DeFi Guide for Beginners

I’ve been in this subreddit for a while now and I’ve seen many times people asking for some guidance on how to get started with DeFi. I still remember how surprised I was when I heard of DeFi for the first time. I’d held Bitcoin and Ethereum for some time, but I hadn’t fully realized how much more I could do with crypto—so I really hope this guide will make things easier for you.

I remember that the more I learned about decentralized finance, the more confused I was. Not only was the theory behind it complex, but I then needed to learn how to use each app and understand what was safe and unsafe. It was a difficult process, but don’t worry. This won’t happen to you because this is exactly the guide I wish I’d read when I was getting started with DeFi. Indeed, we won’t stop just at the theory, but we’ll see how to use all the tools and apps needed.

Note: I assume that you are already familiar with crypto and know what a blockchain is and how popular cryptocurrencies like Bitcoin and Ethereum work. If not, you might want to learn all of that before reading this article. If you are already familiar with crypto, keep reading to learn how to unlock the true power of your assets.

What You Will Learn in This Guide:

What Is DeFi?

Before diving into the practical things, it’s important to understand the basics that power everything we are going to do in DeFi. So let’s start by understanding what DeFi is and how it differs from traditional finance. 

There are many different ways we use our money in the course of our life—buying goods, exchanging our local currency for foreign ones, getting a loan, investing in a company, and more. All these transactions are facilitated by financial corporations, like banks, controlled and owned by a small group of shareholders. 

Since anything we do with our money is controlled by these institutions, this system is known as centralized finance (CeFi) or traditional finance (TradFi). This is the financial system we are all familiar with, in which third parties control all our transactions while charging a fee for their services. For example, whenever you buy a cup of coffee by card, you and the merchant are not the only parties involved in the transaction. Your bank, the shop’s bank, and a financial network like Visa or Mastercard are typically involved too. And each party charges a fee for its service. 

Decentralized finance (DeFi) offers us all the same financial instruments and opportunities of traditional finance (like buying goods, or lending money for a yield) without any intermediary like banks or brokerage firms as they are replaced by blockchain and smart contracts. Using DeFi applications, you will be able to lend or borrow crypto from peers, trade crypto assets without any centralized entity, earn high interest, and much more. In this guide, we will mainly focus on how to use DeFi to earn a high and safe yield on USDC.

Infographic: DeFi vs CeFi

What Are Stablecoins?

Since the first Bitcoin block was mined, volatility has been one of the main problems for the broader adoption of crypto. Popular cryptos like BTC or ETH often reach dizzying heights one day and plummet to gut-wrenching depths the next. Needless to say, the huge volatility would have never allowed for the mainstream adoption of blockchain. That’s where stablecoins come in. 

Stablecoins are a type of cryptocurrency whose value doesn’t fluctuate, thus the name “stable.” They are stable because their value is based on and pegged to stable real-world assets. Usually, stablecoins are backed by currency like the U.S. dollar. 

Those are also known as fiat-collateralized stablecoins because they are backed by money issued by governments. This includes currencies like the USD, EUR, or GBP. As long as the economy of the currency’s country remains stable, so will fiat-backed stablecoins. 

Fiat-backed stablecoins are collateralized 1:1. That means for every stablecoin in circulation, a single unit of currency ($1) is kept in a bank account to back it up. If you want to trade in your stablecoin for cash, you will receive the equivalent directly from the issuer, such as Circle for the USDC stablecoin, or purchase it on a crypto exchange like Coinbase. The stablecoins corresponding to the amount you retrieved will be taken out of circulation if you redeem them with the issuer.

Earn Yield With DeFi: Lending 

Exactly as you can do in traditional finance, one of the main ways to earn yield in DeFi is to lend your funds to someone for interest. So how does that work? How do you lend your funds to someone? Is it safe? How can you be sure that you’ll get your money back?

If you had to lend $1,000 to a friend, you could agree to give him the money if he will pay it back after one year with a 10% yield. So your friend would give you back $1,100 after one year, and you would have realized a nice profit on your funds.

However, if you give the same $1,000 to a complete stranger on the internet, chances are you would never see your money again. That’s why if someone wants to borrow funds via DeFi, they must give collateral in exchange. For example, if I want to borrow $1,000 worth of USDC, I have to give $2,000 worth of ETH as collateral. This way, the other party knows that I won’t run away with their money. I know what you are thinking: “Why the hell would someone give $2,000 worth of ETH to get back $1,000 of USDC? Can’t they just sell $1,000 worth of ETH to get the money they need?” Well, this is exactly what I thought the first time I heard of crypto lending and borrowing, but don’t worry. You’ll understand everything in a minute.

Understanding Crypto Borrowing

At first glance, crypto borrowing might not seem that reasonable. However, there are many reasons for a borrower to use ETH as collateral to borrow crypto instead of selling it. 

  • Liquidity Needs: Let’s say I am a long-term holder of BTC and ETH and I have most of my net worth in crypto while holding very few fiat currencies like the U.S. dollar to pay for day-to-day expenses. However, an unforeseen event like a car accident happens and I need a great amount of USD to repair my car or buy a new one. I could sell $20,000 worth of BTC to satisfy my liquidity needs and buy it back after a year. However, if BTC appreciates in value by 30% in that year, I would incur a 30% loss. Instead of selling, I can use my BTC as collateral and borrow the amount of USD I need while paying a 5% annual fee. This way, I can be exposed to BTC capital appreciation while still having the liquidity I need to pay the unforeseen expense.
  • Investment Leverage: Another popular reason to borrow crypto is to have some investment leverage. For example, let’s say that I hold $20,000 worth of BTC. If Bitcoin appreciates by 30% in one year, I earn $6,000. However, if I use $20,000 BTC as collateral to borrow $10,000 USDC, I can then use that to buy another $10,000 worth of BTC. If Bitcoin appreciates by 30% in one year, I earn $9,000 and, after paying $500 worth of interest, I have a net gain of $8,500 instead of just $6,000. This is the same concept of using leverage as you would see in traditional finance. However, instead of getting the leverage via a broker, I get it via a decentralized liquidity protocol. 

Understanding Smart Contracts

Now that you know why someone would borrow stablecoins for collateral, there are some other pieces to add to the puzzle. If the borrower gives you $2,000 in ETH as collateral to borrow $1,000 in USDC, who’s to stop you from running away and selling it on the market? And what happens if you receive ETH, but then its value drops significantly? If the transactions happened just between you (the lender) and the borrower, the only way to make it work would be to trust each other. However, this is not the premise of blockchains and DeFi. Instead, we need a trustless system where things like this can work without needing trust and without any centralized institutions like banks. This is where smart contracts come in. 

A smart contract is a piece of code on the blockchain that runs when specific conditions are met. When you want to lend cryptos for an interest, instead of interacting directly with the borrower, the two of you will use a smart contract that manages the transaction. This is how it works:

  1. You (the lender) deposit $1,000 worth of USDC into the smart contract using a blockchain application (we’ll see later how to do this). 
  2. The borrower deposits $2,000 worth of ETH as collateral into the smart contract. 
  3. The smart contract gives the borrower $1,000 worth of USDC while locking the ETH deposit. This way, you cannot run away with the borrower’s ETH. 
  4. When the borrower deposits $1,000 worth of USDC back in the smart contract, the code will give him back the ETH deposited minus the interest needed to pay you. 
  5. You receive the $1,000 deposited plus any interest. 
  6. If, in the meantime, the value of ETH drops below a certain threshold, the smart contract will automatically sell ETH and pay you back. This way, your funds are protected against any market drop thanks to the code that runs automatically.

Infographic: DeFi Lending Explained

Now that you have learned the ins and out of crypto lending and borrowing and how smart contracts make all of this possible, you need to understand how to actually use a blockchain app and a crypto wallet to start earning your first yield with DeFi.

What Is a Blockchain App? 

As promised at the beginning of the guide, this is not an average theoretical guide. At the end of it, you will be able to actually start earning yield with DeFi by using all the tools and apps needed. That’s why it’s important to understand what a blockchain app is and how to use it.

A blockchain application (also known as a decentralized application, or Dapp) is a digital program just like any other app we use in our everyday lives. There are blockchain applications for gaming, investing, social media, and music that you can use via your browser or smartphone. The main difference from other apps is that instead of running on a centralized server owned by a company, decentralized applications run on a blockchain like Ethereum or Polygon. 

That’s why Dapps are not subject to the control of any single authority. For example, anyone can develop a social media platform like Instagram and run it on a blockchain to allow any user to publish posts or comments. Once published, no one—including the Dapp developers—can modify or delete any posts.

As already mentioned, there are blockchain applications for many different use cases including gaming, social media, and music. The ones that interest us the most are decentralized applications for lending and borrowing, also known as liquidity protocols. 

So how do we use these apps? How do we add our funds to a liquidity protocol? To do that, we need a cryptocurrency wallet that can connect to blockchain applications. Indeed, while crypto exchanges like Coinbase are the most popular options to start your crypto journey, they don’t allow you to get the most out of your crypto because you cannot connect them to blockchain applications. That’s why we need a non-custodial cryptocurrency wallet.

Setting Up Your Crypto Wallet

What Is a Crypto Wallet and Why Do You Need One?

If you’re not completely new to crypto, you’ve probably already used a cryptocurrency exchange like Coinbase or Crypto.com to buy and store crypto assets like Bitcoin or Ethereum. While they are a perfect way to get started and buy your first cryptos, they don’t allow you to fully explore the opportunities coming from DeFi and Web3. Furthermore, when you store cryptos via an exchange, you don’t fully own them because they control your private key. As the saying goes, “not your keys, not your cryptos.” 

On the other hand, with a non-custodial wallet, only you have access to your private key, and no one can control your funds. Furthermore, a self-custody wallet is also required to use blockchain applications and participate in DeFi. 

Which Crypto Wallet to Choose

There are different types of cryptocurrency wallets available on the market, with the main distinction being between hardware wallets (also known as cold wallets because they are not connected to the internet) and software wallets (also known as hot wallets), which are mobile or desktop apps. 

Hardware wallets are physical devices similar to a USB considered to be more secure than hot wallets. However, they are more difficult to use and are not recommended for beginners. On the other hand, hot wallets are easier to use because they are simple desktop or mobile applications. However, they are considered to be less secure because they are connected to the internet, and thus it can be easier for an attacker to access your private key.

The main problem with both types of wallets is that if you lose, or someone steals, your seed phrase (which is a 12 to 24-word password to access and recover your wallet), you’ve lost your funds forever. A better alternative is to use a smart wallet like Linen Wallet. Smart wallets are a new type of non-custodial wallet that offers advanced security while also being much easier to use. As such, they are the best option to get started with DeFi and Web3. So how can they be so secure while also being much easier to use? Let’s get deeper:

  • Multi-keys: Using a smart contract, Linen Wallet is secured using three keys, not just one like most non-custodial wallets. Two out of the three keys are required to make a transaction. As such, even if someone steals one key, they won’t be able to access your funds. Other non-custodial wallets only have one key, and if someone gets access to it, all your funds are lost forever.
  • Easy wallet recovery: One of the main problems with other non-custodial wallets is that you have to store your private key yourself on a piece of paper or metal card. As such, the risk of losing it is very high. Instead, Linen Wallet makes it easy to manage your private keys—one key is stored in your cloud, one in your mobile device, and one in Linen’s secure server infrastructure, so you can seamlessly recover your wallet using your cloud drive, email, and phone number.

Download and Set Up Linen Wallet

You now need to download and set up your crypto wallet to connect to blockchain apps. Click here to open the Linen Wallet page on the App Store. Once there, click on “Get” to download the app. Once downloaded, follow the instructions in the following video to set up your wallet. It will take less than a minute:

Funding the Wallet

Everything is set up, and the only thing missing is the crypto that we’re going to invest in with DeFi. So we need to deposit some funds to our Linen Wallet. There are two ways to do that:

In-app Purchase by Card

You can purchase USDC directly in the app. Just click on the “Buy Crypto” button in the “Wallet” section of the app, select the crypto to buy (in our case, USDC on the Polygon Network), and add your card details. The only drawback is that Simplex requires a 5% fee with a minimum fee of $10 (This fee doesn’t go to Linen but to the payment processor. We don’t take any fee for deposits).

Deposit Funds via an Exchange

If you already have some funds stored in an exchange, you can send them to Linen Wallet. To do that, follow these instructions:

  • Get your Linen Wallet address—Your blockchain address is like an email that can be used to send you money. You will use it when withdrawing funds from an exchange to send them to your Linen Wallet. You can find your address in the “Profile” section of the app, as shown below:
Screenshot: Profile Section of Linen Wallet
  • Important: As you can see, the address we’ve just copied is on the Polygon Network. For this reason, it is important that the exchange you are using supports withdrawal to the Polygon Network. If you use this address to withdraw but the exchange only supports Ethereum, you will send your funds to someone else. To make a practical example, let’s take the email address “[email protected]” You can imagine your address as the unique address that identifies you on a certain blockchain (“myname” would be your address), while the second part of the email is the blockchain you are using (gmail.com). If you try to send an email to “[email protected],” it won’t be delivered to the person intended. The same applies to blockchain addresses. In this case, Polygon is the network to use and your address is your identifier on the Polygon Network.

    Note: If you have assets on the Ethereum network, you can follow our guide on how to move them to your Linen Wallet on Polygon.
  • Send USDC to Linen Wallet: After copying your Linen Wallet address, you can withdraw funds from the exchange. You can see what the process looks like on Crypto.com in the screenshot below. As you can see, Crypto.com lets you select the network from which to withdraw USDC. If the exchange you are using doesn’t let you choose the network, DO NOT withdraw your funds.
Screenshot: Crypto Exchange Withdrawal

Before we continue, please let me remind you that this is not financial advice and you should do your own research for any project or app you use.

Earn a 15% Yield on USDC

So now that we’ve understood all the basic theory behind DeFi and that we know how to set up and fund our crypto wallet, it’s time to start earning a yield on our stablecoins. You already know what a blockchain app is and how it works on the back-end. Let’s now see what blockchain app to use and how it actually works.

In this guide, we’re going to use Aave, which is probably the most popular and most secure DeFi application.

By the way, I’m not affiliated in any way with Aave and I’m using it for this guide just because it’s actually one of the apps I use for my own DeFi investment.

You can find a detailed guide on how to use the app here.

Conclusion

You now understand all the basic theory behind DeFi. Of course, there is still much more to learn and there are many different ways to earn a higher yield—liquidity pools, impermanent loss, yield farming, and auto compounding are just some of the many things you can go deeper into. However, you already know more than 90% of crypto enthusiasts. If I receive great feedback from this first DeFi guide, I will gladly publish a new episode of this DeFi course so make sure to subscribe so as not to miss it.

If you have any questions or doubts, feel free to ask them in the comments section below. I’m always happy to help.