2020 DeFi Bible — 5 Must Knows Before You Enter The DeFi Space
Guide To Decentralized Finance: From 500% Yields To $24 Million Hacks
DeFi, DeFi, DeFi. The hottest buzzword on the tip of everyone’s tongues in the 2020 crypto realm. Rightfully so? The potential of “decentralized finance” (DeFi) is enormous. A first glance shows it’s extremely disruptive: how else could it be possible to earn a 500% annual interest rate on a “yield farming” account? Yet the first question that comes to mind is “What? 500%? How is that even possible? Let alone sustainable?”
Industry veterans have seen it all before. The last time was in 2017, when ICO investments (or speculations?) returned between 10 X and 1000 X before the whole market collapsed into a prolonged crypto bear market that’s been going on for the past two years now. As prescribed by behavioral finance, the vast majority of people flock to a new trend when it’s actually time to get out. Many, many late comers to the 2017 ICO boom didn’t see a 10 X of their portfolio, but rather a minus 80% or worse. It’s simple market dynamics, but nothing beats psychology. What also didn’t help is that the vast majority of projects were scams or lacked the right mix of team, vision, implementation, to build out what they promised.
So yes: do your own research (DYOR!). And let people like me help you by providing you with a framework to understand the fundamentals, question- and exclamation marks. DeFi is promising. DeFi is full of risks. DeFi is everything at the same time right now. But in the greater scheme of things, the advent of bitcoin in 2008 and the ensuing development of the crypto world in the past twelve years were the first steps to introduce a non-traditional way of thinking about and interacting with finance through new technology. Since then, the crypto realm has continued to evolve at an exponential rate, with newer cryptocurrencies and blockchain technologies consecutively emerging. DeFi is that next stage. It sits at the forefront of innovation in today’s blockchain space and won’t hold back to disrupt every financial service it encounters.
Meanwhile, DeFi popularity has skyrocketed with its market cap in November hovering around 11–12 billion USD, an impressive growth compared to the 1 billion USD back in June.
That leaves the question: what exactly is DeFi and why are so many people talking about it?
(PS: Don’t forget to clap if you like what you read! ;-) )
1. What is DeFi?
One of the main aims and purposes of cryptocurrencies is to make money and payments universally accessible to anyone, anywhere. DeFi takes this a step further by making other traditional financial services — savings, loans, trading, insurance and more — accessible to anyone around the world.
Through decentralized technologies, such as cryptocurrencies and decentralized apps (dApps), anyone with a smartphone or supported wallet and internet connection can utilize a variety of financial services that they may not have access to through traditional means. In other words, the development of DeFi has expanded the use of blockchain technology from simple value transfer to more complex financial use cases.
The development of DeFi has expanded the use of blockchain technology from simple value transfer to more complex financial use cases, including savings, loans, trading, insurance, and more.
Almost all DeFi applications are built on the ethereum blockchain, the world’s second largest cryptocurrency platform after Bitcoin. Ethereum is primarily designed for creating and executing smart contracts, which makes it flexible and easier to build other types of dApps beyond simple transactions.
Smart contracts are programs running on the blockchain that deploy automatically when particular conditions that were written into it are met. As a simple example, a smart contract can be programmed to release funds to another user for Christmas each year. But smart contracts can also enable developers to build sophisticated dApps that provide functions beyond sending and receiving cryptocurrency. DeFi dApps can create stablecoins, lend out money and earn interest, take out a loan, exchange one asset for another, or even implement advanced automated investment strategies.
2. The DeFi suite
Some of the most popular types of DeFi applications include:
I. Decentralized exchanges (DEXes) where you own your keys
A DEX allows users to buy and sell their crypto with one another directly through a smart contract on the Ethereum blockchain, without a central authority. It effectively cuts out any middlemen (especially centralized crypto exchanges) so users can regain control of their finances and no longer need to entrust their money with governments, financial institutions or central banks.
Decentralized exchange platforms (DEXes) such as AirSwap Team, Bancor, IDEX, paraswap, and SushiSwap all have slightly different architectures. One of the most popular DEXes at the moment is the decentralized trading protocol UniSwap. Uniswap is a fully decentralized cryptocurrency exchange that uses Automated Market Making to automatically settle trades and lets users trade popular tokens directly from their wallets.
In an unprecedented move to show gratitude to their early community members, Uniswap conducted an airdrop in October, giving away 400 UNI to each address created before September 1, 2020, that conducted at least one transaction on Uniswap v1 or v2. At the time, 400 UNI was worth between 1,600 and 3,200USD, and currently hovers under 1,000USD. Users with multiple addresses have really benefited from this unexpected gift. Furthermore, in the latest version of Uniswap (launch yet to be announced), UNI token holders will receive a percentage of each transaction that goes through the platform.
II. Borrowing and lending — Higher yields, lower cost
Arguably the fastest growing sector of DeFi, borrowing and lending platforms connect parties through smart contracts rather than leaving the management up to banks. Lenders can provide loans to businesses or deposit money and earn interest as others borrow their assets. Since middlemen are cut out of the exchange, lenders are able to earn higher returns.
Compound is an example of a popular blockchain-based borrowing and lending dApp. Users can lend out their crypto and earn interest on them, or deposit cryptocurrencies to the Compound smart contract as collateral in order to borrow funds. Due to its decentralized nature, users don’t have to specify their personal details (name, financial history, etc.) and their collateral is enough to get a loan. The borrowing/lending rates are algorithmically adjusted based on supply and demand.
III. Stablecoins — Instant processing, lower volatility
Stablecoins are less volatile cryptocurrencies as their price is pegged to a reserve assets such as the US Dollar or commodities like gold. Combining this elimination of doubt over value volatility with instant processing, and the security and privacy of crypto payments, they offer a strong value proposition.
Wrapped Bitcoin (WBTC) is one of the top DeFi tokens by market capitalization, in second rank with a market cap of approximately 1.6 billion USD at the time of writing. WBTCs are a method of sending bitcoin to the Ethereum network so they can be used directly in Ethereum’s DeFi system. It allows users to earn interest on the bitcoin they lend out via decentralized lending platforms. Other popular DeFi stablecoin projects include MakerDAO (DAI) and USD Coin (USDC).
IV. Prediction markets — Bet with lower fees and better odds
Decentralized prediction market protocols allow users to bet on the outcome of future events, such as elections, without intermediaries. Traditional betting platforms tend to maximize the amount of value they extract from customers with high fees, low odds and all sorts of limitations. Blockchain-based prediction markets like Augur and Guesser are changing this by providing a decentralized, peer-to-peer exchange that enables global and transparent access to its markets. Users keep more of their winnings due to low fees and better odds (thanks to the wisdom of the crowd). An observation from coindesk points out that “DeFi has the potential to boost interest in prediction markets, since they are traditionally frowned upon by governments and often shut down when run in a centralized manner.”
V. No-loss lotteries — Play the lottery without losing your money
Another DeFi service includes participating in a no-loss lottery. PoolTogether is a no-loss game where participants deposit DAI stablecoins into a common pot. At the end of each month, a lucky participant wins all the interest earned and everyone else gets their initial deposits back.
VI. Synthetic assets — Bet on real-world assets without holding them
Synthetix is a token trading platform built on Ethereum that allows users to create and exchange synthetic versions of real-world assets. It allows users to bet on crypto assets, stocks, currencies, precious metals and other assets in the form of ERC-20 tokens, without holding the actual asset. The synthetic assets are backed by excess collateral locked into the Synthetix contracts. Synthetix rose to the top of the DeFi dApp charts in 2019 and has focused on transitioning to a decentralized governance structure in 2020. The big Synthetix feature that many are anticipating is when it attains the “ability to trade stocks like Tesla and Apple on top of Ethereum”.
Trade stocks like Tesla and Apple on top of Ethereum, without ever holding the actual shares.
VII. Robo-advisors — Automated smart contract-based investment portfolios
Although relatively nascent to the DeFi scene, investors in DeFi can generate the highest possible yields with the help of robo-advisors. Investors would normally need to keep a constant eye on contracts and quickly reallocate in order to get the best yields. But now a robo-advisor (designed and set through a smart contract) can conduct the monitoring and allocating for investors. For example, an investment pool with five million worth of ETH in it will automatically be moved to a platform that offers the highest percent for collateral on ETH-based derivatives.
Staked’s Robo-Advisor for Yield (RAY) and Rari Capital are two popular robo-advisors that automate the process of finding high-yielding opportunities. RAY targets investors holding ETH, USDC or DAI, who can put their assets into a pool and let the smart contract automatically invest the pool (or part of it) into contracts with the best yield. Rari Capital operates on the same principles, but takes things a step further by offering three separate pools for users with different risk appetites.
3. Why the craze?
The DeFi craze and its exponential growth has been powered by its potential benefits and, without a doubt, the ever present “fear of missing out”. In particular, the “FOMO” of DeFi can be attributed to the mind-blowing high yields promised by yield farming projects, which play on the human weakness and desire of getting rich quick with little to no effort or responsibility. Yields from yield farming projects can range from a hallucinatory annual percentage yield (APY) of 500% to a low APY of 0.57%, with plenty of projects in mid-ranges.
The lure of huge rewards is hard to resist, enticing many to flock towards DeFi and yield farming without understanding the risks involved. However, let’s put the risks of DeFi on the backseat for the moment and consider the many benefits and advantages that make DeFi so compelling.
I. Decentralized — Quick smart contract deployment with little to no human intervention, and at reduced cost
The decentralized nature and cutting out of middlemen from all kinds of transactions is one of the primary advantages of DeFi. Since smart contracts rather than centralized systems or human gatekeepers are at the centre of DeFi operations, they can be deployed quickly and run with little to no human intervention, at reduced cost. The lack of middlemen also means that users don’t need to entrust their money to third-parties and that they are therefore empowered with direct control over their funds.
II. Transparent — One can verify any and every transaction that occurs on the blockchain
DeFi codes and transactions are transparent on the blockchain for anyone to view or audit. This transparency builds trust with users since anyone has the opportunity to verify and understand a contract’s functionality or find bugs. Although transaction activity is public for anyone to view, they are pseudonymous by default so a user’s private details are still protected.
III. Global, permissionless, and inclusive — Anyone, anywhere, anytime
DApps are designed to be global, “permissionless” and inclusive. This means that anyone, anywhere, anytime can access the same DeFi services and networks as long as they have an internet connection. Unlike traditional financial services that usually require you to fill out lengthy forms with personal details and have certain limitations, anyone can create and use dApps from their crypto wallets.
Anyone, anywhere, anytime can access the same DeFi services and networks as long as they have an internet connection.
IV. Interoperable — Open source enables lego-style composability
The codes behind DeFi apps are open source and public for anyone to view, so anyone can “compose” new apps with the code as building blocks. The composability of DeFi lends itself to infinite possibilities as DeFi apps can be put together like “money legos” to build new financial products. For example, a user can buy the stablecoin DAI and then lend it on Compound to earn interest.
The modular composability of DeFi lends itself to infinite possibilities as DeFi apps can be put together like “money legos” to build new financial products.
V. Opportunity to earn — Higher interest at lower cost
Interest rates from central banks worldwide sit at pitiful numbers and seem to just get worse as the years go by. The current American interest rate FED (base rate) is 0.250%, British interest rate BoE (base rate) is 0.100%, and European interest rate ECB (base rate) is 0.000%. In contrast, DeFi offers users the opportunity of earning through interest from lending platforms (as mentioned above) or yield farming. Since middlemen and central banks are cut out of any operations, users tend to earn higher interests.
4. Challenges and risks
Make no mistake, DeFi is risky. Despite the benefits that the DeFi ecosystem has exhibited and the potential it has yet to unleash, it’s not without risks and challenges. As a young financial system compared to the traditional one we’re used to, the entire crypto world is still developing and in the process of ironing out its wrinkles. This takes time and means that it’s important to understand the risks present in today’s DeFi. An immediate flashback to the 2017 ICO boom comes to mind.
I. A repeat of the 2017 ICO boom?
The Initial Coin Offering (ICO) boom of 2017 took the crypto market by surprise as it generated over $6 billion USD, four times more than what was generated between 2013–2016 combined. ICOs revolutionized crowdfunding and helped crypto start-ups attract a record amount of funds with a minimum amount of accountability, and yes, a never ending list of risks. This resulted in a large portion of projects reportedly operated by scammers (over 80% according to Statis Group’s study) while many other projects crashed and burned when they failed to deliver positive returns for investors. Deadcoins has recorded that 780 coins were scams and over 1,000 coins have died out. And yes, another parallel with the current DeFi craze is, well, the crazy names. From JesusCoin, ButtCoin, and CryptoMeth in 2017 to PancakeSwap, SushiSwap, and BakerySwap in 2020. If one thing is clear in hindsight, it’s that the 2017 ICO hype was short-lived and the entire crypto realm crashed right into a bear market in the beginning of 2018. No wonder concerns are growing as to whether the DeFi craze will be a repeat of the past, with projects dying out and many people likely losing a lot of money.
II. Smart contract bugs — Devastating vulnerabilities
As with anything that exists online and in the digital world, smart contracts are vulnerable to both unintended programming mistakes and malicious hacks. Hackers that find bugs in open source code for a dApp can easily exploit them, resulting in the instant draining of millions of dollars. A great example of the past is the Parity Hack, where over 600,000 ETH was lost due to a bug in the smart contract. The most recent prime example is the Harvest Finance hack on October 26, where 24 million USD was drained from Harvest Finance’s stablecoin and BTC pools in less than seven minutes. The hack resulted in Harvest’s governance token FARM plummeting 60% and 400 million USD in total liquidity drained as liquidity providers fled the platform.
Although smart contract bugs and vulnerabilities are a risk, teams like Nexus Mutual are building decentralized insurance to cover users in the event of smart contract hacks or failures. It is an open platform on Ethereum that “uses the power of Ethereum so people can share risk together without the need for an insurance company”.
III. Yield farming — Huge yields at huge risk
Yield farming is arguably the buzzword behind the explosion of DeFi. The concept of yield farming emerged from the DeFi movement as a new way of earning impressive yields on cryptocurrencies. Binance Academy explains yield farming as “the wild west of Decentralized Finance (DeFi), where farmers compete to get a chance to farm the best crops.” Yield farmers use (secret) strategies to move their cryptos between different lending marketplaces to maximize their returns. This pursuit of high yields is incredibly complex, risky, and usually unsuitable for general users.
“It’s all too easy to get caught up in hype and be blinded by outrageous yields. If you aren’t careful or simply unaware of risks such as hidden backdoors in unaudited smart contracts, it becomes increasingly possible that you could get burned.” — DeFi Pulse about Yield Farming.
IV. Differentiating good and bad projects
According to Coindesk, “an ‘anything goes’ culture thrives in DeFi, with ridiculously named projects from Yam to SushiSwap exploding in popularity overnight, only to quickly die out”. It’s difficult for general users to separate good DeFi projects from the bad, resulting in many users getting scammed by fraudulent projects or investing in projects doomed to fail. A quick search on the internet will reveal plenty of horror stories from people who have lost thousands overnight or been subject to farming scams (such as Jhon Doe who lost $140,000 worth of Uniswap’s UNI tokens to a fraudulent yield farming project). There have been numerous failed projects already and the sad reality is that there will likely be more to come. This definitely feels like ICO craze.
V. Security — The biggest risk of them all
Just like a traditional wallet in your back pocket is vulnerable to the deft fingers of pickpockets, the digital nature of cryptocurrencies opens doors to cyber-attacks unless they are properly secured. The basics of protecting and storing cryptocurrencies with secure solutions need to be understood and practiced by cryptocurrency owners. The vulnerabilities of smart contracts are already a risk, and one that is usually beyond the control of general users, so it’s important for cryptocurrency owners to reduce the vulnerability of their digital assets to hackers however they can. Secure solutions include owning your private keys yourself by using cold wallets, wherein NGRAVE’s NGRAVE ZERO is the “coldest” digital wallet available. Another challenge is that users struggle to manage the multiple addresses on multiple individual platforms to access their assets and data. The recently launched DeFi wallet (the first of its kind), Frontier, solves this by combining all of a user’s wallets into a single integrated interface without sharing their private keys. It enables users to track, view and manage multiple wallets, assets and protocols in a novel and secure way.
5. What is the future of DeFi?
Whilst the development of DeFi and the innovative financial technology it represents is very exciting, it’s far from ready for mass adoption. Although DeFi has succeeded in opening up financial services to those who don’t traditionally have access to them, which at its turn draws more and more people to the DeFi movement, it’s hard to tell whether DeFi can shed its Wild West feel and mature sufficiently for mainstream adoption.
I. The technology hype cycle
As a young industry in the midst of development, several challenges and changes threaten the future of DeFi. If anything, it will have to go through the typical stages of technology adoption, commonly referred to as the “technology hype cycle”. Back in 2019, I wrote an article on this cycle in the context of the ICO craze. When we look at the current stage DeFi is in, it’s most likely somewhere between the innovation trigger and peak of inflated expectations.
When we look at the current Hype Cycle stage DeFi is in, it’s most likely somewhere between the innovation trigger and peak of inflated expectations.
II. Ethereum 2.0
Ethereum’s growing adoption and popularity, thanks to the surge of stablecoins and DeFi growth, has also revealed security, scalability and congestion issues in the network. Developers hope to rectify these problems with the launch of Ethereum 2.0, which will bring about big changes including proof-of-stake and sharding updates to the network. Whilst Ethereum 2.0 staking has begun testing, the release of the first phase of upgrade, which will see Ethereum switch to a proof of stake consensus mechanism, has been pushed to November.
Ethereum’s growth has also brought its fees to all-time highs in August and they have consistently remained higher than Bitcoin over the last two months. A tweet from crypto market data aggregator Messari noted that this is the longest period that Ethereum’s transaction fee revenue has exceeded Bitcoin’s. According to cointelegraph, “the surge in transaction costs has reignited vigorous debate within the Ethereum community as to how the network should adapt in the interim before the completion of ETH 2.0’s roll-out, which is currently expected sometime in 2022.” Since most DeFi applications are built on the Ethereum blockchain, the development and eventual release of Ethereum 2.0 will have a large impact on dApps and the DeFi movement. If the solutions from Ethereum 2.0 fall into place beautifully, DeFi may have a higher potential of going mainstream.
III. New regulations
Regulators have been thrown a serious curve ball as DeFi flourishes in a gray space without archaic regulations to stifle technological innovation. On the other hand, the lack of regulation has left the DeFi ecosystem vulnerable to security risks as individuals put their funds in unregulated space. Harsh regulations have been one of the reasons for failed DeFi projects such as Basis, which returned 133 million USD when it concluded it couldn’t work within the US Securities and Exchange Commission (SEC) rules. However, the SEC took a major step towards embracing DeFi in July when it approved an Ethereum-based fund for the first time.
On the flip side, the European Commission’s (EC) new legislative proposal on digital assets poses existential questions for the DeFi industry. The proposed Markets in Crypto-Assets (MiCA) regulations, adopted on 24 September, aim to strengthen consumer and investor protection in the crypto industry. However, a report outlined by XReg Consulting states that “the obligation that crypto-asset issuers must be incorporated in the form of a legal entity could pose significant challenges for DeFi projects where issuance is decentralized and there is no identifiable issuer.” The International Association for Trusted Blockchain Applications (INATBA) also warned that under the proposed MiCA regulation, some early-stage markets like DeFi “would likely no longer be accessible to Europe and her citizens.” Although the EC has approved the MiCA regulations, it must go through additional regulatory review within the European Union, which could take more than a year. In the meantime, DeFi will continue to grow and expand.
“The obligation that crypto-asset issuers must be incorporated in the form of a legal entity could pose significant challenges for DeFi projects where issuance is decentralized and there is no identifiable issuer.”
— XReg Consulting on the European Commission’s MiCA (Markets in Crypto Assets) regulation proposal.
Conclusion — This is only the beginning
Blockchain and its latest buzzword DeFi are at the forefront of today’s financial innovation. With on the one hand hallucinatory yields of up to 500% per annum, and on the other exploited smart contract vulnerabilities that can kill a project overnight, it is clear that we are still in the early days. But the promise is real, and there are many people and projects striving to build a better, global financial ecosystem. The dream is that anyone, anywhere, anytime, can have seamless, secure, and low-cost access to payments and remittances, borrowing and lending, savings accounts, wealth management, and more. Whilst some warn to “look out for the downfall of DeFi tokens […] craving quick, high profits, people will lose money,” other opinions are enthusiastic that DeFi will overcome challenges to become “as seamless as what we’re used to today.” DeFi will continue to grow and redefine the standard of finance as we know it.
About the author: Ruben Merre is a repeat tech entrepreneur, polyglot, life-long learner and founder and CEO of NGRAVE, the digital asset security company behind “ZERO”, the most secure cryptocurrency wallet in the world. Since 2018, Ruben and his team have partnered up with the top tier in nanotechnology, cryptography and hardware security, as well as thought leaders such as Jean-Jacques Quisquater, famous cryptography professor and second reference of the bitcoin paper. The result: a true end-to-end solution for managing digital assets, at maximum security (EAL7, highest security certification in the world), and an intuitive user interaction.
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