DeFi Trading Explained: In-Depth Guide
DeFi trading is the buying and selling of cryptocurrencies on decentralized platforms without using brokers or exchanges. It works through smart contracts and liquidity pools, allowing users to trade directly with each other.
DeFi trading is growing fast, but with no traditional brokers or exchanges, understanding how to trade in DeFi might seem like a challenge, especially for beginners. You’re not alone in finding these difficulties. Many find liquidity pools, automated market makers (AMMs), and minimizing risks hard to grasp at first.
This guide will make DeFi trading easy for you. We’ll explain how it works, which platforms to use, and how to get started with confidence. Whether you’re new to crypto or just want to explore DeFi, this article will guide you step-by-step.
What is DeFi Trading?
DeFi trading is all about buying and selling cryptocurrencies on decentralized platforms without relying on traditional brokers or exchanges. Instead of going through a centralized system like a bank or a stock market, DeFi allows you to trade directly with others using blockchain technology.
How Does it Work?
In DeFi trading, Automated Market Makers (AMMs) and liquidity pools are central to how trades happen. Traditional exchanges typically rely on order books where buyers and sellers place orders at specific prices. But DeFi exchanges use a different approach, one that’s much more hands-off and automated.
Here’s how it works:
Instead of matching buyers with sellers through an order book, AMMs use liquidity pools to execute trades. A liquidity pool, as the name suggests, is a pool of funds (crypto tokens and assets) provided by users. Those who contribute are called liquidity providers. These pools hold pairs of assets, like ETH and USDT, and anyone can deposit their crypto into these pools to help facilitate trades. In return for locking their assets in the pool, liquidity providers earn a share of the trading fees whenever someone trades using that pool. It’s like earning interest on your crypto. Sometimes, also referred to as yield farming.
Check out our list of the best liquidity pools to learn more.
AMMs, built on smart contracts, are the brains behind this system. They use mathematical formulas to automatically set the price of assets in the liquidity pool based on supply and demand. A popular AMM formula is x * y = k, which ensures that the product of the two assets’ quantities (x and y) remains constant (k) after each trade. So, if someone buys one asset, its supply decreases and its price goes up, while the other asset’s price adjusts accordingly. This happens instantly and without human intervention.
Check out our in-depth guide on automated market makers to learn more.
Advantages and Limitations
The key benefits? Lower fees and faster transactions, since you’re cutting out the middleman. Plus, anyone with internet access can join, making DeFi trading globally accessible.
However, it’s not all perfect. One of the main limitations is the high gas fees, especially on Ethereum. Also, transactions can be slower compared to traditional exchanges, particularly during network congestion.
But solutions are in the works. For example, Layer 2 solutions like Optimism and cross-chain trading with platforms like Thorchain are making DeFi more scalable and efficient, reducing these limitations.
That’s DeFi trading in a nutshell: decentralized, efficient, but still evolving.
DeFi Vs Regular Trading
| Factors | DeFi Trading | Regular Trading |
| Control & Ownership | You control your assets directly using decentralized wallets. | Centralized exchanges hold your assets for you, acting as custodians. |
| Intermediaries | No middlemen. Trades happen automatically through smart contracts. | Brokers or exchanges facilitate trades, often adding fees and oversight. |
| Fees | Lower fees since there are no intermediaries, but gas fees can spike with congestion. | Higher fees due to third-party involvement like brokers and regulatory bodies. |
| Transparency and Access | Completely transparent and accessible to anyone with the internet, globally. | Restricted by location and regulations. Transaction records are controlled by the exchange. |
| Security & Risk | You’re responsible for securing your wallet, but smart contract risks exist. | Centralized platforms have stronger security but are prone to hacks or outages |
Risks of DeFi Trading
While DeFi trading opens up a world of opportunities, it also comes with its own set of risks. These risks don’t mean you should avoid DeFi, but it’s important to be aware of them and take steps to protect your crypto.
Smart Contract Vulnerabilities: DeFi platforms run on smart contracts, which are like automated agreements that execute trades. But if there’s a bug or flaw in the code, hackers can exploit it. A well-known example is the bZx protocol hack in 2020, where a vulnerability allowed attackers to drain almost $1 million. Since smart contracts are immutable, once they’re deployed, it’s hard to fix any issues without causing damage.
Check out the biggest DeFi hacks in 2022 to learn more about how these hacks work and occur.
Market Volatility: The crypto market is notoriously volatile, and DeFi trading is no exception. For instance, in March 2020, Bitcoin’s price plummeted over 40% in a single day. If you’re trading on a DeFi platform and the market crashes, your assets can lose value quickly. This isn’t unique to DeFi, but it’s something to keep in mind when trading in such a volatile space.
Liquidity Risks: Liquidity pools are essential for DeFi trading, but if liquidity dries up, trading becomes harder. The Sushiswap migration in 2020 is a good example—massive liquidity shifts led to price slippage, meaning traders didn’t get the price they expected, causing losses.
Impermanent Loss: This happens when you add liquidity to a pool and the price of the tokens you add changes. For example, if you add ETH to a pool and its price doubles, you might end up with less ETH due to price shifts in the pool. It’s called “impermanent” because the price might balance out, but it becomes permanent if you withdraw at the wrong time.
Check out our in-depth guide on impermanent loss to learn how to avoid it.
Regulatory Landscape of DeFi
DeFi operates in a tricky space when it comes to regulation. Since these platforms don’t rely on traditional banks or brokers, they’re often in a legal gray area. But that’s changing as regulators start to focus on DeFi.
In 2021, the U.S. Securities and Exchange Commission (SEC) warned about the risks of DeFi, especially for platforms offering high-yield products that might be seen as securities. The Financial Action Task Force (FATF) is also pushing DeFi platforms to follow anti-money laundering (AML) and know-your-customer (KYC) regulations, even though they are decentralized.
To deal with these challenges, some DeFi projects are trying to stay ahead of the game. Aave, for example, introduced KYC processes for institutional clients to comply with regulations. Uniswap has taken steps too, like removing hundreds of tokens to avoid legal issues.
In the future, we’ll likely see more rules aimed at DeFi. The European Union’s proposed Markets in Crypto-Assets (MiCA) regulation is one example. But because DeFi is global and decentralized, making these rules stick everywhere will be tough.
As regulations evolve, DeFi projects will have to find a balance between staying compliant and keeping the decentralized freedom that makes them unique.
How to Start DeFi Trading: A Step-by-Step Guide
Getting started with DeFi trading is simpler than you might think. Here’s a quick guide to help you dive in.
- First, you’ll need a crypto wallet to store your assets and interact with DeFi platforms. Popular options include MetaMask, a browser-based wallet, and Trust Wallet, a mobile wallet with strong security features. Make sure your wallet supports the blockchain you plan to trade on, like Ethereum or Binance Smart Chain.
- Next, you’ll connect your wallet to a DeFi platform. Visit a decentralized exchange (DEX) like Uniswap, SushiSwap, or PancakeSwap and look for the “Connect Wallet” button. Follow the prompts from your wallet to link it to the platform. Once connected, you’re ready to trade directly from your wallet.
- To make your first trade, simply select the asset pair you want to swap (like ETH/DAI) and enter the amount. Keep an eye on gas fees, especially on Ethereum, as they can fluctuate. Check out our quick guide on reducing Ethereum gas fees.
- After trading, it’s important to monitor and secure your assets. Tools like Zapper and DeBank make it easy to track your portfolio. If you need to manage taxes, Bitcoin.Tax is a helpful tool that consolidates your trades, tracks your transaction history, and automatically calculates your gains, losses, and taxes.
FAQ
How do DeFi traders make money?
DeFi traders make money in several ways. One common method is through buying and selling cryptocurrencies for a profit, similar to regular trading. They buy an asset at a lower price and sell it when the price goes up.
Another way is by providing liquidity to decentralized exchanges (DEXs). Traders deposit their assets into liquidity pools and, in return, earn a share of the trading fees generated by the pool. Some traders also take advantage of yield farming, where they move their assets across different DeFi platforms to earn rewards in the form of interest or tokens.
Lastly, some traders participate in staking, where they lock up their assets in a platform to help secure the network and earn rewards. Each method comes with risks, but it’s possible to earn returns with careful strategies.
What is the best DeFi platform?
There isn’t a single “best” DeFi platform because it depends on what you’re looking for. Different platforms are known for different things.
If you want a popular decentralized exchange (DEX), platforms like Uniswap and SushiSwap are great for swapping tokens on the Ethereum network. PancakeSwap is a popular choice for trading on Binance Smart Chain. Check out our list of best DEXs for more.
For lending and borrowing, platforms like Aave and Compound are well-known and trusted. Check out our full list of best lending platforms and best crypto flash loan platforms.
If you’re looking for yield farming or staking, Yearn Finance offers automated strategies to maximize your returns across different DeFi platforms. Check out our full list of best staking platforms for more.
Ultimately, the best platform depends on your goals, whether it’s trading, lending, or earning passive income. Just make sure to research and choose one that fits your needs.
What are the top 3 DeFi coins?
The top DeFi coins include Uniswap (UNI), used for governance on the Uniswap exchange; Aave (AAVE), tied to the Aave lending platform; and Chainlink (LINK), which provides decentralized oracle services for smart contracts. These coins support major DeFi projects with real-world use cases.
What are the top wallets for DeFi?
Some of the top wallets for DeFi include:
- MetaMask: A browser-based wallet that works with most DeFi platforms.
- Trust Wallet: A mobile wallet with strong security and support for multiple blockchains.
- Ledger: A hardware wallet that offers extra security for storing and interacting with DeFi assets.
Check out our full list of the best Ethereum and Solana wallets for more.