October 21st, 2020
‘DeFi’ is a fashionable term of late, with almost daily news of fortunes being won and lost in the growing DeFi space as the total value increased from $1bn to $8bn in just the last year alone. Not surprising, this has attracted a lot of attention, with top crypto influencer Qiao Wang tweeting that similar to bitcoin pre-2013 and ethereum pre-2015 the current DeFi market represents a “once-in-a-decade” opportunity for investment. So if that’s also attracted your attention, let’s consider what DeFi (short for ‘decentralized finance’) is in more depth, to give you a greater understanding of the risks and benefits of this emerging market.
Step back from the DeFi bubble of 2020 and go back in time to 2008, the year when bitcoin was invented by the mysterious Satoshi Nakomoto in 2008 following the baking crisis of that year. As a decentralized digital currency bitcoin was a radical step forward, giving people the opportunity to store and transfer funds from person to person, without the need for banks or other third parties to be involved. While this was a significant step forward what was lacking, compared to traditional centralised finance is the ability for people to also lend, borrow, invest and earn interest off their bitcoin. It’s this decentralised financial functionality that the so-called DeFi apps or ‘Dapps’ have been launched to provide, especially for people who in the past have not been able to access financial services.
In fact bitcoin is not at the core of DeFi, rather the world’s second largest cryptocurrency platform Ethereum which due to its elegant coded structure allows for automatically executed transactions, using something called ‘smart contracts’. Today nearly all the DeFi products available are built on Ethereum, with an upgraded version of the platform in the pipeline it looks like this is the platform of choice for such Dapps for the foreseeable future. In practical terms what this enables is the removal of the third parties, such as banks, and in turn allows for interoperable applications that mean services can be more easily customised according to user needs again without recourse to a third party for permission.
A popular example of a DeFi application are known as DEXs, that is decentralized exchanges that allow people to easily exchange cryptocurrencies for others. These trades are therefore made directly between people using their crypto wallets and backed up by smart contracts that do all the heavy lighting in the background. Uniswap has been one of the most popular platforms for trustless token swaps, especially for yield farming strategies. As a result, Uniswap became the first decentralized exchange to hit ten-figure volumes, specifically exceeding $1bn in 24-hour trade volume. As Douglas Tjokrosetio explains in his recent blog post on these exotic sounding financial instruments the participants in liquidity mining “are called liquidity providers (LP). They add or deposit funds to liquidity pools, which are smart contracts that hold funds. In return for providing funds and liquidity to the pool, these LPs receive a reward. These rewards come either as fees from the DeFi platform used, or in the form of multiple tokens. The rewards received are often deposited to other liquidity pools to earn more rewards”. Douglas points out that Uniswap rival SushiSwap provides more incentives to liquidity providers by awarding fresh new SUSHI tokens, to lure them away from Uniswap: “Because SushiSwap is community-governed, it redirects its profits back to the community. In contrast, Uniswap directs its profits to a small number of investors. Because of this business model, SushiSwap could provide more incentives and higher rebates to its users.”
While the DeFi market has a lot of potential for innovation, there is plenty of criticism that it’s a bubble which is too risky right now for most people to take part in safely. In September 2020, Bloomberg reported that DeFi made up two-thirds of the cryptocurrency market in terms of price changes and that DeFi collateral levels reached $9bn. By its very nature DeFi applications put the onus on the individual to take responsibility, but this means when errors do take place as the technology is blockchain based they can be hard to correct compared to a high street bank with customer service to offer. It’s also true to say that with all the hype and the relative newness of the DeFi technology and terminology, that finding the right application can be a difficult task for the interested individual.
Perhaps a relatively safer method is taking part in ‘Yield farming’ generating passive income by lending out their income and generating income. But the risks still remain. Grabbing the headlines in August was Yam Finance, an untried DeFi protocol. It was so successful at the outset that within 24 hours of launch some $500m worth of crypto capital was deposited in Yam. After a bug was found in the code Cointelegraph reported its market cap crashed “down to zero” within minutes in mid August.