We all know that savings accounts are useless for saving. Earning interest beyond 1% annually is pretty much a waste of time. Or worse.
Constant increases in inflation and cost of living decrease the value of money over time. It’s happening faster than many people realize.
In reality, the money in your savings accounts has more in common with the vanilla yogurt sitting at the back of your fridge — before you realize, its lost most of its value.
DeFi offers a way to trade, loan, invest, and do nearly everything else, without going through a central bank. This feat is made possible by blockchain technology. It’s more trustworthy and secure than the most efficient and careful person. It removes millions of errors and an unimaginable amount of corruption from your life, allowing faster and more secure finance because fewer people are involved. Plus it is more efficient, so it costs less, sometimes a whole lot less.
It comes as no surprise that retail investors are moving to DeFi. They have the opportunity to mitigate their risks while their money grows.
In this trustless DeFi world, your crypto deposits are secured through smart contracts instead of bankers. And yes, there’s a certain level of difficulty in navigating the DeFi world, it is something that anyone who holds or invests in crypto should explore.
The Benefits of DeFi
Do we really need a middleman to ensure that our money is stored safely?
For one thing, the value of fiat currency is not very safe if its supply can be easily manipulated. For another thing, banks and brokers do not have the best track record for putting their customers first.
By now, the blockchain model has proven to be effective for peer-to-peer transactions.
Cryptocurrencies like Ethereum have built-in features to rival traditional banking services – all without any intermediaries. It is no surprise then, that Ethereum’s smart contracts lead to important innovations in DeFi. Other blockchains behind cryptocurrencies like Binance and Polkadot have also developed their own suite of services using smart contracts.
Let’s Talk About Smart Contracts
A smart contract is an algorithmic agreement that allows for trustless transactions. The code itself acts as an intermediary in the transaction to ensure that it all goes as planned.
Imagine a classic peer-to-peer transaction on Craigslist:
deciding to buy a rare comic book from an anonymous person, I arrive in a poorly lit parking garage. I am promptly beaten up and have my money stolen. But with a smart contract in place, this transaction wouldn’t occur in a parking garage, it would happen on the blockchain and it would be much safer.
A smart contract is a program that executes only when a set of requirements are met.
In this example, these requirements would look something like this:
- Person A must deposit the comic book
- Person B must deposit the cash
Rather than meeting face to face and dealing with uncertainty, the smart contract does the transaction for us. As long as the comic book is verified and legitimate, the transaction goes through.
On blockchains like Cardano (ADA), applications called DApps (decentralized applications), allow different types of smart contracts to be encoded allowing a depositor to earn interest in a process called staking.
The best types of decentralized exchanges have their code vetted and audited. Otherwise, there is the possibility of a hacker abusing a loophole in the code and stealing some of the crypto assets. While a DeFi swap can never be fully secure, several such defi applications have stellar reputations. In addition, they often allow you to deposit or withdraw your holdings at any time.
Popular Uses for DeFi
Lending and Borrowing
Smart contracts offer many interesting use-cases for lending and borrowing money. Using one type of cryptocurrency token as collateral, you can receive a loan in the form of another cryptocurrency. For lenders, it means that they earn interest on the crypto they lend and also receive as an incentive.
When it comes to borrowing money, there are no credit checks involved. Instead, you are allowed to use the bitcoin (btc) you lend out as collateral. You can then borrow other coins, equal to 75% of the value of your lending collateral. This ensures that every user of these protocols can repay their loans.
NFTs as collateral
Newer DeFi protocols even allow you to deposit your non-fungible defi tokens (NFTs) as collateral for your loan. This is ideal as many users move towards turning their collectibles into liquid capital.
Note: Ren is a project that allows any Defi project to change the blockchain they run on. Have a look. It’s fascinating watching the future happen right in front of you.
Liquidity pools
Have you ever heard about a particular digital currency only to find it’s not available on any of the larger exchanges you use? Maybe it will be at some point but that doesn’t exactly help you get in on the ground floor. You can use a DApp and find a place where you could swap Ethereum (ETH) for the one that you want, Algorand for example. Thanks to smart contracts in DeFi, this asset is available to you almost immediately.
In DeFi apps, many smart contracts employ an automated market maker. It eliminates the need for you to find someone willing to trade their token to you. Going back to the Craigslist example, it’s like putting down some comic books and cash so that Craigslist could execute trades on its own. Much easier than trading fiat currency on your own!
That means the next person that needs to buy a comic book can get it immediately rather than waiting for an order to get filled in a peer-to-peer manner. The algorithm within the smart contract manages the supply and executes the trades and swaps for other users.
In essence, this means peer-to-contract transactions. Users can put a pair of tokens into a pool, creating a liquidity pair, for example Ethereum and Algorand. By providing liquidity, you earn a portion of the trading fees as a reward.
Defi Pulse is a website that provides the latest information on top Defi projects and valuations.
Yield farming
Money doesn’t grow on trees, however crypto just might grow in crops. Many users earn very high-interest rates, more than 40 percent annually, by using yield farms. This is done by moving your cryptocurrency holdings into “lending contracts”, a partial hedge against volatility. Depending on the supply and demand, the annual yield you earn will vary. Users can “harvest” their yields and take profits depending on the terms.
All of this helps explain how the DeFi sector grew from a $500 million crypto market cap to over $10 billion in the summer of 2020! Investors and DeFi enthusiasts are always chasing the next thousand percent yield market. However, many of the higher percentage options carry a greater risk.
Yearn.finance is a great place to get started learning about these opportunities, including stablecoins like Dai and USDC.
Risks
If the developers of a new token deposit a lot of Ethereum and their new token allows others to farm it, they’ll encourage users to buy that token with Ethereum. If the developers then decide to suddenly remove all their liquidity, the coin’s price goes to zero and they make off with the money.
Do your own research! If it seems too good to be true….
Popular DeFi Platforms Built on Ethereum
One of the downsides of DeFi platforms is the high barrier to entry. I wouldn’t expect my mom or my dad to get a MetaMask crypto wallet, navigate to a dApp and figure out how to yield-farm. The best way to learn is to take a small sum of cryptocurrency onto leading Ethereum DeFi platforms to learn how they work.
Many of the differences between Ethereum-based platforms come from the ways that the automated market makers work, their governance, and how they adjust to changes in a liquidity pool.
SushiSwap and UniSwap are two of the most well-known DeFi platforms that allow you to use your digital assets as you wish. While they offer similar services, SushiSwap has community-based governance, (as a decentralized exchange or DEX) making it easy for anyone to have a say in the way that new protocols and services are developed.
Individual coins can be vetted and launched on SushiSwap, provided as rewards for people who hold the governance token, SUSHI. Additionally, there is more potential for generating monthly passive income through yield farming on SushiSwap.
Meanwhile, AAVE is another DeFi protocol that specializes in creating lending markets, allowing users to earn up to 15% in annual percent interest for lending the AAVE token on the platform. There are many other interesting and unique DeFi platforms built through the Ethereum blockchain, however, these three will provide you with a solid understanding of how to use them.
Here’s what you can do on each platform:
- AAVE
- Earn interest on crypto that you “lend” out to a pool
- Use your lent-out crypto as collateral to receive a loan
- UniSwap
- Swap tokens
- Joint liquidity pools
- SushiSwap
- Swap tokens
- Contribute to a liquidity pool
- Yield farm
- Lend/Borrow
Key Takeaways
The introduction of DeFi has put another nail in the coffin for traditional financial institutions . The financial system has trouble providing fast liquidity and loans.
DeFi uses Smart contracts to facilitate financial offerings without requiring an intermediary.
You can put even your most obscure cryptos to work without having to find someone that wants to purchase them. It’s like Craigslist, if it were a sentient being that facilitated safe and anonymous transactions between users.
These DeFi platforms are built on different blockchains; though the most commonly used are Ethereum-based.
By depositing pairs of cryptocurrency into a liquidity pool, yield farming or lending out tokens, users earn passive income. In some cases, yield farming pairs on SushiSwap can generate more than 100% in annual percentage yield. SushiSwap is one of the leaders in developing protocols for yield farming and liquidity pools while the AAVE platform provides excellent incentives for lending out crypto.
While there is some level or risk involved, you can mitigate it by using trusted, vetted platforms. Be wary of any yields over 1000%, and make sure you understand how the DeFi platforms work. Your first few times using them will likely be extremely confusing, so play around with a little bit of Ethereum first to get the hang of it.
Emerging DeFi projects are appearing on Cardano, Binance and Polygon blockchains. Perhaps the more popular projects will also allow you to collateralize your DeFi assets.
2021 is very early in Defi and a lot of things are developing quickly.