – what can you do with your tokens

There are two things you can do that should be familiar: depositing and borrowing. But, there’s also lending (which traditionally has been restricted to banks), and there’s staking, which is new to DeFi: it’s similar to depositing but more complex.

1. Depositing

In the world of traditional finance, deposit accounts are a waste of time. The return you get is rarely bigger than inflation, and the banks are using your money to make a fortune at your expense.

In the world of Crypto, things are quite a bit different. Yield rates on depositing Crypto (and Stablecoins) are higher than in traditional finance because of the rates that can be charged to borrowers.

Whether you choose Crypto such as Bitcoin or Ethereum, or Stablecoins really depends on how important real-world currencies are to you.

If you don’t like the idea of the dollar value of your investment going down, then you would buy Stablecoins and invest them somewhere such as AQRU, where you could earn a 7% yield on them per year.

Some people don’t care about regular currencies, however: they believe that the future is Crypto and just want more of it!

If you’re in this camp, you’d buy Bitcoin or Ethereum and then invest that to earn yield. You wouldn’t care about the volatility in the price of the underlying asset against real-world currencies.

If you’re dealing with a company providing investment services (such as AQRU), you need to ensure they are reliable, trustworthy and secure. You’re handing over assets after all!

A good company adheres to money laundering regulations, has a solid reputation and has enough assets to back up their activities, as well as transparency about what they do with your assets.

2. Staking

Staking involves depositing your assets into a pool where you can’t touch them for a length of time (unless you’re with AQRU), so you can earn rewards. This is different to depositing because it’s the blockchain itself that provides the rewards: this could be more of the same token or payment in a completely different token.

The line between depositing and staking can become blurred when a private company owns a blockchain and pays yield in its own tokens, or when a company becomes a middleman selling shares in a pool. Then you’re dealing with a company, not a technology, and the usual rules apply: make sure they’re regulated!

3. Lending and Borrowing

This article doesn’t have many good words for banks, but one thing they’re good at (most of the time) is risk management. In fact, it’s arguable that risk management is their primary activity.

DeFi promises “be your own bank”. There are lending platforms that let you lend to people, which have the technology to make it happen: but is it wise?

In the end, the main risk in Crypto isn’t the technology: it’s people – bad programmers who create buggy code, greedy people who scam other people, unreliable people who don’t pay back loans, and others.

Banks use knowledge of the person or business to assess risk, and they pool risks together to try and balance them out.

In Person-to-Person (“P2P”) lending, you don’t ever know who you’re lending to and have no idea how likely it is you’ll get your money back.

The way P2P lending works is that the borrower has to put up an amount of Cryptocurrency as security for the loan (say, $10,000 of US Dollar Stablecoins).

Then they borrow (for example) 75% of that value as something else that they think might go up in value. The borrower hopes to make a profit on that Crypto so they can pay back the loan and any fees. If the loan isn’t paid back, then the lender keeps the underlying USD Stablecoins.

You can certainly make a profit off this activity, but it sounds stressful at both ends!

P2P isn’t the only option available to borrowers: some Crypto apps and exchanges also offer the chance to use your Crypto/Stablecoins to borrow other Crypto.

Why on earth would anyone do this?

In a phrase: “Yield Farming”. The idea is that you make a profit in one place, and re-invest it in another to make more profit, and then continue doing that.

Sounds good? Well, in theory, it’s a sound idea if your research and maths are good enough to find the opportunities.

There are some drawbacks though.

First of all, we’ve mentioned transmission fees. Moving your tokens from one opportunity to another can wipe out any profit you make until fees become much lower.

Secondly, when you’re farming it makes sense to wait until the crop is “ready” before harvesting it, otherwise you’re just micromanaging tiny sums that don’t generate any meaningful return. This means that for some of the time, the yield is doing nothing.

It can be argued that the best kind of Yield Farming is the kind that happens automatically: i.e. your yield is re-invested automatically. That way, it is never just sitting there.

Interest-bearing Crypto savings accounts like AQRU pay interest every day, and that’s automatically re-invested without any extra fees, effort or research. That’s the easiest kind of Yield Farming.

Risks of “pure” DeFi

Many people are attracted to the idea of finance without Government involvement. While it’s difficult to impossible to shut down technology, it’s not impossible to shut down companies or to prosecute individuals who have been moving money back into the traditional finance system and who are evading tax.

All Crypto activity is taxable: no exceptions. Some people are leaving their funds in the Cryptosystem forever, hoping for the collapse of Governments and regular finance… but that’s probably an unrealistic goal if you want to enjoy any profit.

The Future of DeFi?

That’s still in the hands of regulators and politicians. They might not be able to police the ecosystem, but they can certainly police the companies and individuals that interact with it.

How can I make money with DeFi?

The simplest and yet most intensive way to profit from DeFi would appear to be interest-bearing Crypto accounts, such as those provided by AQRU. It does require you to go through KYC. On the other hand, if you live in the real world, someone somewhere is going to get interested in what you’re doing anyway, and it’s best to be upfront about it.

The app (iOS/Android apps and website) allows you to earn a nice, hassle-free yield from your Crypto without any technical knowledge, a minimum deposit of only 100 Euros, the ability to buy what you need within the app, referral fees and more. The only fee is $20 to withdraw to Crypto, but withdrawal to real (“fiat”) currencies is free too. Sign up for free today and see how you could start earning high returns with DeFi.

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