This is a layman’s guide on getting started with Decentralized Finance, covering what it is, the main moving parts of the DeFi world, and how to get involved with it. This is not intended to be for advanced users but some of those users might find this helpful as a refresher or help to explain it to others in a simple way. That being said, some understanding and willingness to utilize blockchain technology is needed.
This is part one which will tackle the tools needed to get started. You will learn the basics of DeFi, the similarities and differences of DeFi to traditional finance, what you need to get started, security measures, and how to set up three different wallets.
Part two will walk you through more advanced applications like establishing DeFi savings accounts, portfolio management, smart contract “insurance”, DeFi based mortgage lending, and broader implications for the future.
This guide is NOT FINANCIAL ADVICE and is not intended to be taken as such. It is written as an educational tool for those completely unfamiliar with DeFi or cryptocurrency as a whole.
Decentralized finance, blockchain technology, and distributed ledger technology can be a massively confusing topic. It’s usually filled with severe skepticism and confused looks, ultimately creating more questions than answers.
Where is my money when I buy Bitcoin, Ethereum, or other cryptocurrencies? Why is it not physically tangible like coins, paper money, or gold bars? Why do I need to care if I’m using a bank?
Crypto has come a long way in its 10+ year life. There are some very straightforward answers to these questions.
There are projects in the blockchain industry that have real world applications and are being used by some of the most famous brands in the world like Coca-Cola. Financial companies are hiring blockchain experts. Financial institutions like Bank of America have over 80 blockchain patents, while Visa has taken a very strong stance on using digital assets in the future.
Decentralized Finance, also known as DeFi, has a number of practical applications for the normal person, most of those are available in some form today. This is a practical, hands on guide to what you can functionally do with DeFi and a few examples in each area on how to get started. By the end of this article, you should have a rough idea on the basics of using DeFi in your life and what you can look forward to in the future.
DeFi Theory: Understanding the Practical Foundations
Decentralized Finance: What can it do for you?
DeFi gives access to financial applications without needing a middle man or third party authority. For example, if you want to give money to someone in the traditional way, you could just give them paper money (backed by the government). Today if you want to do this electronically, you would send money through your bank. Decentralized finance will let you do this strictly peer to peer, without the need for a bank or government regulation which comes with a number of benefits.
We have covered DeFi very extensively in our Ultimate Guide to DeFi where we tackle the history of finance, why blockchain technology is a much needed replacement, and the multitude of projects working on things from interest savings accounts, lending and loans, exchanges, derivatives, and even smart contact insurance.
Comparing DeFi to Traditional Finance
Modern day finance carries similarities and differences to DeFi. Like most of the daily operations and services available to us in the traditional finance world, with DeFi we are able to deposit and withdraw funds to or from an account, in addition to sending or receiving funds for a payment or service provided. This is assuming that the other party considers Bitcoin, Ethereum, or another cryptocurrency as ‘value’. In addition, security is of high importance in both the traditional world of finance and DeFi, although it’s handled very differently in both realms.
The way these similarities are implemented are foregin to those even heavily involved in the financial world, however. Although the concepts of saving, lending, interest bearing, and even features like liquidity and portfolio management are all present within both worlds, they are tackled in very different ways. We don’t see what happens behind the scenes in financial companies which can lead to abuse within the system. Blockchain enables us to see things much more transparently. The moving parts may appear more complicated to a new user, but this is without a doubt a “feature and not a bug”. This transparency enables us to see finance as it really is – both the good and the bad; both the profitability and responsibility.
How DeFi is Different From Traditional Finance
There are many complexities to DeFi that are vastly different from traditional methodologies in finance, however some of the biggest differences are very simple to understand (and covered in more detail in the Ultimate Beginner’s Guide):
- No Reliance on a Party of Trust: as you may expect, the word “decentralized” in decentralized finance means the system is built on a manifold distribution of working parts instead of one location, company, or bank. This means there is no central authority that oversees everything with ultimate control. This enables the lack of forced features, fees, or overreach with the added notion of personal responsibility.
- Higher Level of Security Against Compromisation or Theft: since DeFi is built on the blockchain, the moving parts are locked in code that cannot be altered or manipulated in a way that traditional finance operations can. It takes a much higher effort to manipulate the system because of the technology involved and also the transparency.
- Equal Participation and Resistant to Discrimination or Censorship: in short, money talks by itself. Blockchain does not care who you are in regards to gender, race, religion, or anything of the sort. Money is the primary catalyst for activating smart contracts.
- More Potential for Privacy: some blockchains are more private than others, but DeFi has a much more open availability to use financial services that don’t require a mandate to know everything about you. This is designed as a feature so you are not open to be singled out, targeted by means of your information, or discriminated against.
What You Need To Start Your DeFi Experience
So What Do I Need to Get Started In DeFi?
Now that you understand a brief of what DeFi is and hopefully read our primer, what do you need to get started when participating in DeFi services? Mainly three things:
- Money: as much as we don’t want to admit, you do need some money to be involved. Fortunately to get started on the very basics you may only need a little as $100 USD. Although every person’s financial situation is different, it’s unwise to consider working with most DeFi services if you actually need the money you are placing on-chain. It should be assumed that the money used is not paramount to your everyday life needs.
- Wallets: cryptocurrency wallets are your gateway to DeFi. They give you access to send and receive cryptocurrency on the blockchain. There are plenty of tutorials on what wallets are and how they work like this comprehensive guide on wallets, this video on setting up a Blockchain wallet, and this guide from EthHub documenting how Ethereum wallets work.
- Some understanding of blockchain technology: although you don’t need a master’s degree to understand most of DeFi, you should know that it is a relatively new thing and therefore it takes more of an approach to function instead of form. As a result, a lot of things are not easily explained yet and may take some knowledge of financial systems or blockchain jargon to get deeply involved.
Understanding Risk, Liabilities, And Commitment
Something that deserves a mention is the risks, liabilities, and commitment to being actively involved in the DeFi process. One built-in advantage of a few traditional services like savings accounts is the ability to drop money into an account and forget about it. This is not really a possibility of DeFi at this time. If you are uncomfortable with this, then DeFi may not be for you. Here is a must read portion of this guide and if you don’t read, you’ll be setting yourself up to fail:
- There can be big risks: many of these services are completely fine to use safely on a daily basis. That being said, some blockchains have issues like congestion, bugs in smart contacts, or scams like fake coins and websites. Understand that the margin for error is higher than you might expect. It is not uncommon for people to lose 100% of their portfolio by being deceived in some way. Being involved in DeFi means that you understand the risks.
- Value can be volatile: lending rates are high right now. While rates on Aave lending are averaging around 5% with some as high as 32% , this can always change. These are attractive numbers, but also remember that the value of assets, even some stablecoins, can fluctuate more than you expect. This won’t just work in your favor but also against you. Be prepared for both.
- It requires you to be responsible for your actions: this cannot be stressed enough that personal responsibility is required. Brand new DeFi services should be approached with caution. Just like a savings account with money service fees or trading stocks, you need to understand that there is possibility of both gain and loss. In the case of something like a fraudulent service, this does not remove wrongdoing from the creator of that service, but it could also be avoided if you are a proper steward of your funds. Enter DeFi with care.
Working alongside personal responsibility, understanding and using security with everything you do will help make things go a lot smoother and prevent your assets from being hacked or lost. It’s worth noting that blockchain technology has built-in layers of security as it has the innate ability to be immutable, encrypted, and distributed, with operational security measures like consensus protocols and mining. Here are some practical habits you would do well to implement if you are participating in DeFi which you may be familiar with if you are into crypto anyway:
- Two-Factor Authentication (2FA): this is the concept of using multiple permission points in order to grant access to a service or product. In the case of using it for cryptocurrency, this is meant to protect your digital assets by requiring another method to prove it’s really you trying to access the funds. This is most commonly manifested in the form of a six digit code through an authentication service like Google Authenticator or YubiKey. There are other methods of delivery for 2FA like SMS and email, but this is generally discouraged if you can avoid doing so since those methods can be easier to hack. A worthy note is that 2FA can typically be used offline and is best used disconnected from the internet and NOT on the device you are using to verify access with.
- Virtual Private Network (VPN): VPNs are able to route the transmission of your data through the internet from a server instead of directly from your computer or device, which drastically increases your security. In addition, this also removes your location data and changes it wherever you see fit, preventing hackers from knowing where you might live, where you do business, etc. VPNs are also helpful in the event you need to be on a WiFi network that you do not control.
- Cold Wallet Security: another layer of security is the use of cold wallets or even connected wallets that can be taken offline. Having a wallet disconnected from the internet makes it more difficult for others to get access to your assets. Ledger and Trezor wallets are popular hardware wallets or you can use older methods like metal cards or paper wallets like Sketchbook.
- Password Strength: it is commonplace to use passwords that are easy to remember or used over and over again. This is very dangerous. Statistics show that some of the most common passwords are the word “Password” while others use common information relative to them like birthdays (BitcoinBorn03012009), anniversaries, or street addresses(DeFi2088 if you live on 2088 MacGuffin St). Studies have shown that mixing up these same phrases slightly, even with Leetspeak, can be hacked very easily (in essentially seconds). Key ways to improve password strength is to make it long, even as much as 25 characters, with random sequences. This essentially makes passwords less like a phrase and more like actual encryption.
- Special Notes on KYC and AML: personal identifiers like Know Your Customer (KYC) or Anti-Money Laundering (AML) methods require unique and personal data from you. Although this is a unique way to identify you for verification, it is extremely counterintuitive to use KYC/AML with DeFi services. One of the foundational pillars of DeFi is the freedom to use financial services while still being anonymous or without compromising personal data.
Understanding The Basic Concepts Of DeFi Application
DeFi can be very complex, so it’s worth your while to go over a little bit how blockchains work. We’re going to go over the basic concepts of DeFi here to help you along. This is not a comprehensive list, we’re just helping you get a better awareness of what is going on behind the scenes:
- The DeFi “Network”: this is an unofficial descriptor of the DeFi ecosystem where two of more parties on a blockchain are participating in a financial practice. There is no defined network per se, but more of an imaginary traffic lane where DeFi is working (think of the old phrase “internet superhighway” toward the end of the Web 1.0 days). Here is a wonderful article on this complex subject.
- DeFi Blockchains (Ethereum): the ETH chain is by far the biggest chain involved in the DeFi ecosystem. You’ll hear about it a lot. Ethereum is almost impossible to avoid in this space because of the huge array of projects built on Ethereum. It’s not the only DeFi chain though, there are other ones like EOS, Band Protocol, and Polkadot. This is covered in the Ultimate Guide to DeFi posted here. These blockchains are also referred to as Layer 1 on the DeFi Network.
- Cross-Chain Traffic: even though all these chains are part of a system, they do not always work independently. There are many blockchains that work with each other like Ren Project. In addition, there are projects specifically for cross-chain communication like Cosmos. This is also part of a Layer 2 system that deals with scalability while working with an integral part of a Layer 1 chain.
- Oracles: they might sound complex at first, but oracles are basically a way for blockchains to interact with the real world and provide decentralized systems with non-blockchain data in a reliable way. This is important to help connect the current financial system to the decentralized system. Currently the leading oracle system is Chainlink, by some margin too. This is also a Layer 2 part of the DeFi Network.
- Gas: the Ethereum network requires fees to be paid for every transaction. Fees are referred to as gas fees. If you are not aware of what gas is (also known as gwei), here is a good primer on the subject of Ethereum gas in addition to a source called the Gas Station which tracks gas related data.
DeFi Wallet Creation And Integration: Your First Steps
Getting Started in the DeFi World: Initial Application With Wallets
For the final portion of this guide we’ll walk through how to set up a wallet using a couple of examples. You will learn how to set up these wallets with options to keep these secure.
There are dozens of popular wallets out there, all with their unique touch and feature set. Just to get started, we will focus on some of the most popular ones: Trust Wallet, MetaMask, and MyEtherWallet.
One of the wallets discussed in the Ultimate Guide to DeFi, Trust Wallet, is among the most popular and easy to use wallets in the space. One of the reasons this was picked for the practical guide is it’s popular integration with most DeFi projects and it’s also easy to use on most mobile devices.
- First, go to the Trust Wallet website here and select your smartphone device. Follow the prompts necessary to get it properly installed on your device and double check all links to make sure they are trusted.
- You’ll be asked to create a wallet by following the on-screen prompts. You will be met with a screen that explains the risks of cryptocurrency and warns you to keep good custody of your assets.
- After reading and accepting the terms, you will be met with a screen for your recovery phrases which are a set of 12 words. You’re allowed to copy these, write them down, or whatever you like. Just put them somewhere safe in case you lose your phone and need to recover the wallet. You will then see a screen to confirm your recovery phases by adding them in. Please remember if you do not keep track of these words, you may not be able to recover your assets.
- Your wallet is now created. You are able to search for the supported cryptocurrencies and deposit any crypto you may have. You can also hit the buy option which will send you to a payment provider where you can buy crypto with your card.
Very popular as a browser extension, MetaMask is one of the most popular wallets in the cryptocurrency space and one of the earliest products to date. MetaMask is also one of the most common integrations for other DeFi projects like Uniswap.
- To get started, go to the MetaMask website and hit download in the top, righthand corner. Once you have clicked the download button, you will be redirected to choose what type of MetaMask installation you prefer: Google Chrome, iOS, or Android or through Firefox or the Brave Browser if you are using those particular browsers. Note: iOS access is only available on TestFlight, which is a limited access beta. The beta is currently full at this time and not accepting new users. We will cover the Brave Browser extension here as this helps complete the crypto experience.
- This will take you to the Chrome Web Store. On the top right on the MetaMask tab, you will see an option that says “Add to Brave” and select it. You will then be taken to the MetaMask wallet screen where you can select “Get Started” below the fox avatar.
- Once the password is created, you will be brought to a seed phrase page where you can write down the 12 seed words associated with your wallet for retrieval. You can opt to write these down and confirm them.
- After the seed phrase section, you will be brought to the main wallet page that shows your current zero balance. From there you have the options to use the wallet by buying or sending ETH to your wallet, add tokens, see your activity, or change the network (defaulted to the Ethereum Network).
Another relatively early wallet in the crypto space is the MyEtherWallet which is been slightly rebranded into MEW, complete with a new UI and smooth experience. The major benefits of MEW are the endless connections it provides from Ledger connectivity, Brave Browser support, and mobile support. We will be installing MEW via Brave and through a mobile device.
- For Brave, go to the MyEtherWallet website and click “Create New Wallet”. It will force you to read a series of screens about protecting your wallets, ensuring security, and understanding the risks to using decentralized wallets. Click continue on the screens after you have read.
- You will then be asked to set up a wallet via mobile device, through an online wallet, or through mnemonic phrases. Select mnemonics phrases. You will then be given a set of 12 seed words that you will need to verify on the next screen. Once you have verified them, you are good to go and be given the option to “Unlock Wallet”.
- Go back to the main MEW page and select “MEW CX” to uninstall the MEW extension on Brave just like you would with MetaMask. After the installation, MEW will show in the upper right hand corner where you can select “Add Wallet”.
- After clicking “Add Wallet” you will be prompted to add your recovery seed phrase from step 2. Enter all 12 words and click “Continue”. From there you can select the address to host the wallet where you can just click the top one on the list. You will then be taken to the main wallet screen and your official setup on Brave Browser is complete!
- If installing on a mobile device, click on the website above in step one and scroll to the bottom to select Google Play or App Store for iOS or locate it on the app store on your device itself. Download the MEW app to your device.
- After opening the wallet, you will be asked to create a new wallet at the top of the screen. You will be given a short prompt to go over the security and precautions similar to the ones in step two. Read them and click “Create a Wallet”.
- You will then be asked to create a six digit passcode and the option to use biometrics like a fingerprint authentication. Accept or deny the biometrics. Click “Finish” when you get to the next screen.
- Your wallet is now installed and created! However, you will be given a pop-up asking you if you want to backup your wallet with a recovery phrase like step two. If you select “Backup Now” you will be sent to a 24-word recovery phrase. Please remember to write this down. MEW will also know if you take a screenshot, so don’t be tempted to do that as such. You will be asked to confirm four different words at random from the list.
- The MEW mobile wallet is now backed up and you have finished the setup process.
Conclusion, But Not Concluded?
This brings the first part of the DeFi Practical Application guide to a close. Hopefully you’ve been able to understand the basics of Defi Theory, learn the concepts of risk and security, and you’ve managed to set up a few wallets.
It’s okay if you didn’t understand it all at once. The DeFi world is complex. You will find that everything listed in part one will be used as a resource in part two. In addition, the three wallets (Trust, MetaMask, and MEW) will all be revisited for more advanced integrations.
Feel free to work at your own pace or re-read part one. Part of being decentralized is the ability for all of us to work at our own pace. This is part of what DeFi is all about.
Additional Reading And Links For DeFi
- Ultimate Beginner’s Guide to Decentralized Finance: https://thedailychain.com/the-ultimate-beginners-guide-to-defi/
- Statistics for Lending Rates and DeFi Resources: https://defirate.com
- DeFi Project List: https://defiprime.com
- DeFi, the Next Big Thing in Finance: https://thedailychain.com/defi-as-the-next-big-thing-in-finance-not-just-crypto/
- What is DeFi?: https://thedailychain.com/what-is-defi-decentralized-finance/
- Is DeFi the new ICO Bubble or the Real Deal?: https://thedailychain.com/is-defi-an-ico-bubble-waiting-to-burst-or-the-real-deal/