If you’re following the latest developments in crypto closely, chances are, about 70% of your feed is all about DeFi. Being a nascent and booming space, it is as promising as it is risky. This time, the Wombat team is figuring out existing opportunities on EOS DeFi and see if they are worth your while. It also marks the first of many posts bringing you more detailed information about the DeFi space in general and individual projects.
Keep in mind that this post shall not be taken as financial advice and serves introductory and informative purposes only. Before making a final decision, please conduct your own research.
What is DeFi?
For those relatively new in crypto, we will start with some basics. DeFi is a contraction of ‘decentralized finance’ used to describe financial applications that use blockchains to facilitate the value transactions. These DeFi applications work without central institutions so that users keep full control of their assets.
Imagine a group of random people just freely lending, borrowing, operating derivatives — in other words, using services customarily provided by big banks and exchanges without the big banks and exchanges. That means no need to wait for loan approval, no stuck assets, no working hours, etc.
Typically, most of the action on DeFi happens in lending and decentralized exchanges.
While there’s been a number of decentralized lending platforms in the Ethereum space like Aave (formerly known as ETHLend) or Compound, lending at this scale is yet to be seen on the EOS blockchain. However, let’s dig into the types of lending platforms that are around in the DeFi space, in general.
Platforms like Aave and Compound allow users to lend and borrow tokens from other users against collateral. The collateral is locked into a smart contract and works as a security deposit in the event of default, meaning that if the borrower can’t repay their loan, the lender can get their money back from the collateral instead.
Borrowers return loans with an interest rate. This rate goes to the respective lenders as payment, effectively allowing lenders to generate financial yield on their crypto assets.
There are very sophisticated mechanisms like Aave’s flash loans, but we want to focus on the most well-known aspects here.
Some people may not call this DeFi application type “lending”, but it’s very similar in essence. In this case, borrowers lock up some collateral (just like in peer-to-peer pools), but instead of receiving tokens from a lender, they receive a certain number of stablecoins from the smart contract. Some very popular examples are Dai (on Ethereum), USN or EOSDT (both on EOS). The borrower can use the stablecoins for whatever they want but will have to return them (plus some interest) in order to get their collateral back.
Many decentralized exchanges (DEXes) try to replicate pretty much exactly what their users know from their centralized counterparts: orders, order books, and trades. We call them bid-ask-DEXes, and examples are IDEX (on Ethereum), Newdex (on EOS) or Nash (using the NEO blockchain). Depending on the implementation, you might have to deposit tokens into the exchange smart contract before you can trade them, but apart from that, each order creation or cancellation is a transaction on the blockchain. This means you can trade tokens without a central counterparty.
Liquidity Pools / Swap / AMMs
Liquidity Pools have become the more successful DEX model, mostly thanks to the sleek and simple Uniswap and heaps of its derivatives. In these platforms, traders can basically swap one token for another at a pre-determined rate without the need to submit orders that might or might not get executed. This works because both tokens are bound in a liquidity pool; the ratio of the tokens on each side of the pool determines the price. The more tokens are in the pool, the smaller the price impact of each individual swap (this price impact is typically referred to as “slippage”).
Traders pay a fee to the liquidity pool for being to swap. This fee is then paid out as a reward to the users who have been providing the tokens in the liquidity pool, divided proportionally based on their share of the liquidity pool.
Effectively, liquidity providers offer tokens for sale at all times and ensure their price consistency. This effectively makes them market makers in this particular token pair, which is also why liquidity pool platforms are called Automated Market Makers (AMMs). This, however, means that liquidity providers are exposed to exchanges rate risks, just like any other market maker in the traditional financial world. The fee they earn should be viewed as compensation for that risk.
Without going into too much detail, on most AMMs, also in EOS DeFi, you receive so-called liquidity pool tokens (LP tokens) when supplying liquidity. These LP tokens represent your share in each of the pools, and whoever holds these tokens has the right to withdraw from the pool at any time, together with the fee gains that might have been accrued by that time.
If you’ve dug into DeFi before, you most likely have heard the term “Yield Farming”. It has originally started as a term for the provision of liquidity and earning of the respective fee on liquidity pools as explained above but has gone a few steps beyond that. Now, not only do you earn fees from swaps on your liquidity pool — you also get extra tokens as a reward for doing so. These tokens typically represent votes in the governance system of the respective platform, or other, auxiliary applications. It could also happen that you have to lock your liquidity pool (LP) tokens to get these reward tokens in return. On Ethereum, for example, you can earn UNI tokens on top of your fee share when providing liquidity for certain asset pairs. On EOS, you mine BOX tokens in Defibox when supplying liquidity for token pairs with a liquidity mining weight of >0.
Earning potential and risks
As mentioned at the beginning of the article, you should do your own research before digging into these DeFi projects. There have been a number of alleged scams or security issues with some of the projects in the past, but we’re still in the very early days of DeFi on Ethereum and all other blockchains, including EOS.
That said, the yields you can earn from these projects can look astonishing at times. Looking at Coingecko’s Yield Farming overview you see numbers as high as 10000% APY (annual percentage yield), so it might look like you can double your money within days. This, however, can prove to be eyewash; in order to make these yields, you will need to make sure that:
- The token pair you’re supplying liquidity for is relatively stable in price, so you don’t lose on exchange rates
- The token you’re earning has a rather stable price. If anyone who mines that token dumps it right away, the rewards in “hard currency” will diminish quickly
For projects with more robust economies, it is possible to see high APYs over stretches of multiple days or weeks, indicating that you could make a good deal by getting involved on short notice. In the long run, however, it’s inconceivable why any opportunity should offer such high returns; there would simply be enough people getting involved with that project to get the APY down to a level that reflects the overall amount of risk.
Should you jump in on DeFi?
So should you get going with DeFi, specifically on EOS? From our perspective, some of the projects like Defibox or Defis.Network are providing great value to the community, independently of the earning potential for individual users. The cool thing about EOS DeFi is that you need very little to get started because you don’t need to pay transaction fees on the EOS network when using Wombat. In your Wombat Explorer, head over to Dapps to find the most popular DeFi Dapps available on EOS, check them out and use them with caution. Many of them are a lot of fun to use and borderline addictive, so make sure you don’t invest money that you might actually need. If you’re making the right moves, EOS DeFi definitely has the potential to earn you some extra money, even if you’re just starting out with a few EOS tokens you’ve earned from playing games on Womplay :-)