The year 2020 will be etched into our collective memories for decades to come, partly due to the global pandemic and partly due to the rise of Decentralized Finance aka DeFi.
Despite DeFi’s unprecedented rise and the boundaries it broke in 2020, the space still seems difficult for many, and even many hardcore HODLERS struggle to understand its full potential. This article seeks to demystify some of the mystery surrounding DeFi and what it means for the world.
What is DeFi?
Decentralized Finance, refers to blockchain-based financial services, equivalent to that of a centralized financial institution, where smart contracts are used to govern interactions between parties removing the need for a potentially corruptible central authority.
Most DeFi projects are built as an application layer on the Etherum network and can be grouped under the umbrella of DApps (decentralized applications). There are other protocols however such as Polkadot and Cardano that have been used by devs for different DeFi projects also although Ethereum remains the most widely used.
DeFi functions as an open financial network that is trustless and decentralized. This openness has attracted many investors, with the value of tokens now locked in DeFi protocols now approaching $68 billion as of mid-March 2021.
Types of DeFi Projects
Despite DeFi’s rapid evolution in recent years its disruption of centralized finance has only just begun and there remains enormous scope to transition more financial services to the blockchain. Below is an overview of two of the main project categories that have already been accomplished in DeFi.
- Decentralized exchanges (DEXs)
Decentralized exchanges facilitate the trading of cryptocurrencies governed entirely by smart contracts without the need for an intermediary. DEXs operate on a peer-to-peer basis by connecting users to buy and sell tokens in a trustless system.
The exchanges are non-custodial meaning that the assets being traded are never controlled by the DEX or held in any third party's wallet. This is the major defining feature of DEXs versus their centralized counterparts and eliminates the risk of a bad acting exchange stealing their user's tokens.
2. Lending Platforms
Just like getting a loan from a bank, DeFi is facilitating loans in cryptocurrency with the added benefit of operating in a decentralized and trustless way. This is democratizing the lending ecosystem and give access to liquidity for borrowers without having to sell their assets. Lenders earn interest on their staked assets in exchange for loaning them out.
To get access to a DeFi loan, borrowers need to over-collateralize their loan by offering assets that have more value than the loan amount. This acts as protection for the lender in case the loan cannot be repaid. Some of the top DeFi lending platforms include Aave, Maker, and Compound.
Making Money with DeFi
The rise of DeFi has opened up new ways to earn money from crypto. Previously investors made a profit through speculation on tokens only (i.e. buying low and selling high) but with DEX and lending platforms now available investors can profit in new ways, namely Yield Farming and Liquidity Mining.
- Yield Farming
Yield farming is the process of depositing your tokens in the most optimal way to generate returns. It is an active investment process where funds are moved from pool to pool, or even platform to platform, in search of the best annual returns (APY) available.
Usually, the percentage of returns is directly proportional to the risk of the pool. However, like with any other investment your strategy needs to be crafted around handling the risks.
The idea of Yield Farming has led to the emergence of automated yield optimization projects like Yearn.Finance that automatically allocates funds to maximize yields.
2. Liquidity Mining
Liquidity mining is a response to Yield Farming. It is the process where a platform rewards tokens to liquidity providers (LPs) in addition to the ordinary returns as an incentive to allocate tokens to their pools.
The tokens rewarded to LPs are usually governance tokens that give holders a vote in the future direction of the platform.