DeFi 101: Part 2 - DeFi In Practice

To be Custodial or to be Non-Custodial?

We can’t discuss the disadvantages of DeFi without also diving into the difference between custodial and non-custodial wallets.

A non-custodial wallet is one where the owner maintains total control over the digital wallet. Non-custodial wallet owners are given a unique private key (typically a long string of randomly generated numbers) that is used to access the wallet. This key is not to be shared with anyone and must be securely stored where you can always access it, or else you can lose access to your wallet entirely.

Due to the complex nature of managing a non-custodial wallet, eager fintechs and other companies began developing custodial wallets. A custodial wallet is a digital wallet where a third party, such as a crypto exchange, holds and stores your keys for you. With this type of wallet, you typically create an account on the exchange and only need your account login information to access your wallet.

The trouble is that the private key is the crucial element needed to hold true ownership over your assets. If you hand that private key over to a custodial wallet provider, you lose control of your assets and must rely on that provider to carry out your transactions and other activities on your behalf.

This becomes particularly problematic if the custodial wallet provider does not have sufficient security measures in place — a problem that became abundantly clear with the recent collapse of the FTX cryptocurrency exchange that resulted in the loss of billions of dollars worth of user funds.

Non-custodial wallets come with a bigger learning curve but can ultimately provide you with better security and control if you take the time to learn how to use them.

DeFi vs. Traditional Centralized Finance: What’s the Difference?

We have already discussed some of the differences between DeFi and traditional centralized finance.

To recap, here are the basic differences between the two:

  • Accessibility: To access DeFi, all you need is the right digital resources, such as an internet connection and a digital wallet. On the other hand, accessing centralized finance requires you to open an account with a financial institution. Depending on the type of financial service you are after, this process can also involve applications, credit checks, and other key barriers to entry that make centralized finance more difficult to access.
  • Fees: Centralized financial service providers will almost always impose a variety of fees on their customers. These can include fees such as transaction fees, membership fees, interest rates, overdraft fees, and many more. Comparatively, though there are sometimes transactional fees to deal with, DeFi has fewer overall fees thanks to the removal of the intermediary and the ability to work directly with another person in a peer-to-peer transaction.
  • Authority: Traditional finance accounts come with all sorts of rules and regulations that limit what you are allowed to do with your own funds and assets. DeFi, on the other hand, has none of these rules and regulations — the only rules to follow are those pre-determined in the smart contracts included with a DeFi product or service.

How Does DeFi Work?

As discussed earlier, DeFi is inherently related to the Ethereum blockchain, with most DeFi financial products and services available through Ethereum.

Ethereum’s creator, Vitalik Buterin, first published his whitepaper on Ethereum back in 2014. In this whitepaper, he outlined more complex use cases beyond creating cryptocurrencies, which included the objective of building a blockchain that simplified the creation of many types of decentralized applications.

Though you do need an internet connection, accessing the major public blockchains — namely, Ethereum and Bitcoin — is fairly straightforward once you have a digital wallet. For DeFi purposes, the Ethereum blockchain is the one you need access to.

To engage with DeFi, you must use software called decentralized applications, or dApps for short.

Dapps are similar to mobile applications, except they exist on Ethereum rather than being web, platform, or cloud-based like a standard mobile app.

Many digital wallet providers offer access to dApp browsers that provide you with easy access to a wide range of dApps. For example, MetaMask is a popular non-custodial wallet option for Ethereum that also offers a gateway for accessing dApps from your desktop or mobile phone.

Popular examples of dApps include:

  • MakerDAO: Remember MakerDAO, Ethereum’s first DeFi application that we discussed earlier? Well, MakerDAO is still up and running, providing users with access to the Dai token, as well as the ability to receive loans in exchange for crypto collateral.
  • EtherTweet: As the self-described “Decentralized Twitter,” EtherTweet is a great example of the potential for DeFi to expand beyond finance and into mass media as well. EtherTweet is modeled after the social media platform Twitter, with the key difference being that posts cannot be deleted.
  • OpenSea: Over recent years, the OpenSea dApp has gained popularity thanks to being a pioneer of the NFT marketplace industry. From OpenSea, you can view, purchase, and trade NFTs. The marketplace is currently home to more than 10,000 NFT projects.

How are dApps Built?

The development process for dApps is not entirely different from mobile web apps.

Like a standard mobile web app, you still need to design a front-end interface that can be used on a desktop and/or mobile device. Additionally, dApp developers need a home for their back-end coding. This coding exists on the developer’s chosen blockchain rather than on a centralized server.

If you are experienced at all with app development and coding, these front-end and back-end tasks are likely familiar to you.

The key difference that sets dApps apart from traditional applications is the use of smart contracts.

A smart contract is a computer program that is stored on a blockchain. In the coding of a smart contract, a transaction protocol is included that defines a set of contract terms and conditions that must be met before a transaction can take place. Smart contracts power the back-end logic of dApps.

One of the reasons why Ethereum is the primary blockchain used for DeFi and dApps is that the Ethereum Network team developed a coding language called Solidity specifically for creating smart contracts on the blockchain.

Smart contracts not only determine when and how a transaction or other activity can be authorized but also ensure the transaction is then communicated to and recorded on the blockchain ledger.

Like with any application, dApps must be rigorously tested and maintained to remain highly secure and fully operational.

Disclaimer: This article is not intended to provide investment, legal, accounting, tax, or any other advice and should not be relied on in that or any other regard. The information contained herein is for information purposes only and is not to be construed as an offer or solicitation for the sale or purchase of cryptocurrencies or otherwise.