DeFi 101: Part 2 - DeFi In Practice

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 you control the private keys used to access and authorize transactions. These wallets rely on private keys (or a recovery phrase that can restore those keys).

Private keys and recovery phrases should never be shared. If you lose them, you may permanently lose access to your funds. Because managing your own keys can be complex, some companies offer custodial wallets. A custodial wallet is a digital wallet where a third party, such as a crypto platform, holds and stores your keys for you. You typically access it using your account login. 

The key difference is who controls the private keys.

If a third party controls them, you rely on that party’s systems and policies to access your assets. ustodial arrangements can introduce third-party risk, including operational, governance, or insolvency risks. Non-custodial wallets give you more control, but also more responsibility.
 

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: Accessing DeFi typically requires a digital wallet, an internet connection, and familiarity with the tools being used.
  Traditional financial services require opening an account with a financial institution and may involve identity verification, applications, or other requirements.
• Fees: Traditional financial services can include fees such as transaction fees, account fees, or interest charges.
  In DeFi, costs often come from network fees and protocol fees, which can vary significantly depending on network activity and the specific application used.
• Authority: Traditional finance operates within established regulatory and institutional frameworks.
  DeFi applications operate through software (smart contracts), but users may still be subject to applicable laws and platform terms. Smart contracts may also carry technical and operational risks.

Many DeFi applications started on Ethereum, and Ethereum remains a major DeFi ecosystem, although DeFi also exists on other blockchains.

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 relevant blockchain depends on the application you want to use.

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

dApps are applications that interact with blockchain networks through smart contracts. They often use standard web or mobile interfaces while the back-end logic runs on-chain.

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: One of the early DeFi applications built on Ethereum. It enables users to interact with the Dai token and access services such as borrowing against crypto collateral. Features and risks can vary depending on how the protocol is used.
• EtherTweet: Some blockchain-based social applications have experimented with decentralized posting and permanent records, although features and availability vary by project and may change over time.
• OpenSea: A widely known platform for buying and selling non-fungible tokens (NFTs). Marketplace activity, listings, and supported projects can change over time.

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 reason Ethereum became a major platform for DeFi is that it supports smart contracts, commonly written in Solidity. Smart contracts can define conditions for transactions or other actions, and on-chain activity is recorded on the blockchain ledger. Like any software, dApps require testing and maintenance, but security outcomes depend on code quality, audits, and ongoing monitoring.

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.