DeFi, or “decentralized finance”, is a sector where blockchain technologies have experienced exponential growth in 2021. In just the past few months, the dollar value of DeFi activity has more than doubled, from one to two billion dollars. The Trends Journal has been reporting on the explosive potential of DeFi, in articles including “WILL BLOCKCHAIN SAVE THE DAY?” (20 April 2021).
But many people, even some who are investing in cryptos, still aren’t sure exactly what Defi involves, or what it takes to participate.
As a general overview, users with a crypto wallet can engage with decentralized apps called dapps, to do many of the same financial related things that are currently done via traditional banking.
According to the popular NASDAQ listed exchange Coinbase, there are dapps that provide an array of services, including:
- Lending: Lend out your crypto and earn interest and rewards every minute – not once per month.
- Getting a loan: Obtain a loan instantly without filling in paperwork, including extremely short-term “flash loans” that traditional financial institutions don’t offer.
- Trading: Make peer-to-peer trades of certain crypto assets — as if you could buy and sell stocks without any kind of brokerage.
- Saving for the future: Put some of your crypto into savings account alternatives and earn better interest rates than you’d typically get from a bank.
- Buying derivatives: Make long or short bets on certain assets. Think of these as the crypto version of stock options or futures contracts.
Currently many dapps run on the Ethereum network, via its “smart contract” software features. Ethereum has been characterized as a sort of blockchain Microsoft, because it currently provides the number one utilized blockchain operating system on which other projects can build dapps. But other networks like Cardano and even Bitcoin are positioning to claim space in the exploding field.
DeFi – A Wild West Of Activity and Schemes
Newcomers to DeFi should stick to proven entities and vehicles. One of the core concepts of DeFi is staking coins to provide liquidity to others and earn a return.
The Uniswap platform is generally regarded as one of the safest places to engage in staking or borrowing cryptos. They have an app that can be used to transfer crypto from Coinbase or elsewhere. Once on Uniswap, it’s fairly easy to stake crypto and begin earning interest.
It’s unadvisable to begin with large amounts. Beginners are advised to stake small amounts, and gain experience and comfort with the process, before committing more funds to DeFi investments.
But even Uniswap is not for people new to crypto investments, as a perusal of their FAQ page should make clear.
An even easier way to get started with DeFi is to use a Coinbase Wallet, via their app. Understand that an account on the Coinbase.com exchange is not the same as the Coinbase Wallet (though the two can be linked). Users with a Coinbase wallet can follow straightforward instructions to use available DeFi apps like the popular Compound app, from their wallet.
Compound, along with Aave, are two most common protocols at the moment for DeFi borrowing and lending (note: Compound’s protocol is currently not fully decentralized, but its governing group is committed to eventually migrating to a decentralized consensus model).
With lending, a user provides the protocol with an asset, which is subsequently utilized to make loans. The protocol issues new tokens in exchange for the tokens given, which represent the asset plus interest (and which can be transferred just like any other token). The user receives the underlying asset plus interest for the time it was supplied when these tokens are repaid.
When it comes to borrowing, a user puts collateral (in the form of a certain token) and receives a loan in another token. The user receives the collateral back after repaying the loan plus interest.
DeFi loans are overcollateralized due to the volatility of cryptocurrency. This means that if you want to borrow 1000 USDT (U.S. Dollar stablecoin token) and use ETH as collateral, you’ll need to put down 1250 USD in ETH.
Why would someone take out a loan rather than just selling collateral, especially if they have to deposit more in collateral than the loan is worth? A user might need cash, but also want to hold onto a token (like Bitcoin) because they believe the future of the token looks bullish. Also, taking out a loan against a crypto asset sometimes has tax advantages compared to selling it (for more info, see the informative article here).
DeFi encompasses a lot of activity at this point, and much of it is high risk. An excellent article on decrypt.co covers myriad aspects of DeFi in detail, urging caution, especially in projects that are outside the crypto mainstream.
It’s important to realize that anyone who knows how to code can write a “smart contract” to the Ethereum network, for example. The integrity and terms of that contract, as far as what it does, is up to the user to ascertain and verify.
Advantages and Disadvantages of DeFi
DeFi, like blockchain technologies in general, create efficiencies by dispensing with the need for central institutions to mediate contracts and agreements between parties (eg. buyers and sellers, or lenders and borrowers).
The terms, the rules and the transactions themselves are all handled by the blockchain network, the dapp software, with all transactions written into the blockchain database in a way that is impervious to being gamed.
Some of the noted advantages of DeFi are that it is:
- Open: You don’t need to apply for anything or “open” an account. You obtain access to dapps by creating a wallet.
- Flexible: You can move your assets anywhere at any time, without asking for permission, waiting for long transfers to finish, and paying expensive fees.
- Fast: Interest Rates and rewards often update rapidly (as quickly as every 15 seconds), and can be significantly higher than traditional Wall Street.
- Transparent: Everyone involved can see the full set of transactions on the blockchain ledger
Some aspects of DeFi, and many blockchain technologies in general, are held up as positives by some, and negatives by others.
For one thing, many DeFi apps have “pseudonymous” protections. While you don’t need to provide your name, email address, or other personal information to utilize a dapp, things like IP addresses, transaction amounts and public wallet addresses are recorded on the blockchain.
Blockchain databases are transparent, which many participants, but not all, consider a plus.
What’s beneficial about transparency? Accounting, for one thing. A bank, or any system subject to audit, is made more trustworthy by transaction records that are indelible and verifiable to any interested party.
With transparency, system fairness that can be proven. Smart contracts which comprise dapps on the Ethereum network, for example, are code, and the results of what they do can be verified on the blockchain.
There are other aspects to DeFi that clearly constitute negatives, compared with traditional finance, at least at the moment. Transaction rates on the Ethereum blockchain can make active trading expensive, when it comes to things like trading and buying derivatives. Some of Ethereum’s current scaling problems and consequent transaction fee rates are being addressed by the upgrade to Ethereum 2.0 that will be completely rolled out on the network very soon.
Other negatives are that the sector is new tech that is prone to volatility, and with dapps, it becomes completely incumbent on the user to maintain records for tax purposes. Regulations regarding that can vary greatly from state to state and region to region.
Clearly, DeFi is not for everyone, at least at this point. But for those who have experience in investing and trading cryptos, leveraging this new area to reap financial benefits might make a lot of sense.