What does DeFi mean?
The term DeFi is an acronym for Decentralised Finance and refers to an ecosystem of digital assets, smart contracts, protocols and decentralised applications (DApps) built primarily on the Ethereum blockchain network. As many DeFi projects share a common technology platform, these applications are highly inter-operable.
DeFi is currently the fastest growing area in cryptocurrency. Unlike FinTech, which is based on proprietary software, DeFi is founded on open source software. DeFi projects are not centrally governed and are not managed by an institution and its employees, but rather are written in code - or smart contracts - to be more precise. These smart contracts are programmable, automated and enforceable agreements that eliminate the need for intermediaries (e.g. banks or lawyers); instead, smart contracts operate autonomously on blockchain technology platforms.
DeFi systems are ‘trustless’, meaning that participants involved do not need to know or trust each other or a third party for the system to function. DeFi applications are also ‘permissionless’ in that anyone can use them. DeFi makes financial services (e.g. savings, loans, exchanges, trading, insurance) accessible to anyone in the world with a smartphone and internet connection. DeFi applications are highly sophisticated and automated in functionality - made possible on smart contract blockchains, such as Ethereum. Furthermore, as the only pre-requisite for participation is the means of connectivity, DeFi has opened up financial services to everyone, even the unbanked. This truly is a ground-breaking and disruptive technology innovation, breaking new frontiers and continuing the financial revolution started by the introduction of Bitcoin in 2009. Decentralised Finance has opened new possibilities across a wide range of financial products and services, including: cryptocurrency exchanges, derivatives, borrowing and lending, margin trading, synthetic assets, insurance contracts and algorithmic trading.
What is all the DeFi hype about?
After the ICO craze and bubble of 2017, the world of cryptocurrency fell into a bit of a lull, with significant price drops leading the market into Bear territory, while investors nursed severe hangovers. But now we are on a roll again, with the advent of DeFi and the explosion in the decentralised finance space. The hype is palpable. New projects are springing out of nowhere in days and attracting huge sums of investors’ funds, with prices of new tokens surging to extraordinary levels in a clamour to get a piece of the DeFi action. The main difference between the rise of DeFi and the ICO craze of 2017 is that these DeFi projects and protocols have a genuine and functioning use case. No more promissory white papers; these days it’s about the launch of powerful apps from the get-go. However investors should beware: many of these projects are launching with unaudited and unproven code, straight into production. Do your due diligence!
It’s really all about the Yield
In the aftermath of the unprecedented monetary policy response to Covid-19 across the globe, interest rates have crashed to all-time lows and returns for savers are near zero, or in some cases negative. DeFi offers much higher returns to investors than traditional financial products and institutions. The main source of excitement around DeFi currently centres on the high-yield interest income that can be earned by depositors of crypto into DeFi protocols. In some instances, depositors can earn over 100 times the typical APY offered on a traditional bank savings account or fixed income security. In addition to higher interest rates, many DeFi projects also reward participants with their native tokens, providing something similar to an ‘equity kicker’. It is possible to receive annual percentage yields (APY) of over 100% in some instances, when factoring in the various bonuses and incentives. This is quite naturally fuelling both interest and hype around the DeFi yield craze, although these rates will inevitably decline over time.
What does APY (Annual Percentage Yield) mean?
It is important not to confuse APY with APR (Annual Percentage Rate). Both terms are used in relation to investments and loans but there is a distinct difference. Whilst APR represents the annual rate charged for earning or borrowing money, the APY additionally takes into account the effect of compounding. Annual Percentage Yield (APY) is the annual percentage yield that will be earned on an investment, including compound interest. In the case of deposits, the APY represents the amount of interest you will earn on your deposited funds in one year and is derived from the interest rate and the frequency of compounding. Compounding is achieved by earning both interest on the principal investment and adding the effect of further interest on earnings.
Why are DeFi APY rates so high?
First and foremost, this is a risk and reward play: with higher rewards comes increased risk. By depositing funds into a DeFi protocol, you are lending your cryptoassets and earning interest in return. On the other side of your deposit is someone willing to borrow at a higher rate than the one you are receiving. But as this is a decentralised protocol and not a centralised company seeking profit, there is no middleman (e.g. a bank or financial services company) taking the NIM (Net Interest Margin) for their own benefit. They have been removed from the equation – so now you start to see the attraction of DeFi! However, there is an important aspect to note. With constant fluctuation of supply and demand on DeFi applications, the available yields can be ever-changing and volatile.
What is DeFi yield farming?
Yield farming, also known as Liquidity Mining, is the means by which investors can make a higher yielding return on their crypto. Yield farming involves lending funds to others on decentralised finance platforms running complex computer programs called smart contracts. These smart contracts are used to execute and control defined rules and instructions in relation to collateral and payments. In return, investors earn fees in the form of crypto tokens. Yield farmers use highly complex strategies to automate the movement of their crypto funds across different lending marketplaces to maximize their returns.
How does yield farming work?
Yield farming works by the practice of staking or locking up cryptocurrency within smart contracts for maximising return on investment. In return for providing funds to these liquidity pools, investors earn rewards in the form of more crypto tokens. A component of these protocols that generates the higher return is the fact that you are not only staking your crypto in the lending pool, but also in the governance of the protocol itself. Many of these DeFi protocols pay rewards for active participation (i.e. voting) and these governance rewards are in turn reinvested into the pool, boosting the overall returns. DeFi projects that have launched native governance tokens include: Compound (COMP), Balancer (BAL), Curve (CRV), Nexus Mutual (NXM), Sushiswap (SUSHI) and most recently Uniswap (UNI).
DeFi yield farming is fundamentally based on this approach but there is a way to further compound returns by utilising leverage to gain additional exposure to various crypto assets collateralised with fiat-backed stablecoins. Those yield farmers aggressively chasing the highest returns have found opportunities to borrow cryptocurrency at a lower rate than the returns they can achieve elsewhere, thereby opening up the opportunity of arbitrage across a range of DeFi protocols.
What exactly does Liquidity Mining mean?
Liquidity mining is the secret sauce in yield farming and describes the element whereby the liquidity provider (i.e. investor) receives new (governance) tokens in addition to the underlying return on assets lent to the pool. A DeFi pool is essentially a marketplace where participants can lend, borrow or exchange tokens. The use of these platforms incurs fees, which are in turn paid out to liquidity providers according to their share of the liquidity pool. You could see this as ‘mining’ new tokens and these represent additional rewards to those you receive for providing liquidity to the pool. Eventually, as acceptance and usage of each DeFi platform increases, so may the value of its native governance token. This has the potential to ‘juice’ a yield farmer’s overall returns.
What is a liquidity pool?
When you invest your crypto funds into a DeFi protocol, you are contributing your assets to a pool of cryptoassets in which other participants can lend, borrow or exchange tokens. As more funds are deposited, all liquidity providers benefit as they essentially own a share of the pool. The more trading activity in that pool, the more fees it will have earned, in turn increasing the value of each participant’s share.
- Compound is a decentralised blockchain based protocol that allows people to lend and borrow cryptocurrency. Founded by Robert Leshner in 2017, Compound is a DeFi system of openly accessible smart contracts built on Ethereum.
- The Compound protocol supports lending and borrowing of a unique set of cryptocurrencies: DAI, ETH, USDC, ZRX, VSDT, WBTC, BAT, REP and SAI.
- Compound’s token is an ERC20 called a cToken or COMP; these cTokens represent a user’s Compound funds. Once they have been converted into ERC20, the assets are freely tradable, movable and usable in dApps.
- The decentralised system is governed by COMP token holders; anyone who owns 1% plus of the COMP supply can suggest and vote on submissions to change the protocol.
- Putting your crypto into Compound is like depositing your money into a savings account in a bank - albeit with higher risk! It will go into crypto in your Compound wallet and you can immediately start earning interest (in the form of the token you lent), which is then added to a global pool of that token in a smart contract in the protocol. This basically allows you to spend the money you are saving whilst still saving.
- Once your crypto is swapped into Compound, you can borrow against your collateral. There is no credit check necessary. You pay interest on the amount borrowed and the limit varies for each token. However, when you wish to borrow, you must always put up collateral. Interest rates fluctuate depending on the market demand and supply of each cryptocurrency. The volatility of interest rates should decrease as the protocol grows.
- cTokens enable the user to earn interest on their money and also transfer, trade and use that money in other applications.
- cTokens gain interest through their exchange rate and over time, you should be able to convert your cTokens into an increasing amount of the actual asset. However, the number of cTokens will remain the same, so if you transfer a cToken then you in turn transfer the balance of the underlying asset inside the Compound protocol, therefore your balance will decrease.
- The Aave protocol is a decentralised finance (DeFi) cryptocurrency allowing users to act as lenders or borrowers in the market. AAVE is an Ethereum based ERC-20 token.
- AAVE token holders hold the right to vote on changes to the protocol (1 AAVE = 1 vote).
- It was originally released in 2017 as ‘ETHLend’ (LEND) by Stani Kulechov and a team of developers, with the intention to allow users to lend and borrow cryptocurrency among themselves. However, the project slowed in 2018 and was getting little attention, due primarily to a combination of the bear market at the time and lack of liquidity. They rebuilt the product and released Aave in early 2020, which is now one of the leading decentralised protocols.
- The Aave market runs on an algorithm, so loans are gathered in a large pool, instead of being matched to a particular lender. With Aave, users can take out a loan in an alternative cryptocurrency to the one they deposited.
- The interest rate for lending and borrowing depends on the utilisation rate (i.e. how much of the available assets are used). The more assets used, the higher the interest rate, which encourages people to lend more capital. Conversely when hardly any assets are used, the interest rate will be low to encourage borrowing.
- There is no credit check system, however all loans are overcollateralised, therefore you must deposit more than the amount you wish to borrow.
- Aave has a liquidation process, which is initiated when the collateral you provide falls under the collateralisation ratio (specified by the protocol). At this point they may liquidate your collateral and charge a fee.
- Another feature of Aave is the ability to get a flash loan if you are a DeFi user. These are uncollaterised loans that only exist for the size of one Ethereum block. Flash loans use the unused liquidity left over that is not taken up by the borrowers. The user borrows crypto with no collateral and returns the loan in the same transaction, but they must pay the one-block interest fee.
- AAVE has a ‘safety module’, which was put in place in case of a situation where there is a shortage of capital and there is not enough capital in the protocol to cover lenders’ funds. In this instance, the safety module is sold for the assets needed to make up for the lack of capital. Only AAVE deposited specifically in the safety module can be liquidated in this situation and in exchange, depositors receive a regular yield, paid in AAVE.
- Curve is an Ethereum based DeFi protocol which launched in January 2020 and then in August 2020, Curve launched a decentralised autonomous organisation (DAO) and its governance token CRV, which is used as the form of payment to liquidity providers.
- The Curve decentralised exchange is an automated market maker (AMM) platform, used to manage liquidity. Automated market makers (AMMs) are markets where assets can be traded automatically and without permission. So trades take assets in and out of liquidity pools, instead of specifically trading between a buyer and a seller.
- CRV is a freely tradable token that can be purchased on major exchanges, such as Binance.
- Curve is an efficient AMM platform for exchanging tokens, without paying high transaction fees. It also avoids major slippage, as the protocol accommodates liquidity pools made up of assets that behave similarly. This is unique to Curve and helps to maintain the decentralised nature of the exchange and improve the accuracy of the algorithms.
- The founder and CEO of Curve, Micheal Egorov, says that Curve “favours stability and composability over volatility and speculation.”
- Liquidity providers can earn trading and interest fees on Curve. Fees are influenced by the amount of trading on that day, so days with high volume and volatility offer liquidity providers the opportunity to earn higher rewards.
- In short, Curve aims to allow investors to earn high rewards from lending protocols without the high levels of volatility normally associated with cryptocurrency.
- Curve integrates with external DeFi protocols and only supports stablecoins.
- The total CRV supply is 3.03 billion tokens, 62% of which are distributed to liquidity providers. CRV had no pre-mine (a maximum supply created before the crypto is made publicly available) so tokens can be unlocked over time.
- Similar to systems of other cryptocurrencies, if you hold above a certain amount of CRV tokens that are ‘vote-locked’ then you have the potential to suggest an update to the Curve protocol. Other vote holders can then decide whether they want this proposal, by ‘locking up’ CRV tokens if they agree, and the longer a token is locked up for, the more voting power it has.
- Uniswap is an Ethereum based decentralised exchange (DEX) and automated market maker (AMM) protocol, which uses smart contracts, allowing users to trade through the liquidity pool.
- Uniswap is one of the largest decentralised exchanges in terms of market capitalisation and is one of the top 3 most popular Ethereum dApps.
- UNI is Uniswap’s primary token. It is an ERC-20 token and therefore follows Ethereum’s ERC-20 token standard requirements.
- Through Uniswap, users can exchange ERC-20 tokens on a decentralised and permissionless protocol, so participants are not required to know or trust each other or a third party organisation in order for the system to work.
- The decentralised nature of the market means that every user has equal opportunity as there is no central authority. However this also means that there is no one to block bad actors or to oversee risks, therefore one must be careful of scams. Do your own research and due diligence and always assess new projects for themselves, as there is no one overseeing quality control on decentralised platforms.
- The advantage of a permissionless and decentralised protocol is that it is highly anonymous. There is no KYC needed and you aren’t required to register or log into the market in order to trade. All you have to do is connect to a supported Ethereum wallet, such as Metamask, ensuring high privacy protection. As all ERC-20 tokens belong to the Ethereum network, they can be exchanged between any ERC-20 compatible wallet, exchange or dApp.
- Decentralised exchanges (DEXs) are non-custodial, so they do not directly hold users funds and they do not store large amounts of cryptocurrency in network wallets, reducing the risk of being hacked.
- Uniswap was founded in 2018, by developer Hayden Adams. It is an inclusive protocol, so anyone can list tokens, swap tokens or add tokens to the liquidity pool. The platform also encourages external API integrations.
- Users on the Uniswap network can earn rewards by acting as a liquidity provider. Each liquidity provider will gain a proportional share of the trading fees, depending on their contribution to the pool. This allows them to still be able to profit without selling off their asset. The liquidity pool enables users to swap two Ethereum assets in a simple transaction.
- Uniswap also helps new businesses looking to gain access to international liquidity. They use the DEX to seed a liquidity pool, allowing new projects the ability to release their tokens directly to the market and reach a larger audience.
- Synthetix is a decentralised synthetic asset issuance protocol built on Ethereum. The Ethereum based token for Synthetix is called SNX.
- Synthetix is currently being used for cryptocurrencies, commodities and synthetic fiat currencies. Synthetic assets (synths) are basically a combination of assets that hold the same value of another asset.
- Synthetic assets are collateralised by SNX tokens and when the tokens are secured into a contract, then synthetic assets can be issued.
- Due to the existence of the pooled collateral model, smart contracts can be used to allow direct conversations between synthetic assets, without involving counterparties. This resolves the liquidity issues of decentralised exchanges.
- SNX tokens are used to back synthetic assets and the incentive for SNX holders to stake their tokens is that they will receive back a proportion of the fees generated by their activity on synthetix. However, you do not need SNX tokens to trade on the Synthetix exchange; rewards are generated when a synth is traded and these are then gathered in a fee pool where SNX stakers can claim their share.
- The value of the SNX token comes from fees generated on synth exchanges.
- Mintr is a dApp for SNX holders to mint synths against their SNX. When synths are minted, SNX stakers will become subject to debt; then when they want to access their SNX and leave the system, they have to burn synths as a method of paying back their debt.
- Synthetix has been undergoing trials for Ether as another form of collateral. This would allow for instant trading as traders could then borrow synths against their ETH. However, this means that they will not be involved in the system’s ‘pooled debt’, so they will not receive rewards as the risk has been eliminated.