- DeFi is an emergent financial technology that allows users to consume and provide financial services without a third party.
- Some of the most popular yield generation strategies include Staking, Liquidity Provision and Lending.
- Smart Contract, Impermanent Loss and Rug Pull risks are some of the main pitfalls investors will need to navigate.
What is DeFi?
Decentralized Finance (DeFi) is a new and emergent financial technology that allows users to consume and provide financial services without the need to rely on a third party, with transactions secured utilizing blockchain/distributed ledger technology, much like that used by cryptocurrencies.
In traditional centralized finance, when consumers transact, save and invest, they rely upon a centralized entity (such as a credit card company like Visa, a bank or an investment management company) whose goal is to turn a profit. Thus, they usually take a cut at the cost of the consumer.
While cryptocurrency solves the problem of having a middle-man at the center of each monetary transaction, the aim of DeFi is to cut out the middle-man from the saving/lending/investing process, thus also removing fees here.
Of course, it isn’t all just about reducing fees. Just like cryptocurrency, DeFi is decentralized and permissionless in its nature, thus removing the ability of any one centralized power (be that governments or banks) to manipulate an individual’s access to financial services.
At present, individuals are able to secure loans and other financial services without the need for credit checks or going through the Know Your Customer (KYC) process, so long as they have sufficient collateral (usually in the form of crypto) to put up.
DeFi developers have built a multitude of so-called Decentralised Applications (dApps) that run on one or multiple smart-contract enabled layer 1 blockchains (such as the ethereum, Tron, Solana or Cardano blockchains). dApps are the heart of DeFi and the health of a smart-contract enabled blockchain’s DeFi ecosystem can often be measured by how many/the variety of dApps it has running.
Those seeking to invest can go into the websites of these dApps, connect their wallets and deposit funds into various yield-producing strategies as they choose. Those seeking to borrow can utilize a variety of DeFi platforms to borrow against collateral (usually bitcoin or ethereum).
How Can You Utilise DeFi To Generate Yield?
The generation of yield in DeFi, often referred to as “yield farming”, can be done in a number of ways. A few of the most popular methods are summarised below:
1) Staking – Proof of Stake (PoS) cryptocurrencies require a certain number of holders to lock up their crypto for a certain period of time in order to secure the network. This is called “Staking”, and the holders of Staked cryptocurrencies are compensated via yield (almost always in the same cryptocurrency as that being staked).
According to staked.us, stakers of Ethereum (2.0), Cardano and Solana can expect a yield of between 4-6%. Most centralized cryptocurrency exchanges will allow users to stake their crypto on their website, but it is also possible to stake crypto via various dApps.
2) Liquidity Provision – When crypto investors provide liquidity, they are essentially pooling their crypto into a fund that facilitates trade on a Decentralised Exchange (a type of dApp, also referred to as a DEX) or other type of DeFi application. In contrast to centralized finance where there is a high barrier to outside entrants into the world of market-making, crypto Liquidity Providers (LPs) are able to participate through the use of automated market makers (AMMs), one of DeFi’s most promising emergent technologies.
In most cases, prospective LPs will need to provide liquidity in both of the cryptocurrencies of the trading pair they are providing liquidity for. Crypto holders can become LPs using a number of DEX platforms. Some of the most popular include Uniswap, PancakeSwap, Orca, Curve Finance and SunSwap. Yields can vary wildly based on the perceived riskiness of the cryptocurrencies involved.
3) Lending – Crypto holders can utilise a variety of centralized and decentralized applications to lend their tokens to borrowers by locking their crypto into so-called “vaults”. Rates on leading cryptocurrencies such as bitcoin and ethereum are typically quite low, but rates on stablecoins can be very attractive (anything up to 30%). Some examples of the most popular Lending DeFi platforms include AAVE, Compound and JustLend.
What Are The Risks?
Given the youth of the DeFi space and its lack of regulation, prospective investors face a litany of risks. Below are summarised a few of the main ones to take note of.
1) Smart Contract Risks – DeFi is powered by smart contracts, which are essentially just code. Poorly written code can expose potential DeFi investors to loss if it leaves room for hackers to exploit funds.
2) Impermanent Loss – Some investment tactics in DeFi, such as staking and liquidity provision, require that investors lock up funds for a certain period of time. During this time, the price of cryptocurrencies can move wildly, exposing investors to losses.
3) Rug Pulls – This is when a fraudulent developer creates a new DeFi token with the intention of pumping the price to draw in gullible investors, only to then pull out as much value as possible before abandoning the project and letting the value of the token crash to zero. Sometimes investors in scam tokens aren’t even able to sell them, as happened famously happened with the Squid token last year. Unfortunately, due to a lack of regulation to protect investors from bad actors, DeFi is rife with such pitfalls.
4) Regulation Risk – There is practically no regulation in the DeFi space at the moment. But this could quickly change in the coming years and the impact on investments across the space will be hard to gauge.
5) Market Risks – Stablecoins play a key role in the DeFi space, with investors keen to lend them out for high yields and borrowers keen to borrow them against collateral. But as seen earlier in the month with Terra’s algorithmic stablecoin UST, investors in stablecoins must factor in the risk of a de-pegging event that could see them lose much of or all of their capital.
Current State Of The DeFi Market
According to DeFi analytics website DeFi Llama, the total Trade Value Locked (i.e. the total sum of money committed in DeFi smart contracts) across the entire space stands at just below $100 billion as of 26 May. That compares to a TVL of more than $172 billion at the start of the month and a TVL of over $220 as recently as the end of December.
This month’s sharp decline came in wake of the collapse of the Terra ecosystem, which was triggered by the de-pegging of its US dollar stablecoin UST and a subsequent “bank-run” like rush of capital out of the stablecoin that triggered hyperinflation in LUNA. The Terra ecosystem was at one point the second largest in the DeFi space (only behind ethereum) with a TVL of nearly $22 billion as recently as 5 May. TVL is now only around $170 million, with the collapse sending a chill across the entire industry.
A further headwind to the growth of the DeFi space in recent months has been the broad downturn in cryptocurrency prices, with the likes of bitcoin and ethereum down in the region of 60% versus the record peaks they printed last November. DeFi investments are still viewed as highly speculative in nature, hence in risk-off cryptocurrency market conditions, it isn’t surprising to see investors avoid pouring more money into the space.
Still, despite recent de-risking that has seen capital leave DeFi in recent weeks, TVL in the space is still nearly 100x versus this time two years. DeFi remains very much at a nascent stage in its development. As developers and innovations build better and more trustworthy dApps, the long-term trajectory is almost certainly tilted towards greater adoption and further growth.
Regulation could also play a pivotal role in allowing DeFi to break into the mainstream. A strong, well-thought-out regulatory environment could protect prospective investors from many of the aforementioned risks (like rug pulls and centralization by stealth). Indeed, regulation is likely a pre-requisite if big money is ever to come anywhere near the space (i.e. major asset/pension fund managers, for example).