You can start earning rewards in DeFi in just 3 easy steps. Here's everything you need to know in about how to get started with DeFi!
Decentralized finance, or DeFi, is creating a new financial paradigm that allows users to generate yield without needing a bank. In DeFi, users can also access investment opportunities that were previously only available to the wealthiest individuals and institutions. By learning how to get started with DeFi today, you can prepare yourself for the financial system of the future!
DeFi has grown significantly over the past several years. There are new lending protocols, exchanges, and markets launching all the time. All of these protocols offer potential investment opportunities.
In this guide, we’ll explain the most common investments in DeFi and the most reputable protocols. We'll also we’ll teach you how to protect yourself and mitigate risk. Most importantly, we'll explain how to get started investing in DeFi in just a few steps.
DeFi is a movement happening in the cryptocurrency and web3 world, and revolves around the idea of self soverign money. Which means you are in full control, and actually own these funds. Without anyone being able to censor you. This internet native money is put on a blockchain for everyone to verify. DeFi is short for decentralized finance. Decentralized finance runs on top of stablecoins, and native cryptocurrency assets called tokens. In decentralized finance you will see the same type of capbilities. You can lend, borrow, and do different things that can also be done in traditional finance as well.
DeFi apps will typically have a token involved. These tokens allows the protocol/DeFi app to “Decentralize” their decision making, which makes these tools owned and governed by a communitty. The community will often times act in the best interest of the token holder which will in turn stregthen the core value proposition of the protocol or DeFi app itself.
Why Does DeFi or Decentralized Finance Matter?
Is DeFi a good place to put my money?
Turning your cash into crypto to get started with DeFi can be done in just three steps!
Let’s go over a brief description of non-custodial wallets, then dive into the most common DeFi applications on the blockchain!
Creating a non-custodial wallet is one of the first things you need to do to get started with DeFi. Unlike with a centralized exchange, non-custodial wallets allow you to store your tokens privately. They are the most secure way to store crypto because nobody, except you, has access to it. They also allow you to connect directly to the blockchain to make investments without an intermediary.
Getting a good non-custodial wallet that you like using is one of the most important parts of your DeFi experience. You want a wallet that makes spending, sending, and investing your tokens easy, all while remaining secure.
A few options for wallets include:
MetaMask, launched in 2016 by ConsenSys, is one of the most widely used wallets in crypto. It works with EVM-compatible blockchains and can connect to just about every major DeFi application. It's a great wallet option for beginners and advanced users alike.
MetaMask has browser extensions for Chrome, Firefox, Brave, and Microsoft Edge. It's also available for download on any Android or iOS mobile device, and it's easy to sync across multiple devices.
The Rainbow Wallet, launched in 2019, is an Ethereum-compatible wallet with a great UX design. It is available on any Android or iOS mobile device but does not offer a desktop product. One notable drawback: The Rainbow Wallet can only be used on the Ethereum blockchain.
The Linen Wallet was founded in 2018 and is known for its unique approach to security. With the Linen wallet, you have 3 separate private keys. Keys are stored separately on your mobile device, in the cloud, and on Linen's private servers.
One single key is useless without the others, so if you lose one your crypto is still safe!
The Floors Wallet is specifically for NFTs. It allows users to track their portfolio with up-to-date stats on every NFT they own or are considering buying. It will even recommend when it is a good time to buy or sell based on recent market activity. This wallet is not available to the public yet, but you can join their waitlist or get early access by buying a Floors NFT here on OpenSea.
Once you’ve chosen a wallet and sent some tokens to it, the last thing to do is connect to a protocol!
One of the easiest ways to get started with DeFi is to invest with a lending protocol. Lending protocols are applications that connect lenders and borrowers directly on the blockchain with no 3rd parties. They allow borrowers to create complex transactions and allow lenders to earn a return.
To access this type of investment, lenders deposit their tokens into a pool that investors can borrow from. Borrowers continuously pay fees until they repay their loans. These fees go directly to lenders, proportionally to their total stake in the pool. If you own 10% of the total tokens in a lending pool, 10% of the fees the pool earns go directly to you.
Loans are always overcollateralized, meaning that borrowers have to lock up more assets than they borrow. If their collateral drops below a pre-determined threshold, their loan is liquidated to protect the lender. This process makes lending one of the least risky investments in DeFi!
In traditional finance, banks make money by lending out their customer's funds. Lending protocols simply remove the bank, allowing users to earn 100% of the rewards earned from lending their money.
Rewards generated on the blockchains are often significantly higher than the average savings account. Like, 1000% higher (we’re pretty sure that’s significant, right?)
Is that not reason enough to learn how to get started with DeFi!?
Two of the most popular lending protocols in DeFi are AAVE and Compound. Both offer lending pools in a wide variety of different tokens. Options include stablecoins like USDT, USDC, and DAI to cryptocurrencies like ETH, AVAX, or even Wrapped BTC. According to DeFi Llama, AAVE and Compound had more than $9 billion combined in total value locked (TVL) as of August 2022.
Decentralized exchanges, or DEXs, are another important part of the DeFi ecosystem. They are one of the first things to use when you're learning how to get started with DeFi.
DEXs allow users to cheaply swap tokens directly on the blockchain (read: without a middleman taking a cut). They also offer a unique investment opportunity: becoming a liquidity provider.
Some of the most notable DEXs that have processed billions of dollars in transactions include Uniswap, Curve Finance, and Balancer. Each supports Ethereum as well as its major layer-2 networks.
Unlike centralized exchanges, DEXs like Uniswap have public liquidity pools. Anyone, even if you're just learning how to get started with DeFI, can provide liquidity to these pools. These pools are a combination of two or more tokens, and allow users to swap one token for another.
Liquidity pools are the backbone of the exchange. By providing liquidity to the exchange, users keep DEXs liquid so they always have tokens to offer traders.
For example, a liquidity pool of ETH and WBTC allows anyone to trade ETH for WBTC and vice versa.
Liquidity providers make it possible for other people to trade tokens on the same blockchain easily, cheaply, 24 hours a day. Each time someone trades with the pool, they pay a small fee. Liquidity providers earn fees every time someone trades with the pool.
While providing liquidity typically pays a higher APY than lending, it also involves more risk due to something called impermanent loss.
The math behind impermanent loss is complex, but to keep it simple: as the value of one or both of the tokens in a pool fluctuates, the exchange rate of that pool changes. As the rate changes, the amount of each token that each liquidity provider owns changes along with it.
Let’s take the same ETH and WBTC pool as an example. If the value of WBTC rises in comparison to the value of ETH, liquidity providers will receive slightly less WBTC when they withdraw their tokens and slightly more ETH. This fluctuation always results in a lower total dollar value than if the user had simply held both tokens in their wallet.
That is ok, as long as the fees that the liquidity provider receives are greater than the impermanent loss they incur. It is always important to understand the tokenomics of a liquidity pool before investing. Investing in pools of tokens that tend to remain stable in value in comparison to one another also helps mitigate impermanent loss.
As DeFi has attracted more and more investors over the past several years, gas fees on Ethereum have risen substantially. Unfortunately, this has put many of these investments out of reach for retail investors. If you're learning how to get started with DeFi, but find it to be too expensive, don't worry!
There are now multiple scaling solutions for Ethereum that offer cheaper and faster transactions. Layer 2 blockchains make getting started with DeFi much more affordable. As these solutions evolve, more and more DeFi apps are offering support for them.
Ethereum’s most notable scaling solutions to date are Optimism, Arbitrum, and Polygon. Each work with many of Ethereum’s most prominent DeFi applications, including AAVE V3, which launched in March of 2022. These layer 2 blockchains have more than $3 billion combined in TVL across their DeFi protocols. Polygon alone has more than $2 billion!
You can send any Ethereum ERC-20 token to these networks by using their bridges (Optimism, Arbitrum, Polygon) or even hop between them using the Hop Exchange.
There is no such thing as a risk-free investment. When you are learning how to get started with DeFi you need to be aware of the potential risks.
The most notable risk in crypto is volatility. It’s not uncommon to see the price of a token dip more than 10-20% in a single day, and in 2022 alone we have seen the entire market fall by more than 60%, including Terra’s LUNA dropping literally to 0 in just a few days in May of 2022.
Many of the risks that we have seen associated with DeFi have involved centralized companies, such as Celsius and Voyager Digital. Both have halted all withdrawals, leaving their customers unable to retrieve their assets. Even major exchanges get hacked sometimes.
Other common risks in DeFi include:
This rule is especially true when you're just learning how to get started with DeFi. Limiting your overall exposure to the market is the single best way to mitigate risk in crypto.
Another important practice is to store the private keys to your wallet offline, in a secure, safe place. Never, under any circumstances, share that private key with anyone other than a trusted friend or family member.
Safety around your keys has to be a top priority if you plan to hold tokens in a non-custodial wallet. If you lose access to your private keys you may lose access to your crypto. If an attacker gets ahold of them, your tokens are as good as gone.
When you are interacting with DeFi applications, be discerning when it comes to what applications you are willing to invest with.
Only invest with applications that have a long history of success, and have been audited by independent third parties. Here is a list of AAVE’s audits as an example of what you should expect to see.
While it’s generally safe to connect your hot wallet to dApps, be careful about signing transactions and prompts. Never interact with unknown coins or NFTs that show up in your wallet if you don’t recognize them, as they could contain malicious code.
Despite the many risks involved with DeFi, there are also many great opportunities. This is an exciting new frontier that is changing the world of finance and investing, opening up opportunities to people who never previously had access to them.
Don’t let the risks scare you away! As long as you are careful, this is still a great time to learn how to get started with DeFi.
Don’t take it from us, even the Fed has said that DeFi “may lead to a paradigm shift in the financial industry and potentially contribute to a more robust, open and transparent financial infrastructure.”
As long as you are taking precautions and you’re mitigating risks, taking part in this system now can offer great returns and can help you learn about the financial system of the future!