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How does DeFi Work?

DeFi or Decentralized Finance is the main driver of the cryptocurrency market’s resurgence in 2020 and 2021. With the rise of Defi coins and other altcoins, the dominance of Bitcoin has dropped from around 62% at the beginning of January 2021 to around 45% in August 2021. 

Despite its contribution to the global cryptocurrency market, DeFi has remained among the most opaque areas of the crypto industry to the outside world. Most people have heard about Bitcoin but don’t know anything about Decentralized Finance DeFi. In this article, I’ll try to walk you through the basic concepts associated with DeFi and how it works. 

What is DeFi?

DeFi or Decentralized Finance encompasses all financial services that are carried out on a blockchain. The main characteristic feature of DeFi based financial services is that there is no central authority. This helps the system to replace middlemen in a traditional finance world with a smart contract. In layman’s terms, you can call it a merger of traditional banking services with blockchain technology. 

How does DeFi Work?

DeFi works on a decentralized infrastructure. To provide financial services, decentralized finance uses smart contracts and cryptocurrencies. In this way, it does away with the need of intermediaries, which are used by the traditional financial services. 

For any transaction in the traditional financial world, it is the financial institutions that act as guarantors. As your money flows through these institutions, it gives them immense power. It is also a fact that billions of people around the world don’t have access to these financial institutions (such as banks). 

To do away with the need of these immensely powerful financial institutions, DeFi protocols have introduced smart contracts. During transactions, it is the smart contracts that replace the financial institution in the transaction. The decentralized infrastructure to DeFi applications is given by the Ethereum blockchain, which is a Do-It-Yourself (DIY) platform for DApps or decentralized applications. 

Currently, most DeFi protocols use the Ethereum blockchain. However, there are many other decentralized finance protocols that have started to migrate to other blockchains in search of increased speed and scalability. 

What is a smart contract? It is a type of Ethereum account, which has two main functions:

  • Hold funds
  • Send or refund funds automatically when certain conditions are met

The best thing about smart contracts is that they can’t be altered when live. They always run as programmed. Let me explain it with the help of an example. 

Suppose, a smart contract is programmed in such a way that an allowance is scheduled to be sent on a particular date or day (say, 5th of every month or Friday of every week) from Account A to Account B. The only thing that is needed to be satisfied is the availability of the required funds in Account A. Once a smart contract is programmed, no one can change it. In this example, no one can change the smart contract to release allowance from Account A to Account C and steal the money.

Another important advantage of smart contracts is that they are available for public inspection and audit. If there are bad contracts, they will come under the scrutiny of the community pretty quickly. This means that currently, the Ethereum community needs more technical members for reading code for contract scrutiny. 

A check is kept on the developers by the open-source-based community through the scrutiny of the technical members. However, the need for technical members for reading code will diminish over time once:

  • it becomes easier to read smart contracts
  • Other ways are developed for proving the trustworthiness of code. 

Top 4 Best DeFi Applications and Protocols

  1. Decentralized Exchanges (DEXs)

One of the most successful applications of decentralized finance is in the case of Decentralized Exchanges or DEXs. Unlike centralized exchanges (such as Coinbase, Binance, Kraken, and others), decentralized exchanges (such as Uniswap, SushiSwap, and Curve) operate without an intermediary. 

A central authority operates trading platforms of centralized exchanges. They are custodial in nature. The central authority of Coinbase and other centralized exchanges are trusted by the buyers and sellers for keeping their digital assets safe. 

However, decentralized exchanges don’t need you to keep faith in any intermediary. The buyers and sellers can directly connect through the Decentralized Exchanges (DEXs) for buying and selling cryptos in a trustless environment. 

  1. Lending Platforms

The lending ecosystem is democratized by decentralized lending platforms such as Aave (AAVE), Compound (COMP), and Maker (MKR). These DeFi lending platforms provide both lenders and borrowers an open system. 

Decentralized lending platforms use smart contracts to replace the intermediaries (such as banks) involved. In this way, the borrowers and lenders can lend and borrow in an open system. While the lenders can loan their cryptocurrency assets to earn interest, borrowers can access liquidity without having to sell off their assets.  

  1. Prediction Markets

DeFi ecosystem is dominating the prediction market as it is eliminating the need for intermediaries by using blockchain functionality. Some of the most popular DeFi prediction markets include Augur (REP), FTX Token (FTT), and Gnosis (GNO). These made significant headways during the US Presidential Election 2020. Augur reached a milestone of more than US$8 million volume. 

  1. Yield Farming

Yield farming is the hottest new DeFi space in the decentralized finance market. It involves the process to lock up cryptos in exchanges to earn a reward. Two major cryptos in this field are Compound (COMP) and Aave (AAVE). The popular crypto coins and stable currencies such as Ether, Tether, DAI, and others are staked by the yield farmers. 

Invest in DeFi Now

Mark Cuban, a renowned American billionaire entrepreneur and crypto enthusiast,  believes that the Defi industry is relatively small currently. However, it has the potential of exploding in the coming 10-years. 

Alex Alexandrov, Founder of Velas and, believes that especially after the Layer-2 implementation of Ethereum, DeFi will start becoming mainstream. This is mainly because it will help in the emergence of real investment opportunities. 

To get the maximum return in the coming 5-to-10 years, you should start investing in DeFi now. Keep an eye on the market news, price statistics, block times, and others to time your trading of Defi systems and tokens for maximum profit. 

You can buy and sell DeFi tokens against various fiat currencies (US Dollar USD, British Pound, Canadian Dollar CAD, South Korean WON, Singapore Dollar, Chinese Yuan, Hong Kong Dollar, etc.) through a wide array of crypto exchanges. 

If you want to increase your investment explosively in the coming 10 years, buy DeFi coins now. 

Diversify your crypto coin portfolio by including other cryptocurrencies such as Bitcoin Ether ETH, Bitcoin Gold, Bitcoin Cash BCH, Basic Attention Token, Ethereum Classic, Binance Coin, Wrapped Bitcoin (some also call it wrap bitcoin or wBTC), USD Coin, Gemini Dollar, ERC20 tokens (created on Ethereum blockchain), NFTs, and others. 

Also, invest in various types of stocks, mutual funds, index funds, real estate, and others to improve your personal finance. If possible, get help from a portfolio manager or wealth management firm for maximum return. 

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NapBots provides you various indices that include a basket of tokens with high market capitalization and are categorized by theme (such as Solana, NFT, DeFi, and others). This platform introduces an intuitive interface as well as advanced allocation tools for enabling new investors to create and manage advanced crypto indices easily.

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