This is Chapter Two, focused on Decentralized Finance, in a series of articles that will be released about yield farming. The purpose of this series is to introduce the concept of yield farming to those who are unfamiliar with it, then move into various yield farming strategies and finally step-by-step walkthrough of the process. I hope you enjoy the series and any feedback you have would be greatly appreciated.
Chapter Two - Decentralized Finance
Decentralized (adjective) controlled by several local offices or authorities rather than one single one
Finance (noun) the monetary resources and affairs of a country, organization, or person
Decentralized Finance (DeFi) is the emerging technologies that are based upon distributed ledgers such as the blockchains used by cryptocurrencies. It is important to understand the basics of decentralized finance which is the financial system that yield farming takes place on.
What is Decentralized Finance?
While cryptocurrencies like Bitcoin are a store of value, Decentralized Finance or DeFi, are the platforms that allow you to trade, lend, borrow, stake and yield farm cryptocurrencies. In DeFi, unlike traditional finance, there are no banks giving users rather than financial institutions control over their own money. Transactions in DeFi are usually both cheap and quick and the accuracy of the transaction is based on user input.
In centralized finance your money is held within a bank whose purpose is to make money for itself and its shareholders. These banks are part of a financial system that moves money from one institution to another charging fees for performing transactions and charging high rates for borrowing. These institutions are bureaucratic and often slow, think of how long a credit application can take to get approved. Centralized financial institutions are highly regulated by the government but they hold your money and control it.
How do Decentralized Finance Transactions take place?
Transactions in DeFi take place through peer-to-peer networks, often called a decentralized exchange or DEX, that rely on security protocols, software, hardware and connectivity. Instead of holding money in a bank, you hold money in a digital wallet in terms of cryptocurrency that can be transferred in seconds (or minutes at most) by anyone with an internet connection without needing third-party approval.
Unlike bank transactions, DeFi doesn't need to associate your name with the movement of your money instead relying on the ledger to use addresses that signal from and to where the money gets transferred. Think of this address like your home address and a piece of mail coming from another address. Get the address wrong, however, and you can lose the funds.
What technology does Decentralized Finance use?
Cryptocurrencies are built upon underlying blockchain technology and the DeFi platforms use these blockchains to perform a user's activities. A blockchain is a distributed and secured ledger which is another way of saying a database that stores financial transactions.
When a transaction takes place, the data is recorded on a block of data that is verified by other uses. Once these users agree on a transaction data block, the block is closed, encrypted and linked to the previous block hence the term "blockchain." They are set up in a way that makes them unchangeable and thus secure.
DeFi also uses smart contracts, based on software coding, to ensure transactions occur smoothly. For example, if you lend a borrower money the "smart contract" ensures that the borrower is overcollateralized and will trigger a liquidation of the collateralized holdings to pay you back if the borrower has any issues with the loan.
Total Value Locked
Within any platform you can total up all the value of the cryptocurrency that lies within, this is called total value locked or TVL. It is simply the sum of all the cryptocurrency deposited, staked, loaned or being held within liquidity pools.
Whiteboard Crypto YouTube Video - What is DeFi?