The DeFi ecosystem is the big thing in the crypto world right now, a bit like the Initial Coin Offerings (ICOs) that were all the rage in 2017. In June, nearly $1 billion was locked up in DeFi's protocols, according to measurement site DeFi Pulse. By the end of August, investors had deposited $9 billion in smart contracts in various DeFi protocols.
What is DeFi?
So what is this mighty wild beast known as DeFi? And isn't all cryptocurrency finance decentralized, anyway? Sort of. The DeFi movement refers to a specific genre of financial product that advocates decentralization above all else, and uses lucrative incentive mechanisms to encourage investors to play along.
The world of decentralized finance (DeFi) is composed of a multitude of non-custodied financial products built around a culture of highly experimental and highly lucrative crypto projects that have attracted the attention of large corporations and venture capitalists, and a few scammers.
How does DeFi work?
Among the most popular projects are the Aave, Maker and Compound lending protocols. These are protocols that allow you to borrow cryptocurrencies instantly and often in large amounts if you can prove that you can repay the loan in a single transaction. You can also earn interest on borrowing cryptocurrencies.
There's also Uniswap, a decentralized exchange that allows you to trade any Ethereum token you want, or make money if you add liquidity to the market for any token. DeFi also deals in synthetic assets, such as Synthetix's tokenized shares or Maker's decentralized stablecoin, DAI, whose value is algorithmically determined by the protocol. And other services move Bitcoin to Ethereum in a non-custodial manner or offer decentralized price oracles, which, among other things, allow synthetic assets to be accurately linked to their non-synthetic counterparts.
What gives these protocols the DeFi label is that they are - at least in principle or ambition - decentralized and non-custodial.
Non-custodial (or non-custodial) means that the development teams do not handle investors' tokens on their behalf. Unlike, say, depositing your money in a bank or lending your cryptocurrency to a crypto lending company (such as Cred), with DeFi protocols you always retain control over your coins.
Decentralized means that the creators of these protocols have delegated power over their smart contracts to the community - in the spirit of the hacker ethic, their creators get rid of as much power as possible as quickly as possible and let the users vote on the future of the network.
Explanatory video of Defi created by the channel Finematics
The space often falls short of their ideals. Even in some of the largest DeFi protocols, close readings of their smart contracts reveal that the teams have immense power or that the contracts are vulnerable to manipulation.
But it is very lucrative for some traders. Many of these lending protocols offer crazy interest rates, further increased by the phenomenon of yield farming, whereby these lending protocols offer additional tokens to lenders.
Those governance tokens, which can also be used to vote on proposals to improve the network, are tradable on secondary markets, meaning that some annual percentage returns work out to 1000%.
What are some of the main DeFi protocols?
Aave, Compound and Maker are DeFi's main lending protocols, with billions of dollars of value locked up in their smart contracts. The premise is simple: you can lend cryptocurrencies or borrow them. All of the major protocols are Ethereum-based, which means you can lend or borrow any ERC-20 token. As mentioned above, they are non-custodial, which means that the creators of the protocols have no control over their holdings.
Interest rates vary. At the time of writing, you can lend Maker's decentralized stablecoin, DAI, for 3.3% at Compound, or borrow it for 4.3%. At Aave, it's 25% to lend and 40% to borrow. But the percentage points vary a lot every day, so take things with a grain of salt.
These protocols triggered the so-called "yield farming" craze. In mid-June 2020, Compound came out with $COMP, a governance token that allowed holders to vote on how the network would operate.
Those who lent cryptocurrencies on Compound earned $COMP for their efforts, sort of like loyalty points. They could use these governance tokens to vote on proposals to improve the network. This was only one use for the token. The other, which brought fame and infamy to DeFi in equal measure, was to earn $COMP for speculative purposes. The statistics explain why. On launch day, June 17, 2020, $COMP was worth $64. By June 23 of the same year, a single $COMP was worth $346. Other lending protocol developers began to take notice and launch their own governance tokens. Aave has one, $LEND, as do a host of other DeFi protocols.
The cost of a single $YFI, the governance token of DeFi performance aggregator yearn.finance, peaked at $41,000 in mid-September 2020, quadrupling the price of Bitcoin at the time and doubling its all-time high. And all this because of a token introduced by the creators of yearn.finance as having "0 value." They wrote when launching the token, "Don't buy it. Earn it."
Decentralized exchange platforms and liquidity providers
Decentralized exchanges are another popular type of DeFi protocol. Such as Uniswap, Balancer, Bancor and Kyber. 1inch aggregates all decentralized exchanges into one website.
All of these exchanges are examples of "automated market makers". Unlike, for example, the centralized exchange Binance, or the decentralized exchange IDEX, where traders buy and sell cryptocurrencies among themselves, these automated market makers have liquidity pools.
Let's break that down: liquidity means how easy it is to move money in a market. If the market for some token is highly liquid, it means it's very easy to trade. If it's illiquid, it means it's hard to find buyers for your tokens.
Liquidity funds are large token matching vaults, say, a liquidity fund for ETH and BTC, that traders can use to make trades. So if someone has put $1 billion in ETH and $1 billion in BTC into a liquidity fund, there is enough money circulating around the exchange for traders to trade the assets seamlessly.
The DeFi part is that all of this happens without custody, and any ERC-20 token can be added to these exchanges. This gives the market more options, as centralized exchanges will not list certain tokens due to legal issues and because many tokens are, well, scams. The other DeFi part is the incentive structure. Those who fund these liquidity pools earn commissions every time someone makes an exchange, plus various performance farming rewards that dangle from some of the protocols.
Decentralized stablecoins and synthetic derivatives
Here's what the centralized world of synthetic assets likes: there's about $14 billion worth of Tether, the largest stablecoin in the ecosystem in terms of dollar backing. Tether claims its coins are fully backed by U.S. dollar cash reserves. But the answer to these claims is behind closed doors, and the company has previously admitted that these tokens were at one point only 74% backed by the U.S. dollar. The company is now under investigation by the New York Attorney General.
The problem is that those who trade in these coins must trust that the companies that create them are true to their word and that these tokens are always redeemable for dollars. But companies betray the trust of their users; human beings can fail. Lawrence Lessig's motto, "The code is the law," motivated the rise of decentralized stablecoins, whose linkage to the asset it represents is determined by a complex, self-sustaining algorithm. The most popular stablecoin is the DAI, produced by Maker.
How to get started in the DeFi world
Here's what you need to do. First, get a wallet that is compatible with Ethereum and can connect to various DeFi protocols through your browser. MetaMask is one of the best choices.
Second, buy the coin corresponding to the DeFi protocol you plan to use. Right now, most DeFi protocols live on Ethereum or the BSC network, so you will need to buy ETH or BNB to use them.
Third, play the DeFi game. There are countless ways to do this. One way is to lend your cryptos. An easy way to see how to get the best deal is to use yearn.finance, which lists them in one simple place. You could become a "yield farmer" by earning governance tokens that are awarded for lending your cryptocurrencies. More information on the potential benefits of yield farming can be found at sites like yieldfarming.info.
A second way to play would be to put your funds on a decentralized exchange, such as Uniswap, and earn commissions by becoming a market maker. You could even put them on the controversial SushiSwap, which allows you to earn performance farming tokens on your market making.
Thirdly, you could invest in one of the most experimental and crazy DeFi projects, such as Based.Money, whose token price is "reset" daily, skewing the token price.
But one thing to keep in mind: The space is full of risks, scammers and mistakes. This is a highly experimental and risky space within the crypto world, which is itself a highly experimental and risky space. Scammers are rampant, and people often discover vulnerabilities in smart contracts that reveal how token creators have all the power (and the project is not decentralized at all, after all).
Be careful colleagues!
