Decentralized finance (commonly referred to as DeFi) is an experimental form of finance that does not rely on central financial intermediaries such as brokerages, exchanges, or banks to offer traditional financial instruments, and instead utilizes smart contracts on blockchains, the most common being Ethereum. DeFi draws inspiration from blockchain, the technology behind the digital currency bitcoin, which allows several entities to hold a copy of a history of transactions, meaning it isn’t controlled by a single, central source. That’s important because centralized systems and human gatekeepers can limit the speed and sophistication of transactions while offering users less direct control over their money. DeFi is distinct because it expands the use of blockchain from simple value transfer to more complex financial use cases.
Bitcoin and many other digital-native assets stand out from legacy digital payment methods, such as those run by Visa and PayPal, in that they remove all middlemen from transactions. When you pay with a credit card for coffee at a cafe, a financial institution sits between you and the business, with control over the transaction, retaining the authority to stop or pause it and record it in its private ledger. With bitcoin, those institutions are cut out of the picture.
Is investing in DeFi safe?
No, it’s risky. Many believe DeFi is the future of finance and that investing in the disruptive technology early could lead to massive gains.
But it’s difficult for newcomers to separate the good projects from the bad. And, there has been plenty of bad.
As DeFi has increased in activity and popularity through 2020, many DeFi applications, such as meme coin YAM, have crashed and burned, sending the market capitalization from $60 million to $0 in 35 minutes. Other DeFi projects, including Hotdog and Pizza, faced the same fate, and many investors lost a lot of money.
In addition, DeFi bugs are unfortunately still very common. Smart contracts are powerful, but they can’t be changed once the rules are baked into the protocol, which often makes bugs permanent and thus increasing risk.
When will DeFi go mainstream?
While more and more people are being drawn to these DeFi applications, it’s hard to say where they’ll go. Much of that depends on who finds them useful and why. Many believe various DeFi projects have the potential to become the next Robinhood, drawing in hordes of new users by making financial applications more inclusive and open to those who don’t traditionally have access to such platforms.
This financial technology is new, experimental and isn’t without problems, especially with regard to security or scalability.
Developers hope to eventually rectify these problems. Ethereum 2.0 could tackle scalability concerns through a concept known as sharding, a way of splitting the underlying database into smaller pieces that are more manageable for individual users to run.
How do I make money with DeFi?
The value locked up in Ethereum DeFi projects has been exploding, with many users reportedly making a lot of money.
Using Ethereum-based lending apps, as mentioned above, users can generate “passive income” by loaning out their money and generating interest from the loans. Yield farming, described above, has the potential for even larger returns, but with larger risk. It allows for users to leverage the lending aspect of DeFi to put their crypto assets to work generating the best possible returns. However, these systems tend to be complex and often lack transparency.
GUIDE TO GET INTO DEFI
Before we start, there are 4 elements to understand before jumping onto DeFI:
- Fiat-to-crypto exchange. These are website platforms where you will use your credit/debit or bank account to purchase cryptocurrencies.
- Crypto-wallet. This is software that you install on your computer or phone to be able to access and interact with the cryptocurrency you have purchased.
- Crypto-to-crypto exchange. These are website platforms where you can use your cryptocurrency from your crypto-wallet to purchase other cryptocurrencies. You cannot buy cryptocurrency using a credit/debit card or bank account from this website.
- Crypto banks. These are website platforms where you can deposit your cryptocurrency to earn interest. You can also take out fiat or cryptocurrency loans from these platforms where you will pay interest.
The 4-step guide is summarized below:
- Buy cryptocurrency from a fiat-to-crypto exchange:
Start your DeFi experience by buying Bitcoin and Ether. Fiat-to-crypto exchanges are usually limited in the number of cryptos on offer due to regulatory requirements; however, crypto-to-crypto exchanges allow you to access hundreds of cryptocurrencies as they are not regulated as heavily. Thus, to own other cryptocurrencies such as DAI, transfer your Bitcoin or Ether to a crypto-to-crypto exchange to make your purchase.
- Create a software wallet to store your cryptocurrency:
Software wallets are a quick and easy way to store your cryptocurrency. They can be created in a matter of minutes, where you just click on “Create New Wallet”, and you are asked to remember a 12-word recovery phrase and your cryptocurrency wallet is created. As long as you create a software wallet on your own computer on your private WiFi network, your software wallet should be secure. Most people lose their cryptocurrency as they have forgotten or lost their recovery phrase. Thus make sure you write your recovery phrase on a piece of paper and store it in a safe location, or store it in a password manager like LastPass or Dashlane.
Software wallets are either multi-coin or single-coin. Multi-coin wallets are able to store cryptocurrencies from different blockchains such as Bitcoin, Ether, Tomo, XRP, and more.
MyEtherWallet and Metamask are Ethereum wallets, thus they can store any coins that are based on the Ethereum network. Single coin wallets can be useful if you are mainly looking to participate in that specific blockchain network alone; however, I recommend multi-coin wallets.
- Transfer your cryptocurrency from the exchange into your wallet:
From your crypto-wallet, extract the wallet address of the cryptocurrency you want to perform the transfer in. In our example below we are transferring Ethereum from Coinbase into TrustWallet.
IMPORTANT: You will lose your cryptocurrency if you send from one cryptocurrency (i.e., Bitcoin) into another cryptocurrency’s wallet (i.e., Ethereum). You must make sure that you are sending Bitcoin into a Bitcoin wallet address, Ethereum into an Ethereum Wallet address, XRP into an XRP Wallet address, and so on. If you send cryptocurrency into a different cryptocurrency’s wallet address, it is lost forever!
In the example below from Coinbase, we have cut and paste our wallet address in to the “Recipient” and selected to send over USD10 worth of ETH, which is about 0.0557 ETH. In the confirmation window, it shows “Network fee”. This is the amount of ETH that you need to pay in order for your transaction to go through. It shows that it is USD$0.05 cents. The charge for your network fee is dependent on how much traffic there is on the network, and not on the amount that you are transferring. You could be sending over a million dollars worth of ETH (5555 ETH) and the charge could still be USD$0.05 as long as the network is not overloaded. Compare this to a bank which would charge you a percentage of the amount being transferred. This is one of the advantages of the DeFI system. Always make sure you have a small amount of cryptocurrencies to pay for network fees for any crypto transfers.
- Transfer your cryptocurrency from your wallet to a crypto-bank to earn interest:
Crypto-banks connect you, as the depositor who wants to generate interest from your capital, to borrowers who pay you interest to use your capital to make purchases or investments. Most borrowers on DeFI are borrowing crypto to perform margin trading; however, there are some who are using those loans to make fiat currency purchases or investments. Some individuals prefer to use crypto loans rather than selling their crypto to minimize capital gains, or they may have bullish views on their crypto holdings and prefer not to sell it.
Most crypto-banks differ in terms of the interest generated, range of cryptocurrencies they have available to generate interest, frequency that the interest is being paid out, and the user-friendliness of the platform. The platforms I have suggested are pretty stable and secure, and the funds are insured but there is always a risk of a security breach with crypto.
How will Ethereum 2.0 impact DeFi?
Ethereum 2.0 isn’t a panacea for all of DeFi’s issues, but it’s a start. Other protocols such as Raiden and TrueBit are also in the works to further tackle Ethereum’s scalability issues.
If and when these solutions fall into place, Ethereum’s DeFi experiments will have an even better chance of becoming real products, potentially even going mainstream.
Bitcoin as DeFi
While Ethereum is top dog in the DeFi world, many proponents of Bitcoin share the goal of cutting the middleman out of more complex financial transactions, and they’ve developed ways to do so using the Bitcoin protocol.
Companies such as DG Labs and Suredbits, for instance, are working on a Bitcoin DeFi technology called discreet log contracts (DLC). DLC offers a way to execute more complex financial contracts, such as derivatives, with the help of Bitcoin. One use case of DLC is to pay out bitcoin to someone only if certain future conditions are met, say, if the Chicago White Sox team win its next baseball game, the money will be dispensed to the winner.
Most applications that call themselves “DeFi” are built on top of Ethereum, the world’s second-largest cryptocurrency platform, which sets itself apart from the Bitcoin platform in that it’s easier to use to build other types of decentralized applications beyond simple transactions. These more complex financial use cases were even highlighted by Ethereum creator Vitalik Buterin back in 2013 in the original Ethereum white paper.
That’s because of Ethereum’s platform for smart contracts — which automatically execute transactions if certain conditions are met — offers much more flexibility. Ethereum programming languages, such as Solidity, are specifically designed for creating and deploying such smart contracts.
For example, say a user wants his or her money to be sent to a friend next Tuesday, but only if the temperature climbs above 90 degrees Fahrenheit according to weather.com. Such rules can be written in a smart contract.
With smart contracts at the core, dozens of DeFi applications are operating on Ethereum, some of which are explored below. Ethereum 2.0, a coming upgrade to Ethereum’s underlying network, could give these apps a boost by chipping away at Ethereum’s scalability issues.
The most popular types of DeFi applications include:
- Decentralized exchanges (DEXs): Online exchanges help users exchange currencies for other currencies, whether U.S. dollars for bitcoin or ether for DAI. DEXs are a hot type of exchange, which connects users directly so they can trade cryptocurrencies with one another without trusting an intermediary with their money.
- Stablecoins: A cryptocurrency that’s tied to an asset outside of cryptocurrency (the dollar or euro, for example) to stabilize the price.
- Lending platforms: These platforms use smart contracts to replace intermediaries such as banks that manage lending in the middle.
- “Wrapped” bitcoins (WBTC): A way of sending bitcoin to the Ethereum network so the bitcoin can be used directly in Ethereum’s DeFi system. WBTCs allow users to earn interest on the bitcoin they lend out via the decentralized lending platforms described above.
- Prediction markets: Markets for betting on the outcome of future events, such as elections. The goal of DeFi versions of prediction markets is to offer the same functionality but without intermediaries.
In addition to these apps, new DeFi concepts have sprung up around them:
- Yield farming: For knowledgeable traders who are willing to take on risk, there’s yield farming, where users scan through various DeFi tokens in search of opportunities for larger returns.
- Liquidity mining: When DeFi applications entice users to their platform by giving them free tokens. This has been the buzziest form of yield farming yet.
- Composability: DeFi apps are open source, meaning the code behind them is public for anyone to view. As such, these apps can be used to “compose” new apps with the code as building blocks.
- Money legos: Putting the concept “composability” another way, DeFi apps are like Legos, the toy blocks children click together to construct buildings, vehicles and so on. DeFi apps can be similarly snapped together like “money legos” to build new financial products.