DeFi: everything you need to know about it
By OSOM finance on The Capital
Last week, we shared with you our thoughts about the intriguing novel category of financial assets worth looking into, namely, cryptoassets that are enabled by blockchain technology. We discussed how this field contains in it a lot of promise but also bears with it significant risks, including for investors.
However, investing into potentially highly volatile assets representing risky projects is not the only way for a would-be investor to benefit from the crypto space. Another even more novel opportunity is presented by the projects that form the so-called decentralized finance, or DeFi, ecosystem.
DeFi can be thought of as a set of often interoperable protocols, platforms, and tools that allow people to use crypto assets in many of the same ways in which one can use money and assets in traditional finance. However, if one wants to, one may use crypto assets through DeFi without exposure to cryptocurrency markets’ well-known volatility.
The reason for this is that, while it is also possible to use crypto assets like Ether (ETH) to enter the DeFi space, one can also rely on so-called stablecoins like DAI or USDC. Stablecoins are also crypto assets, but they are designed so that their value does not fluctuate very much. Programmatic stablecoins like DAI or synths in the Synthetix ecosystem attempt to achieve this by using complex algorithms for managing the volatile collateral and always keep its value around a certain level. Simpler stablecoins like USDC just issue one token for each real US dollar or unit of another established national currency kept in a frequently audited reserve.
At the time of writing, the DeFi space tracker Defipulse estimates that a total of around $750 million of crypto assets is locked in various DeFi protocols. DeFi is a rapidly developing, cutting edge space, but it already offers many interesting opportunities, both mimicking traditional finance and sometimes going beyond it. Let us look at some of them.
Some DeFi examples
The cornerstone of the traditional financial system is the saving and lending mechanism. Many people do not spend all the income they receive, preferring to leave some of it for future contingencies or accumulation. Using deposits of various types, banks allow them not to just keep the money under the mattress but also increase it. They offer savers interest rates on deposits, and they normally manage to deliver because they lend the deposited funds to companies needing money to invest or people willing to buy stuff on credit at somewhat higher rates.
The DeFi space has several savings-and-lending (S&L) tools available. There are protocols like Nexo, Dharma, Bitgo, and Compound that use smart contracts to allow people to deposit crypto assets and earn passive income on that money. Like banks, they loan the deposited funds to try to earn higher interest than they have to pay to depositors.
The key difference, at least so far, however, has been in the way the loans have been secured. The companies operating crypto lending protocols usually have neither the desire nor the resources to attempt to enforce repayment. Thus, to mitigate the default risk, borrowers are required to post a substantial amount of certain crypto assets as collateral in order to receive a loan. Sometimes, the loans are intentionally overcollateralized.
The best example of an overcollateralized S&L system is the Maker protocol that operates the DAI stablecoin. DAI is itself used in many S&L schemes as a deposited and borrowed asset but creation of its new units is in itself an act of borrowing. In order to receive some amount of DAI, a user must first deposit at least a 1.5 times higher dollar value in either ETH or BAT or USDC.
The high collateralization obviously limits the appeal of DeFi loans, but work is underway to attempt to reduce the collateral requirements. On the other hand, DeFi protocols offer significantly higher interest rates to savers than traditional banks. You can look at some of the lending rates here. The entry is also a lot easier than in traditional finance. In most cases, not even basic KYC is required.
One of the cool ways to enter the DeFi space and test it out with a small amount of crypto is by using the Pooltogether no-loss lottery. It is a no-loss lottery because the money deposited is not shared between the lottery provider and the winner but is instead loaned out using the Compound protocol. After the loan period ends, everyone gets their principal back, but one lucky person gets the whole amount of interest. If you are interested in Pooltogether, we have made a video tutorial on how to use it easily.
Please note, however, that the no-loss feature refers to the way the Pooltogether lottery is designed, not the guarantee of outcome. No 100% guarantees can be given in legitimate finance, even if it is DeFi.
A separate category of projects in DeFi involves the so-called staking as a service. Several major working blockchain platforms (Tezos, Cosmos, Solana, Algorand) use proof-of-stake (PoS) for consensus instead of proof-of-work. What this means, put simply, is that in order to be a validator, one needs to not only provide adequate hardware (though way less demanding than for mining) but also deposit a certain amount of cryptocurrency. In return for freezing some of the currency, stakers are rewarded just like miners in PoW blockchains.
A host of projects (Certus One, Chorus One, Everstake, Mythos, etc.) have emerged to allow people to stake their cryptocurrency without themselves doing any validation. Some cryptocurrency exchanges like Binance and Coinbase also offer clients to stake their cryptocurrency for them.
There is obviously a lot more to the DeFi space than we could analyse in this article, including decentralized exchange (DEX) protocols like Kyber and Uniswap, DeFi insurance projects like Opyn, prediction market platforms like Augur and Gnosis, and so on. However, the article on the DeFi space will not be complete without mentioning the major risks that it contains along with its exciting potential.
The risks
The risks participants in the DeFi space face can be broadly split into two categories: technology-related and economic.
Technology-wise, DeFi is a complex web of smart contracts and other sophisticated tools like oracles that often have no official entities managing them and capable of compensating clients for damage in the case of hacks or major bugs.
Oracles have already shown themselves to be potentially the weakest link in the space. They are trusted sources of information for smart contracts, and in DeFi, they are mostly responsible for supplying up-to-date price or interest rate signals. These sources can be provided either by trusted third parties like Coinbase Oracle or enabled by a decentralized network like Chainlink or Oraclize. Decentralized oracles usually further rely on data from decentralized exchanges like Kyber and Uniswap.
A detailed discussion of the oracle problem in DeFi is beyond the scope of this article, but if you are interested, you can read up on it further here and here. A recent oracle vulnerability led to two successful attacks on the bZx lending protocol that cost its clients around $1 million in ETH at the then current price.
The second set of potential issues with DeFi is related to its economics. First, DeFi protocols in various ways rely on cryptocurrency markets (especially decentralized ones) that often have insufficient trading volumes to resist price manipulation.
Some DeFi protocols like Maker rely on volatile assets to create stablecoins like DAI. In some scenarios, the underlying assets may prove too volatile for maintaining stability. During the latest crypto market crash, the Maker community barely managed to keep the DAI system afloat. The solution came in part through adding USDC as a form of collateral.
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In summary, the DeFi space represents an interesting alternative way of using blockchain and cryptocurrency technology for growing one’s savings that potentially requires less exposure to crypto asset volatility. However, DeFi has its own unique risks that need to be taken seriously.
