What Is DeFi? (A Beginner’s Guide to Decentralized Finance)
It’s fair to say that DeFi has been one of the buzz words of late, especially so in the world of crypto. DeFi tokens have been among the year’s best performing digital assets, with numerous seeing huge gains. But, crypto traders alike are still struggling to comprehend what DeFi is all about.
Decentralized Finance (DeFi) is a financial service that uses cryptocurrencies that can be programmed through smart contracts to build exchanges, lending services, and insurance services without centralized authorities.
Just like cryptocurrencies, DeFi takes away the need for a centralized entity. But the way it works remains baffling even for advanced traders. Read on to find out how DeFi works, and let’s decipher the truth if you can make money from DeFi?
Centralized Finance (CeFi) vs. Decentralized Finance (DeFi): The Differences
The financial system and services today are usually centralized. For example, banks, insurance companies, investment services are controlled or offered by a centralized entity or a person. In other words, your funds in a centralized exchange are managed by a responsible party. It is up to the entity to decide the trading fees you should pay or manage your transactions and activities.
Although CeFi and DeFi aim to facilitate the use of cryptocurrencies for different financial needs, they both are executed differently.
Decentralized finance is an open system of finance, which through blockchain technology, allows for the facilitation of financial services from peer-to-peer and gives people full control of their assets.
Stipulations for such an agreement on a decentralized application (DApp) can be written in code onto the blockchain through smart contracts. So when the stipulation for the loan is met, the funds will be released. This is just one of many functions Dapps serve. They work in the way that regular applications would, but they are entirely decentralized and without a centralized control based on one single entity.
What Are DApps?
DApps are built on an open-sourced distributed platforms and a decentralized peer-to-peer network where no one has control over the network. It enables you to buy, sell, trade, lend and borrow cryptocurrencies on a decentralized network.
These applications are usually programmed on a platform like Ethereum to write automated code (smart contracts) and derive the rules on how the financial services will work in a decentralized manner. Once it is programmed, they are immutable, meaning no one will have control over the rules except what was written in the smart contracts.
Types of DeFi DApps
There are various types of DApps in existence, catering to the many different needs of users. Here are some of the main ones.
Borrowing and Lending DApps
With borrowing and lending DApps, you can do what you probably expect – borrow and lend cryptocurrencies. While the loan agreement is arranged through a smart contract. From the lender’s point of view, using these DApps has the advantage of being able to earn interest on the crypto you lend, and due to over-collateralization, there is only a minimal risk of the assets not being repaid.
From the borrower’s point of view, using these DApps has the advantage of there being no credit checks, low transaction fees, and instant settlement.
Decentralized Exchanges (DEXes)
Through decentralized exchanges (DEXes), users can trade digital assets amongst each other without the need for a central entity to hold their funds or to deposit funds in the first place. Users instead link their wallets to the exchange and then verify the transaction themselves.
On Uniswap, a popular DEX, users can also provide liquidity to the exchange for an incentive (a proportion of the trading fee shared amongst all the liquidity providers). Using this method to add to the liquidity pool negates the issue of being reliant on market makers to provide liquidity. Such reliance would be impractical on the Ethereum blockchain because of its low throughput for transactions.
The price of assets on DEXes is commonly determined by automated market makers (AMM), protocols written into the smart contracts of the blockchain which use mathematical formulas to determine the price.
An advantage of DEXes is that because of minimal maintenance; trading fees are also minimal. Additionally, as long as the smart contract is robust, they are considered very safe.
A disadvantage is that, compared to more established, centralized exchanges, which may offer – as Bybit does, for example – derivatives and margin trading, they often lack in the variety of trading that they offer.
Investors can enjoy peace of mind by taking out insurance to cover their digital assets. This can cover the eventuality of a bug on a smart contract, for example, or a hack on the blockchain. On the other hand, some Dapps also provide insurance for actual events in the same way typical insurance would, like for flight delays.
Through its open-source technology, DeFi offers safe payment solutions for private individuals and businesses. Blockchain technology helps prevent fraud, gives banking services to those previously unbanked, offers payment in different cryptocurrencies and digital tokens. Best of all? It allows instant processing times.
Examples of payment Dapps: Flexa
Prediction Market DApps
If you want to predict the event’s outcome for money, you no longer need to go to a bookmaker. DeFi is the solution. You can predict the results of elections, sports events, and even future developments in the world of crypto.
Examples of prediction market Dapps: Augur
Stablecoins are cryptocurrencies pegged to the price of a stable asset, such as the US dollar. By offering price stability and low volatility (two factors that can notoriously plague cryptocurrencies), they reassure users when performing transactions on DApps.
Stablecoins play a fundamental role in different areas of DeFi. One of them is with liquidity pools. Stablecoins are a preferable choice because it provides stability, and hence more liquidity. Also, the lack of volatility in stablecoins provides opportunities for steady yields for investors in DeFi.
Examples of stablecoins: DAI
To use DApps, users will need somewhere to store their cryptocurrency and tokens. That’s where wallet Dapps come in. They are downloadable as an add-on on your internet browser. Users can also sync up their wallet Dapps with other Dapps to make transactions quick and easy.
To perform transactions on DApps, you need tokens – not actually cryptocurrencies themselves. On the Ethereum network, you use Ether to gain access to these tokens, like how you use real money to get tokens for an arcade machine. But just like you use the tokens to play the games, you use the tokens in the former case to use the DApps in some ways. Just like with cryptocurrencies, tokens can be traded and fluctuate in value.
Tokens can have different features within a Dapp, and some may fall into more than one category:
- Application Tokens: These tokens provide access to a good or service on DApps.
- Governance Tokens: These tokens help to govern the protocols of the DApps. For instance, if decisions need to be made on a change within the Dapp, stakeholders can vote on the implementation.
- Transactional Tokens: These tokens are used to pay for goods and services on a DApp.
- Security Tokens: It is a form of investment, just in the way traditional securities would be, such as shares or bonds.
The Ethereum network hosts most DApps (although a significant minority exists on other networks, such as EOS, NEO, and Tron). Launched in 2015, its creator Vitalik Buterin had become frustrated with the limitations of the Bitcoin network to build DApps, and so envisaged Ethereum to go beyond just being digital money.
Ethereum’s more advanced technology (as compared to Bitcoin) allows for the implementation of these Dapps. However, the launch of more sophisticated DApps causes the network to face scalability challenges in coping with the extra demands. As a result, the Ethereum 2.0 upgrade on the network is here to address the issue.
Terms in DeFi You Should Know
Here are some of the main terms associated with DeFi that you should know.
As its name suggests, DeFi offers a decentralized alternative to the centralized infrastructure of finance. The nature of decentralization allows the distribution of planning or decision making stray away from the authorities or a central group.
Decentralized Applications (DApps)
DApps form the backbone of DeFi. They operate in the same way that regular apps do but does not run by a single entity. The functions of these DApps in DeFi range from borrowing, lending, insurance, and payments – to name but a few.
Decentralized Exchange (DEX)
As discussed in the article, DEXes allows users to trade digital assets peer-to-peer. In contrast to centralized exchanges, they are in complete control of their funds at all times.
Liquidity pools remove the need for DEXes to rely on market makers for liquidity. Whereas users provide liquidity in exchange for incentives. These can be trading fees, interest, bonuses, or other incentives unique to the exchange.
Just as lego has composability (can be put together in different ways), so do DApps in DeFi. That means you can mix and match other DApps for various functions.
The vast majority of DeFi Dapps are open-source. That means coding is available for anyone to see and interact with, and scrutinize as they see fit.
An oracle is used on a blockchain to provide smart contracts with information from the outside world. They are an essential part of how smart contracts operate, as they cannot access the data by themselves. It is with this information that they provide that smart contracts can be executed.
Over-collateralized loans form a fundamental part of the DeFi infrastructure. In the absence of credit checks, they are a form of insurance for lenders if the borrower defaults on any loan on a DApp.
However, a key difference to normal collateralization of a loan is that, in DeFi, you need to over-collateralize. This means that the borrowers would need to put forward more in assets than the value of the loan itself. The minimum collateralization ratio is 150%. For example, if somebody wanted to borrow $200 of DAI, they would need $300 of Ether to back it up as collateral. That is to protect against potential price volatility in the market.
DeFi allows anyone to take part. You don’t need a bank account. All you need is an internet connection so you can use the DApps.
A smart contract is a self-executing contract written onto a code of a blockchain. They execute when specific stipulations are met. Examples include loan agreements, insurance agreements, or the sale of a house.
This is the process of converting real-world assets such as loans, or real estate, into programmable data to be stored on a blockchain. By cutting out the middleman, it takes away many of the overheads and administrative costs, which are usually involved in such procedures.
Total Value Locked (TVL)
This is a measurement used to gauge the size of the DeFi industry. It is the total value in dollars locked into DApps in the capital. For example, this capital may be liquidity in a DEX trading pool or a loan on a borrowing and lending Dapp. In 2020, the TVL in DeFi has increased significantly. In January 2020, it was around $600 million, but this had rocketed to over $11 billion by November 2020.
This is one way of making profits while supporting the DeFi ecosystem through the borrowing, lending, and exchange of tokens. As a yield farmer, you’ll be providing liquidity to the liquidity pool with an underlying mechanism in exchange for incentives.
Can I Make Money From Investing in DeFi?
The short answer is yes, but as with anything when you’re trying to make money, it comes with a risk.
How You Can Make Money From DeFi
There are numerous ways in which investors can earn a passive income from DeFi:
Earn Interest Through Yield Farming
As already referred to in the article, yield farming is one of the main ways to make money from DeFi. As with all things DeFi, it is still a relatively new concept, but it exploded in popularity through the summer of 2020.
It involves the lending of crypto assets, namely ERC-20 tokens and stablecoins, for the purposes of providing liquidity to the DeFi ecosystem. This is done on DApps, with users earning fees or interest in crypto in return. Let’s look at a few of the most popular platforms on which you can take part in yield farming:
This platform is one of the most popular for yield farming because of the relatively simple way it can be done. To encourage the use of the DApps (and therefore providing liquidity), users receive the COMP token, specific to the DApp (the more you use it, the more tokens you get). From the investor’s point of view, they hope that these tokens’ value appreciates over an extended period.
In COMP’s case, it did – and massively – in a concise space of time. Since its release on June 18, 2020, with a price of $61. By June 21, 2020, it had rocketed to $372. Since then, it has depreciated and become relatively stabilized around the $100 mark (as of early November 2020). However, it had seen some price spikes (most notably in early September, when it surged above the $250 mark).
Aave Open Source DeFi Protocol
Aave is another popular platform for yield farmers. It is a decentralized protocol for the borrowing and lending of tokens. Interest rates are determined by an algorithm based on market conditions. Tokens that are borrowed will immediately start earning interest.
As a decentralized exchange protocol, users utilize Uniswap to facilitate token swaps. In other words, liquidity providers can earn fees off the Uniswap platform by providing liquidity to its liquidity pools. For example, liquidity providers make 0.3% of the trading fees just by facilitating the particular liquidity pool.
On the contrary to its perks, all trades, including yield farming, comes with a set of risks. That’s especially when smart contracts can be riddled with bugs. That was precisely the case with the token YAM in August 2020. There’s over $400 million locked into YAM on Uniswap, but there was a bug after it transpired. Subsequently, its price crashed spectacularly from over $100 to around the $1 mark.
Although DeFi hasn’t seen such a retraction (yet), it’s worth noting that what happened with YAM could quickly happen again. Short-term greed can lead to long-term pain as prices surge to unsustainable levels. We iterate this a lot at Bybit, but that’s because it’s true: do your research! Investigate the merits of the DeFi project for yourself.
Additionally, yield farming isn’t for beginners. Although we’ve explained it here in layman’s terms, it takes a good deal of detailed technical knowledge to be truly successful at yield farming. If you don’t know what you’re doing, you could easily lose out on your capital.
DApps PoolTogether Lottery
OK, you might not earn money, but you can’t lose it either. If you win, great, and if you don’t, you get your money back. The DApp PoolTogether is a no-lose lottery. Built on the Ethereum blockchain using DAI, users receive one ticket for every $1 deposited. It is made possible because the prize doesn’t come from the funds for the tickets bought. It comes from the interest accumulated from money deposited into the pool.
The History and Future of DeFi
The history of DeFi is a short but eventful one, born out of the wish to utilize blockchain technology to benefit financial applications.
The term was first coined in August 2018, in a Telegram chat between entrepreneurs and Ethereum developers. The topic of conversation was how an open-source financial-based application could be built on the Ethereum blockchain – hence the term decentralized finance, or DeFi, was born.
The first real DeFi application precedes that by a year – with the launch of MakerDAO in 2017. By allowing users to lend DAI (against Ether as collateral), it opened the door for the borrowing and lending of money without a central entity’s need.
From there, the DeFi ecosystem grew exponentially, with other protocols focusing on borrowing and lending being launched in 2018. Among them was Uniswap, which allows you to swap any ERC-20 (tokens on the Ethereum blockchain), and is now one of the biggest DApps by a number of users.
Throughout 2019, DeFi continued to grow, but in 2020, a year will be remembered for some rather unsavory worldwide events, which will also be remembered as the year DeFi exploded.
To generalize, DeFi’s DApps now have a multitude of functions in addition to borrowing and lending, including DEXes, insurance, and payments.
The Future of DeFi
So is DeFi the future of finance? Or just a fad?
The DeFi boom has already shown signs of contracting, but this was an inevitability. The real question is: will it crash, or will it level out and reach a level of long-term sustainability?
For DeFi to reach such a level, several fundamental issues will need to be addressed. Security is still a concern; issues like smart contract bugs remain a prominent concern for users and investors. This issue of smart contract security is directly addressed with the growth of smart contract insurance DApps. That is when the eventuality of a smart contract bug occurs, and the potential for assets could be lost. These sorts of DApps can also provide cover against hacking – which unfortunately does occur, albeit a rarity. In one instance, in April 2020, $25 million of cryptocurrency was stolen from the borrowing and lending of DApp Lendf.Me.
Also, just as is the case with crypto in general, regulatory concerns linger. At present, there is the potential for DeFi projects to be made illegal at short notice, as very little in the way of regulations exists in the sphere. Some industry-wide regulations would boost long-term confidence.
With economic concerns on a global scale not likely to fade anytime soon, stablecoins have enormous potential to expand their usage in the coming years. Countries with hyperinflation such as Venezuela have been early adopters, and this trend will likely continue.
The Bottom Line
DeFi has the potential to revolutionize the financial industry as we know it. No longer do people have to rely on central entities for loans, insurance, or making payments. And the decentralized blockchain technology makes the use of DeFi Dapps, for the most part, a very safe experience. However, security concerns remain, with smart contracts bugs and time to time rearing up and hacks occurring, and they must be dealt with for DeFi to continue its healthy growth. Also, as already addressed, the explosion in the amount of DeFi Dapps has caused scalability issues – but this is something that it is hoped Ethereum 2.0 will combat.
For the investor, the possibilities of making money from DeFi may seem exciting and indeed do exist, but they should be approached with caution. Yield farming is not for beginners and necessitates significant knowledge and research to master effectively. Whether it will ever completely take over centralized finance (CeFi) is doubtful. Still, as long as appropriate risk mitigation procedures are put in place, DeFi will go mainstream – its potential is too great.