DeFi: What it Is and How to Invest Safely
DeFi is a coverall term for the attempt to represent traditional financial structures through blockchain technologies.
Standing for “decentralized finance”, this approach attempts to emulate financial operations through code and blockchain transactions. It is decentralized, because there is no human operator to oversee or approve the transfers of value. In theory, DeFi can emulate multiple actions within the financial system, although the limitations of code mean the exact technical solutions differ from the backend operations of banks or stock traders.
DeFi began as a tool to use idle crypto assets, including BTC. Because cryptocurrencies are not connected to a real economy, financial operations began to utilize the resource to generate returns. Initially, those startups started off slowly, and gained speed after August 2020, with new projects and tokens appearing almost daily.
DeFi as an idea has been around since 2018, when the first steps were taken in what turned into a market boom in 2020. At that time, some projects emerged as staples, while others only existed for less than 48 hours before crashing. Still, DeFi remains one of the fastest-growing trends in crypto, and deserves attention both to seek out returns and avoid the riskiest projects.
It is still early to determine whether DeFi is a short-term trend, or will usher in a financial revolution. There are high hopes that DeFi tools will offer bank-like services to the unbanked, and democratize investment.
How DeFi Works for the User
A DeFi potential user can access most projects by opening an Ethereum wallet, most often MetaMask. Most DeFi platforms will have easy tools to connect to wallets.
Projects like Compound will communicate directly with wallets, and calculate safe lending and borrowing rates. For participation in almost all DeFi projects, it is necessary to hold some ETH to pay network fees.
You can also access one of the leading DeFi lending projects, Compound, through the newest versions of the Exodus wallet. The wallet will allow the exchange of any asset into the DAI stablecoin, which will then accrue interest based on the current available rate. This is one of the simplest and most straightforward approaches to passive income through DeFi.
DeFi is not a beginner strategy, and can lead to significant losses. It is best to avoid investing funds you cannot afford to lose. The space issues multiple tokens and has multiple models of passive returns, though most are untested and risky.
Make sure you research the economic model of a token, and avoid locking in funds if you are uncertain. Most users will not read or understand the smart contract underlying some DeFi projects, so they may incur losses on a technicality, or a deliberate attempt to scam.
What DeFi Can Do?
DeFi techniques vary in their complexity. As a basic example, all crypto coins copy the model of payment systems, such as bank accounts or fintech solutions such as Paypal, Payoneer or others. Bitcoin, Ethereum, and any other coin can be used as a means of payment. DeFi, however, goes beyond this. The most common types of DeFi projects include:
- Escrow services
- Insurance of crypto assets or crypto-backed loans
- Derivative products
- Tracking and analytics of the blockchain
- Prediction markets and outcome betting on real-world events
- Dollar-pegged coin issuers
- Fast payment processors
- Liquidity mining and Yield Farming
- No-loss Lottery
- Generating dollar-pegged assets that can be used on other trading platforms.
For instance, a payment or escrow service can be linked to a plane’s schedule. If a plane is late, this information can be passed to a smart contract, which will make an immediate compensation payment, without the need for centralized approval.
DeFi also works internationally without additional burdens or fees. It can be a tool for international remittances, where other methods to send money are prohibitively expensive or unavailable in all regions. DeFi avoids some of the requirements of banks, by accepting cryptocurrencies as collateral in lieu of traditional assets.
So far, DeFi projects offer:
- Relative anonymity, except for basic blockchain tracking;
- No KYC required from most projects;
- Border-free, with no limitations in trading.
This differentiates DeFi from older crypto projects, where regulators caught up with exchanges and token sellers, requiring customer data and ID verification. For now, DeFi has avoided scrutiny. All financial operations hinge on smart contracts, and look no different than regular transactions on the Ethereum blockchain. Because ETH is not considered money, and all assets and tokens are used entirely outside the monetary system, so far DeFi remains unregulated by central banks or securities regulators.
It is possible that this freedom may diminish. In the past few years, even decentralized exchanges like EtherDelta faced investigation from the US Securities and Exchange Commission. IDEX, one of the larger decentralized exchanges, also had to include KYC for traders.
So far, almost all DeFi projects operate without customer verification, and with no oversight. This makes the projects extremely risky, but also available to anyone in the world with access to a mobile phone and ETH coins.
How DeFi Compares to the Legacy Financial System
The legacy financial system is highly complex and liquid, running through trillions of dollars in value. All operations are strictly regulated, with special attention to customer tracking. In the past decade, secrecy has almost disappeared from official usage of financial services and banking.
DeFi, on the other hand, is still a nascent phenomenon. Only in the fall of 2020, the funds locked in DeFi projects exceeded $10 billion, a drop in the ocean compared to the size of traditional markets. However, DeFi offers an alternative for anyone to access risk profiles and operations that are heavily restricted in the world of traditional finance.
Perhaps the most democratic tool offered by DeFi is trading. While crypto exchanges have existed for more than a decade, their model usually involves a centralized trading platform, relying on order books. The DeFi approach employs smart contracts to achieve trader and settlements. This either includes some form of order books, or algorithmic trading based on the supply of a token pair. Smart contracts offer various forms of asset swapping or exchanges, with no barriers to entry.
In most cases, using a decentralized exchange is as simple as owning ETH coins and deciding to trade. DeFi is not under the oversight of central banks, and does not handle fiat in any form.
To achieve a more intuitive pricing, though, DeFi uses coins pegged to the US dollar. Those coins can circulate around the ecosystem, and only rarely to be exchanged for actual fiat. In the meantime, price discovery is growing for ETH, BTC, as well as other coins and brand-new tokens.
Listing and trading are immediate for new DeFi projects. Unlike older crypto startups, a token will launch without delay, and without waiting to be listed on any exchange. Decentralized algorithmic exchanges make this possible, vastly increasing the choice of newly created crypto assets.
Is DeFi Like a Bank?
In some ways, DeFi projects work like a bank, in that they store crypto assets in smart contracts. This storage then gives liquidity to create new coins and trade them. As of October 2020, the value deposited in DeFi projects was around $10 billion, up from $1 billion just a few months prior.
In this regard, DeFi starts to resemble fractional reserve banking, which generates new value from initially deposited funds. Usually, participants will lock in BTC or ETH, and be able to generate stablecoins or other tokens to gain returns on their deposits.
Even after months of rapid growth, the cryptocurrency projects only host a very small amount of funds. To compare, in 2019, the US banking sector had $17.9 trillion in assets. So DeFi has a long way to go, to rival even smaller commercial or investment banks.
DeFi also does not use physical vaults or centralized deposit features. Instead, funds can be locked in smart contracts, independent of any human decision. There is one exception - the creation of Wrapped BTC, or WBTC, requires the deposit of BTC into a specified address.
To use WBTC, custodians will store BTC just like a bank. In exchange, they will issue a token, which works like BTC-backed fiat money within the Ethereum ecosystem.
DeFi thus resembles banking, extended to the offerings of various lending products, though the types of loans are quite different from those offered within the traditional fiat lending system.
DeFi and Ethereum
The bulk of DeFi projects hinge on using the Ethereum blockchain. Of the top 20 projects on the Ethereum blockchain, 10 are various forms of DeFi. Added to this is one of the most visited exchanges for 2020, UniSwap, which also falls within the DeFi category.
Other blockchains are quickly catching up with DeFi projects, but the trend continues to favor Ethereum. Thus, the economics of tokens and gas payments are one of the most important points to master when investing in DeFi.
As of the fall of 2020, investing in DeFi is heavily dependent on the ability to transact on the Ethereum network. To do this, a user will need to pay a fee known as “gas”. The biggest barrier to entering the DeFi space is actually the steep gas price for any transaction. For some projects, speed is of utmost importance, and fees are only accessible to very large players. This makes DeFi rather risky, as even a few hours may make a difference between a gain and a loss for some of the newest projects.
Even BTC is not sitting idle, as more and more owners decide to lend their coins through Ethereum-based protocols. This is a new trend, which may expand based on recent observations.
DeFi remains highly risky, and is not a hold-and-forget strategy. It is still best to research all new projects, deciding which ones are raising too many red flags.
How DeFi Lending Works
Lending startups are some of the key new developments in decentralized finance. In the years past, crypto owners would be faced with two choices - either buy and hold, or trade. Lending brings the option of putting one’s crypto coins to work, which is riskier, but may bring higher returns.
Lending works through organizations that pool resources and put idle assets to work. For instance, having BTC or ETH does not always translate into easily selling those assets for fiat. Instead of just holding them, it is possible to lend them to other traders. Issuing a loan is automatic, achieved through the algorithm of a smart contract.
Once the conditions of a loan are fulfilled, there is no other authority that can stop the loan, or prohibit the trades. Only few exceptions apply in the case of blacklisted wallets, belonging to hackers or flagged by users for potentially illegal activity. But in general, DeFi is censorship-free, and available to anyone willing to join one of the multiple projects.
The ETH sent to the platform is then turned into a collateralized loan, which is denominated in DAI. DAI is a stablecoin, pegged to the value of the US dollar. The user then has multiple possible scenarios - to use DAI for trading, sell it for actual US dollars, or loan it to third parties and earn interest. As already discussed, sending the DAI to an Exodus wallet allows users to gain interest on the sum immediately. Of course, that interest may end up being less than the change of value of the ETH that was loaned.
Issuing and receiving loans is highly risky, due to the volatile nature of crypto asset prices. Each loan must be over-collateralized. If a trader needs to borrow 200 DAI, they will need to put in $300 as collateral in ETH. If the price of ETH falls, the collateral will be liquidated to cover the loan.
|Top DeFi Lending Projects||Project||Features||Availability on Exchanges|
|Maker DAO||Generates DAI stablecoin||Coinbase||AAVE|
|Multi-coin lending protocol, offering fixed or variable rates||Binance||Compound||Algorithmic money-market protocol|
|Coinbase Pro||DyDx||Borrowing, lending and betting tools, decentralized exchange||-|
New projects are constantly emerging, and most of them also feature a native token, which is paid out as a reward for market participants, or generated or destroyed algorithmically based on overall activity. Each DeFi token has a different economic model, relying on burns and generation to achieve returns.
DeFi Insurance Projects
Because of the highly risky price action of crypto assets, as well as potential technical difficulties, a new type of DeFi project has appeared. Insurance startups were only a handful as of 2020, with new projects showing up. One of the latest projects to start trading is DeFi Insurance Protocol (DFIP). Its native token started trading at $0.03, but quickly dipped to $0.008. As of October 9, 2020, the project was still in its price discovery stage.
Nexus Mutual is one of the first projects to insure against smart contract failure. The algorithms of smart contracts are released often without auditing, and may malfunction or hold unexpected vulnerabilities. Nexus Mutual aims to mitigate that risk. As of October 2020, Nexus has insured more than 421,000 ETH.
Insurance is still the youngest type of DeFi startup, with unknown results so far. Cautious optimism about the projects suggests they may take off, as almost all investment will be risky. Insurance in DeFi is specifically targeted to crypto assets, including a coverage on total loss, hacks and other crypto-specific threats.
Other DeFi Projects and Earnings Schemes
Less significant projects, which still attract attention, include PoolTogether, touted as a risk-free lottery. The PoolTogether project requires a MetaMask wallet and some assets. Joining the pool means locking those assets for a predetermined time. During that time, the entire pooled fund is gaining interest through other DeFi projects.
In the end, only one player receives the interest as a reward, while the smart contract returns the funds to the rest of the pool participants.
Augur (REP) is another project that has existed since the 2017 ICO boom. Augur is an automatic outcome betting market, where returns can be achieved by locking in funds and betting on real-world events, sports, or other outcomes.
What Gives Tokens Value?
Most DeFi projects will issue their proprietary token. The chief source of value for that token is based on how it trades on exchanges. But as already discussed, the entire DeFi sector depends on how much ETH, BTC or other assets are locked in as collateral. DeFi tokens trade both on centralized markets such as Coinbase or Binance, and on algorithmic exchanges. Both types of exchanges are important for the final price of the token.
The value of tokens is also determined by public interest, as DeFi assets are heavily promoted on social media. Token issuance is also not dependant on approval by any agency, although some regulators will test tokens and check if they are in fact unregistered securities. In DeFi space, token issuance has been so fast that no regulator has scrutinized the new assets as of 2020.
DeFi tokens, just like other crypto assets, are extremely volatile. Their value also depends on investor behavior, which is very fickle. Fluctuations of trading and liquidity have led to tokens losing 97% of their value in recent weeks, as investor interest waned. Those same tokens appreciated rapidly with initial enthusiasm and liquidity inflows.
UniSwap and Token Value
One of the most widely used exchanges for DeFi operations and tokens is UniSwap. It is a decentralized exchange operating smart contracts and oracles (software that gathers price information), which is capable of swapping between tokens on the Ethereum network.
A simple equation is at the heart of value determination for multiple DeFi tokens. The UniSwap 2.0 formula for any asset pair, including pairs between two tokens, looks like this:
x * y = k
x is token x quantity
y is token y quantity
k = constant
This formula determines how much the price of an asset will slip, depending on how much of both X and Y tokens has been deposited in the liquidity smart contract.
“There are multiple genres of AMM-based DEXes, but UniSwap is specifically what’s known as a “Constant Product Market Maker,” or CPMM. This simply means that UniSwap, like other CPMMs, relies on the equation x*y=k to create a price spectrum for token pairs per the available liquidity of these pairs.
For example, if UniSwap had an EXAMPLECOIN/ETH pair, the EXAMPLECOIN (X) supply would decrease if the ETH (Y) supply increased, with the opposite being equally true, so as to preserve the constant of K, i.e the pool’s price of EXAMPLECOIN,” explains UniSwap.
The UniSwap 2.0 approach deals away with order books, because of the need to run all trades on the blockchain. Simulating order books would be too expensive on the Ethereum network. For that reason, the continuous price-setting formula was established. This has allowed almost all newly minted tokens to start trading immediately, as the founder teams also created liquidity by locking in ETH and supporting their own coin.
But some projects became dishonest, creating so-called “rug pulls”, or selling to naive investors, while in the end pulling away their liquidity and letting the project crash to zero. Because UniSwap has been around for only a few months, it is difficult to establish which tokens will have sufficient liquidity, and which ones will be gone within 24 hours.
UniSwap trading is riskier, since traders cannot see the order books and make predictions. The levels of liquidity locked within the exchange’s smart contracts may disappear within hours without warning. For that reason, buying new DeFi tokens, or trading on UniSwap is considered high-risk.
Token Value and Stablecoins
Coins with their value pegged to the US dollar are instrumental in performing DeFi operations. Despite the usage of BTC and ETH, the need for a stabilized asset means DeFi in a way operates intuitively using the value of the US dollar.
The most important stablecoin is DAI, an asset that started off with a low supply and grew immensely in 2020. DAI is created when other digital coins and tokens are locked into smart contracts. DAI is highly liquid, and usable for most forms of trading, as well as for generating and repaying crypto loans.
It is possible to also buy other types of stablecoins, such as USDC, and use them within DeFi lending protocols. Using stablecoins as collateral has the advantage of avoiding the effects of price volatility and liquidations. The value of USDC is pegged to the US dollar, thus the coin does not fluctuate and cannot trigger liquidations within the Maker DAO DeFi ecosystem.
Biggest Risks in DeFi
The risks in using DeFi protocols involve sudden volatility on the markets, especially deep drops in the price of ETH. In that case, collaterals may be liquidated, incurring automatic losses.
Other risks involve faulty smart contracts which end up losing or stealing funds.
Investing in so-called “fast food” tokens is perhaps the riskiest DeFi activity. Those tokens depend on the liquidity pools on UniSwap, which we discussed at length previously. Buying such a token exposes traders to both technical risks and a “rug pull”. In that case, the token founders boost the price, then withdraw all liquidity for that token.
Tools to Track DeFi Projects
It is possible to assess the health of the DeFi ecosystem, while being aware that conditions may shift. Various tools track the health of the ecosystem and the risks of investing.
- EthGasStation, to determine if transacting on the Ethereum network is affordable. On some occasions, the gas price is extremely steep and only “whales” manage to absorb the fees.
- DeFi Rate - a project dedicated to gathering detailed data on the DeFi space.
- DeFi Pulse - data on the most active projects, rated by funds locked and overall activity.
- Top DeFi tokens rated by market capitalization, with price performance history. Past performance is not a guarantee of future success, but this list contains some of the older, better-established projects.
- DeFi Prime - a list of curated resources on projects, tools and categorized opportunities for various types of projects.
- GitHub list of older and more current DeFi projects, decentralized exchanges and other protocols.