DeFi, is a decentralized financial system that connects investors and borrowers without requiring a centralized institution. It cuts out the middleman from all kinds of transactions, and ensures that the borrowing and lending process is:
Scroll on to learn why DeFi has risen from less than $1 billion to a total value locked (TVL) of more than a $100 billion in just three short years.
What is DeFi?
DeFi is a rebuttal to the oligarchical nature of traditional finance. Instead of funds being strictly controlled by a small pool of banks and corporations, DeFi opens investment pathways for just about anyone with an internet connection. This removal of intermediaries combined with the transparency of the DeFi platform has established trust among its increasing pool of users.
How Does DeFi Work?
DeFi is an overlapping ecosystem of decentralized applications and smart contracts that (mostly) operates atop Ethereum, an open-source blockchain technology that has recently dominated financial headlines. A smart contract is a self-executing contract with the terms of the agreement between buyer and seller being written directly into the computer code.
Smart contracts take the place of traditional banking middlemen; Ethereum’s robust programming technology, Solidity, opens the door for smart contracts to have all the logic necessary for DeFi applications, or DApps.
Understandably, ETH is required to pay for transactions on the Ethereum network; however, most DApps don’t demand personal information in order to register. Anyone can use DeFi products by visiting an application’s site and connecting via a MetaMask wallet or similar protocol. In doing so, users can play with various financial toys. The four most common playgrounds are:
- decentralized exchanges
- lending platforms
- asset management
Why Use DeFi?
Born out of the 2008 crisis, DeFi boomed during the pandemic when, yet again, investors’ faith in the overall market waned. Alternative investments are a relatively safe strategy when the global economy is dipping.
But what makes DeFi more strategic than gold or real estate?
There are three main reasons:
Many interested investors struggle with accessing bank accounts or borrowing platforms due to conflicts regarding permanent addresses, credit history, or lack of banking infrastructure. DeFi allows anyone with a stable internet connection to access complex financial products, lending services, stores of value, as well as investment and trading opportunities. Built on decentralized networks like Ethereum, DeFi products can never be shut down nor denied to those who wish to utilize them.
Additionally, many financial institutions require high costs in exchange for handling your money. DeFi expenses are minimal in comparison, opening up investments to a new echelon of society.
What’s revolutionary about DeFi is its removal of banks. Many investors have been hesitant to collaborate with powerful banks in fear of the bureaucratic hoops the government forces them to jump through. Up until the explosion of blockchain technology, investors had no choice but to work with them. This lack of freedom makes DeFi seem all the more attractive due to the inherent level of control investors can have over their portfolios. Smart contracts operate blindly; once they are deployed, Dapps can run themselves with minimal human intervention.
Smart contract codes are transparent on the blockchain, which is almost like a public ledger; anyone can audit them. Every transaction is available for public view. Some may say this could raise privacy concerns, but all transactions are pseudonymous meaning they are not linked with investors’ true identities. Part of the disinterest in traditional banking was the lack of visibility, and therefore lack of trust, between investors and big banks.
Advantages of DeFi:
Much of the excitement surrounding DeFi centers on its nickname, “Money Legos.” Any DeFi investor can create anew, build atop, customize, or mix-and-match any preexisting DeFi product without the need for permission from anyone else. DeFi protocols are modular; they can continue to overlap to scaffold an increasingly dense mechanism of interoperating components.
Personalization is exciting, but the lack of permission is the selling point. Traditional banks take a long time to process transactions; those bureaucratic hoops and their strict requirements have prevented many people from diving into the deep pools of financial literacy. DeFi is the new lifeguard, saying to people of all incomes, races, genders, and locations, “come on in, the water’s fine.”
Immutability and Security
It’s nearly impossible to manipulate the records of the blockchain network. This adds a heightened element of security. Because all information cannot be tampered with, financial operations automatically become more reliable and more conveniently auditable.
Interest Rates and Yield Farming
In addition to allowing you to store your wealth in a new type of savings account, DeFi allows you to earn income. Certain platforms like Aave and Compound welcome investors to deposit assets and lend them out to borrowers. Later, at an agreed time and date, investors receive their interest. Compound offers up to 4.3% interest while Aave’s interest can be as much as 5.73%. These percentages are persuasive when compared with the 0.6% and 0.7% currently offered by traditional banks for savings accounts.
Yield farming, also known as liquidity harvesting, allows investors to lend cryptocurrency in return for interest. If a cryptocurrency coin appreciates quickly, it can be a hefty payoff. With a dash of capital, a sprinkle of intuition, and a spoonful of patience, DeFi seems a worthy investment, especially now that crypto values are reaching the skies. Olga Kharif of Bloomberg compared lending cryptocurrency in current times to banks gifting tulips during the Dutch tulip craze.
Tokenization bridges the gap between DeFi and CeFi(centralized finance). In 2020, Metamask announced its crypto wallet would facilitate token swaps directly within its browser extension. The integration of tokenized assets and equity into DeFi protocols, the current illiquidity of the DeFi sector is rejuvenated, enabling a vaster range of opportunities for investing from the CeFi perspective.
Disadvantages of DeFi:
Scalability and Increasing Fees
Scalability is the measure of a system’s ability to rise or fall in both performance and cost on any given network. For mass adoption of blockchains, networks would need to be able to handle millions of users. According to Amber data, Ethereum faced congestion in March of 2020. There were 19,922,385 unconfirmed transactions as of the 8th of June, up 225% from the total of 611,872 on March 1st.
These transactions could become expensive during congestion periods. DeFi transactions demand extended periods of time for confirmation. Ethereum can process 13 transactions every second. Contrarily, CeFi counterparts can accommodate thousands of transactions within that same second. This comparison paints DeFi in an unattractive light; the increasing fees and unsolved scalability problems are visible flaws within the DeFi system.
Responsibility is a double-edged sword. On one end, it is empowering to handle one’s own finances without assistance from big banks. It’s endearing how DeFi opens financial literacy to demographics that have been previously closed off or disinterested. However, finance is a complex language; it takes years to become fluent. DeFi does not assume responsibility for investors’ mistakes. Many fresh wannabe-investors are diving into pools they don’t know how to swim in. While not necessarily DeFi’s fault, the platforms could perhaps offer more explanations and tutorials for those who don’t know what they are getting themselves into.
Stani Kulechov, Founder and CEO of Aave, argues that DeFi is to finance as electric cars are to the automobile industry. Everyone knows it’s the future, but many are still slow to trust in its capabilities. Despite the overflowing data backing up DeFi’s claims of success, average consumers demand years, if not decades, of provable success before considering it a worthy investment.
How to Invest in DeFi?
Lending platforms pay investors an APY (annual percentage yield) for locking assets into a smart contract. These tokens are used by interest-paying borrowers, a percentage of that interest being later returned to the lender. As the entire process is governed by smart contracts, there is little to no risk of the borrower failing to repay their debt. Investors can withdraw staked assets at any time.
If you want a bank to lend you a loan, you must provide sufficient collateral. Borrowing DeFi works similarly, except the collateral is not physical property like a customary house or a car; instead, it’s most often cryptocurrency. Investors will often opt for the safer solution of borrowing stablecoins and using their more valuable assets like Bitcoin as collateral so they don’t run the risk of buying back at a higher price. The important implication is that the borrowing doesn’t necessarily need to sell their crypto stock to gain liquidity. Ledger Academy draws it like this:
Some dexes (decentralized exchanges) support swaps between token pairs like ETH and USDT. The inherent liquidity comes from those pooled tokens that belong to liquidity providers. LPs are simply just ordinary DeFi users who put their tokens into whatever smart contract is controlling the pool at hand. By doing do, these users can earn a fee from each swap, proportional to their pool share. The more trades conducted via that pool, the more the investor could earn. To maximize returns, LP aggregators pull real-time data to help investors predict potential profits from their pools.
DeFi is an ecosystem of financial applications built atop blockchain technology. Although still new, it’s success is too impressive to ignore. Whether we like it or not, whether we fully understand it or not, decentralized finance is here to stay. Designed specifically because of decreasing faith in international economies, DeFi provides an investment playground that is somehow more secure while also being more liberating. Investors looking to make quick cash may not be as interested. However, forward-thinking investors who hope to generate long-lasting wealth cannot afford to overlook DeFi.
Contact Coinful Capital for more specific information on how to weave DeFi into your personal portfolio.