DeFi is a well-known term, especially for those who are familiar with the cryptocurrency market. Decentralized finance is supposed to improve the financial system and ease payment operations significantly. However, DeFi isn’t just about transferring money. It has various facets that should be discussed.
We have created a comprehensive guide that will show you DeFi from different sides.
DeFi: Check Basics
DeFi, or decentralized finance, is a familiar word for anyone connected to finance and technology. The term was created in 2018 in a Telegram chat of Ethereum entrepreneurs and developers. They were trying to find a name for the ecosystem of financial applications, built with blockchain technology, that expands users’ options beyond simply sending money from point A to point B.
When seeking information about the roots of DeFi, it’s highly likely you will find an assumption that DeFi appeared in 2009 along with Bitcoin as it was the first application built on blockchain.
However, if the ecosystem appeared in 2009, why was the term created only in 2018? The launch of MakerDAO in December 2017 is a more realistic point. MakerDAO is a protocol built on Ethereum that enables users to issue a cryptocurrency that is bound 1:1 to the value of USD using digital assets as collateral. As a result, a user could borrow Dai again ETH, which created a precedent to get a loan without including a centralized entity. Simultaneously, dollar-pegged crypto didn’t rely on keeping USD in a bank account.
After that, more financial protocols started to enter the market, creating an interconnected ecosystem. Just to mention, Uniswap enabled customers to exchange any token for Ethereum seamlessly and without permission.
Since then, numerous DeFi applications have entered the market. The use-cases vary from usual ones such as lending, borrowing, and trading, to hardly-imaginable ones, such as streaming payments and creating synthetic assets.
DeFi: What Does It Stand For?
The definition of decentralized finance is quite simple. But it may not be that clear what the key differences between DeFi and the usual financial ecosystem are. Let's discover the characteristics of protocols and applications that constitute the DeFi ecosystem.
- Decentralized. The protocols and applications enable users to control their funds and private data and transfer assets without requiring any interaction with intermediate financial institutions. The networks are built on blockchain, which is run by thousands of nodes around the world. Thus, a network is managed by a community of users. No authority can take control over funds or an application.
- Limitless. There are no limits to access the ecosystem globally. Anyone from anywhere can use the networks.
- Frank. Applications' code can be seen and examined by anyone. Thus, there is no hidden information about the workings of protocols and apps.
- Lego. Open-source code allows developers to invent a new application built on the code of an app with similar purposes. A new application is supposed to be more innovative and useful than one that came before it. As a result, the system looks like pieces of lego.
Nothing is perfect, and DeFi applications are no exception. The most challenging thing for applications and networks is to be fully decentralized. Full decentralization creates problems for an app's development as technical teams can't react as quickly as they can with centralized projects. As a result, not decentralization but openness is a crucial quality of DeFi protocols. Users can access most protocols.
DeFi is applied to various use-cases. Let's discuss the most popular ones.
DeFi: Lending and Borrowing
The lending and borrowing concept exists both in a traditional financial system and a crypto one. As lending and borrowing have existed for ages, the idea is familiar to every adult: a lender provides funds - fiat money or crypto assets - to a borrower in return for a regular interest rate. Usually, such deals are enabled by financial institutions or independent entities, including P2P lenders. If we talk about the crypto market, the concept is facilitated either through a centralized finance entity, for instance, BlockFi or Celsius, or via a decentralized protocol, for instance, Aave or Maker.
How It Works
The process of lending and borrowing on a DeFi protocol is like this: a lender should choose a coin and a smart contract using a DeFi app. They send tokens for lending into a 'money market' with the help of a smart contract. After that, these tokens become available to those who want to borrow. The smart contract issues interest in the tokens native to the platform being used (every platform that enables lending and borrowing has its own token. Earlier, we mentioned Dai, the native token of the Maker platform). Such tokens are automatically distributed to the user and can be redeemed later for the user's underlying assets.
The interest received by lenders and paid by borrowers is calculated using the ratio between the supplied and borrowed tokens in a particular market. The borrowing annual percentage yield (APY) is always larger than the supply APY in a particular market.
Loans in native tokens are over-collateralized as borrowers have to guarantee, using cryptocurrency, that their value is greater than the actual loan.
Why You Should/Shouldn’t Use the Concept
The concept of DeFi lending and borrowing has clear advantages and pitfalls.
- No third-party interaction. DeFi allows users to lend and borrow in a decentralized system, obtaining full control over their funds.
- Anonymity. DeFi applications allow users to lend and borrow privately without the need to share personal data with a central authority.
- Additional funds. Imagine that a person needs additional funds due to unexpected expenses but doesn't want to sell their assets as these can be reinvested in the future for more significant gains; borrowing allows them to keep their own funds.
- Deal with taxes. By borrowing, it's possible to delay or even avoid paying tax on capital gains.
- Leverage. Borrowing allows users to utilize the funds in question to increase their leverage on certain trading positions.
- Higher payments. A dramatic change of APYs within a short time frame. This can mean that users who don’t follow their interest rates daily repay more than they expected.
- Third-party smart contract tampering.
- Terms and conditions. Users should be careful with the features of every protocol to avoid unexpected fees and wallet issues.
- No recovery. It’s vital to re-check address details as there is no opportunity to recover lost funds.
- Capped funds. Unfortunately, borrowing is capped, and the cap depends on several factors:
- Availability of funds. This factor is logical, and it also relates to the traditional financial model. It's impossible to borrow more than a lender provides.
- Collateral factor. Every collateral token has its own ‘quality,’ and the amount of borrowed funds directly depends on that. For instance, Dai has a collateral factor of 75% on the Compound platform. As a result, a user can borrow no more than 75% of the value of their supplied Dai.
- Technical limits. The borrowed amount shouldn't exceed the value of one's collateral multiplied by its collateral factor.
Another way to gain passive income is to use the DeFi staking concept.
What Is It About?
The concept is based on crypto holdings. Users have to store their assets on the Proof of Stake (PoS) algorithm, ensuring the correct operation of the blockchain. In return, they receive rewards; the annual standard reward is around 13% of their holdings. Users’ tokens are locked into the smart contract. When a person locks their funds on the algorithm, they become a part of the network validators that confirm its security.
Validators prevent cheating, so this is rewarded. It doesn’t mean that a user has to inspect the network. Once funds are staked, the PoS mechanism starts to handle the rest. The only thing that may be required sometimes is to claim rewards for staking.
A staker can earn not only staking rewards but also a percentage of the revenue on the tokens accrued by the products and services offered by the platform. For instance, it’s possible to earn a share of the fees from swaps on liquidity pools.
Staking is only available to cryptos built on PoS, including EOS, TRON, Tezos, and also Ethereum after the new ETH2 upgrade.
Where to Stake
Staking is available on various platforms:
- Staking Aggregators. These allow users to pool cryptos and send them to protocols with a higher yield. For instance, Plasma.Finance, Zapper, Zerion. However, lending and borrowing aren’t available on such platforms.
- Stable coin staking platforms. Besides staking, lending and borrowing are also available on such platforms. It’s possible to borrow stable coins against other cryptos. These platforms have their own stable coins available for borrowing.
- Synthetic token staking platforms. Such protocols present synthetic assets that represent physical assets, including fiat money, stocks, bonds, etc.
Why You Should/Shouldn’t Use the Concept
- Minimum actions. The key staking advantage is that no trades or transactions are required. Finding the platform is the only thing that needs to be done.
- Newbie-friendly. Staking is much easier and clearer for crypto newbies than cryptocurrency mining.
- Safe and less risky. Staking is less affected by hidden fees, corruption, or lack of transparency.
- Higher interest. Staking may provide higher interest rates rather than traditional savings accounts.
- Full control. Users have full control over their assets.
- Not as profitable as one might desire. It's a well-known concept that riskier assets provide larger rewards. As staking is one of the safest ways to generate passive income, the rewards aren’t high.
- A decrease in cryptocurrency turnover. If a user keeps coins for as long as possible to maximize the potential profit, there is a risk of a decrease in the turnover of the cryptocurrency in general.
DeFi: Yield Farming
Yield farming and staking look quite similar. Yield farming allows farmers to gain rewards on their crypto holdings. A user invests a cryptocurrency unit into a lending protocol. As a result, they get interest from trading fees. The users of the DeFi protocol pay marketplace fees for trades. The platform shares these fees with liquidity providers. The amount depends on their share of the liquidity pool. It’s possible to gain additional yields from the governance token of the protocol.
When you take a bank loan, you have to pay back the loan amount with interest. The same concept works for farming, but in this case, the cryptoholder is a bank. Farming uses crypto that would have been wasted in an exchange or a hot wallet.
Farming incorporates two leading terms - liquidity providers and liquidity pools. A provider is a user who deposits their assets into a smart contract. A pool is a smart contract loaded with cash. The concept of yield farming is built on the automated market maker (AMM) model, which is well-known on decentralized exchanges. The model excludes the conventional order book, which includes “buy” and “sell” orders on a cryptocurrency exchange. The AMM model makes liquidity pools with the help of smart contracts instead of stating the trade price of an asset. The pools execute trades using predetermined algorithms.
Farming vs. Staking
Although the concepts are quite similar, staking usually involves large amounts of crypto assets and may require a lot of time before the fund matures. Farming allows for earning many governance tokens in exchange for lower fees generated on several liquidity pools.
Why You Should/Shouldn’t Use the Concept
- High returns. Yield farming provides an opportunity to earn one of the highest levels of passive income.
- Difficult to calculate. Although it’s possible to calculate anticipated yield return using an annualized model, all calculations are approximate as the market is highly volatile.
- High volatility. Despite possible high returns due to high market volatility, there are risks of a drop in profitability.
- Liquidation. DeFi applications provide liquidity using customer deposits. However, if the loan price is higher than the collateral value, the loan is liquidated. For example, if a loan in ETH is secured by BTC and the ETH rate increases, the loan will be liquidated as the collateral price will be lower.
- General risks. Every crypto user should remember the common risks such as hacking and code bugs.
DeFi: Decentralized Exchanges (DEX)
A decentralized exchange plays a major role in the cryptocurrency world. Such an exchange doesn't involve a third party for clearing transactions. It enables trading using self-executing smart contracts and contributes to instant trades with lower costs compared to a centralized exchange. Decentralized exchanges are non-custodial. This means that only the user is responsible for keeping and saving funds, wallets, and private keys.
Key storage is a vital issue when talking about cryptocurrency exchanges. They should be written down in a safe place that can be reached only by you or your attorney if you no longer can access the key.
Although the idea of being decentralized includes the lack of the requirement to follow Know-Your-Customer or Anti-Money-Laundering regulatory standards, countries are implementing more and more laws that make the exchanges match the standards.
Order Books vs. Liquidity Pools
As the cryptocurrency exchange market is well-developed, there are already multiple generations of exchanges.
- Exchanges with order books. The first generation of crypto exchanges uses order books. If you are familiar with trading, you know that an order book includes records of buy/sell orders for a specific asset. The spread between ask and bid prices defines the asset's market price. During trades, such information is stored on-chain; the funds are located off-chain in the user's wallet. Decentralized exchanges are widely specialized to particular financial instruments executed in a decentralized manner.
- Exchanges with liquidity pools. Exchanges with liquidity pools don't use order books to define the market price and execute trades. Rates are determined by liquidity pool protocols. The trades are made instantly between wallets of crypto holders. Such decentralized platforms are ranked in total value locked or the assets' value held in the protocol's smart contracts.
- Aggregators. To provide a higher degree of security and decentralization, exchanges apply various protocols. However, there is a pitfall: doing this may lead to scattered liquidity across platforms. Low liquidity is a big problem for big traders and investors who are looking to invest considerable sums. Decentralized exchange aggregators are used to solve this issue by deepening asset liquidity pools among both centralized and decentralized exchanges.
It doesn’t matter which crypto topic we discuss; the security issue always arises. Thus, DeFi contributed to the insurance point as well. Insurance is supposed to protect crypto enthusiasts from losing private keys, exchanges, and storing contracts hacks, unexpected bugs, etc.
Although insurance isn’t widely discussed or developed yet, and the percentage of insured crypto holding is low, DeFi insurance protocols are supposed to democratize insurance.
Insurance Can Protect From:
- Intermediate redemption of tokenized cryptos;
- Increased volatility;
- Theft and crypto wallet attacks;
- Hacks on exchange platforms.
There is no doubt the DeFi ecosystem will continue expanding. More DeFi solutions will enter the market, generating large market volumes. Although DeFi concepts hide risks, their advantages prevail. Analysts predict further development of the DeFi insurance applications and networks.