Beginner's Guide to Decentralised Finance (DeFi): Is It a Scam or the Future of Finance?
Joel Koh●
Today, the global financial system is still dominated by centralised financial systems run by central authorities. Think financial institutions like central banks, regulatory bodies, banking institutions and more.
In the past, centralisation was welcomed as it served as a maintainer of stand standards and stability in the global financial system and was viewed as more reliable and safe compared to personalised management.
However, these centralised financial (CeFi) systems have their flaws.
In reality, these systems are prone to issues like mismanagement and fraud as seen with events like the Global Financial Crisis (GFC) of 2008 and the recent FinCen leaks which revealed the flaws of centralisation.
Not to mention that although most of the world has a smartphone, the latest data from The World Bank’s Global Findex database revealed that 1.7 billion adults around the world remain unbanked.
There is also a lack of reliable banking accessibility and financial stability or accountability in many countries.
Enter Decentralised Finance (DeFi).
DeFi has been touted as a potential solution to the problems of centralised financial systems.
As a transparent financial system built on decentralised and open-source blockchain networks like Bitcoin and Ethereum; DeFi is looking to reconstruct the global financial system in an open, permissionless way.
It also can provide the underbanked access to financial services and commerce opportunities that they might not get from centralised financial institutions.
Not to mention that you will be handsomely rewarded if you participate in DeFi through DeFi staking; with some DeFi projects paying out more than 100% in annual percentage yield (APY).
Intrigued?
Here is what you need to know about DeFi!
Disclaimer: The information provided by Seedly serves as an educational piece and is not intended to be personalised investment advice. Readers should always do their own due diligence and consider their financial goals before investing in any investment product. The writer may have a vested interest in the investments products mentioned.
What is DeFi?
Simply put, DeFi is an umbrella term for the digital ecosystem of financial services built on a public decentralised blockchain network like Ethereum.
The defining feature of DeFi is the use of technology to remove intermediaries between parties in a financial transaction and achieve the goal of decentralisation.
In other words, DeFi aims to provide an open borderless alternative to any traditional financial system you use today.
Today, DeFi users can engage in peer to peer lending and borrowing, trade cryptocurrencies and tokenised stocks, earn interest on their cryptocurrencies in ‘savings accounts‘ and more.
All this is achieved with the help of decentralised smart contract protocols (more on that later) that eliminate the need for any financial institutions to act as the middlemen for the transaction.
According to DeFi Pulse, about US$83.41 billion (S$112.06 billion) dollars worth of cryptocurrency is locked into the various DeFi protocols that make up the DeFi ecosystem.
However, do note that although the number may seem impressive, a lot of these coins have low liquidity and cannot be sold on exchanges.
To put this into context, only US$961 million worth of cryptocurrency was locked in a year ago, marking an almost 57 fold increase in the amount invested.
Although the amount invested into the DeFi ecosystem is increasing steadily, the DeFi ecosystem is only in its infancy with infrastructure still being established.
An important thing to take note of is that is little to no regulation and oversight of the DeFi ecosystem.
It’s really the wild west out there.
But on balance, many have predicted that DeFi will eventually transform the world of finance.
The Technology Powering DeFi: Ethereum Blockchain
Today, most of DeFi is built on the Ethereum blockchain: a decentralized, open-source blockchain with smart contract functionality. Ether (ETH) is the native cryptocurrency of the platform.
Ethereum is a digital ledger that allows multiple parties to hold a copy of its transactional history. In other words, no one person can control the Ethereum blockchain.
On Ethereum, you can build decentralised applications (dapp) which according to Ethereum.org are:
an application built on a decentralized network that combines a smart contract and a frontend user interface.
Note, in Ethereum smart-contracts are accessible and transparent – like open application programming interfaces (APIs) – so your dapp can even include a smart contract that someone else has written.
Whereas:
A smart contract is code that lives on the Ethereum blockchain and runs exactly as programmed. Once they are deployed on the network you can’t change them. Dapps can be decentralized because they are controlled by the logic written into the contract, not an individual or company.
DeFi applications run on these smart contracts: programs that are designed to run automatically when specified conditions are met.
For example, you could program a smart contract to manage borrowing and lending. Let’s say a user takes out a loan against a smart contract and locks up collateral in the form of cryptocurrency. If the user defaults and does not pay within a certain timeframe, their collateral will be automatically liquidated to settle the loan.
The more popular DeFi applications include:
- Decentralised Exchanges (DEXs): Digital exchanges that allow users to trade fiat currencies and cryptocurrencies without the need for a centralised intermediary.
- Stablecoins: Cryptocurrencies that are pegged to external currencies (e.g. USD) in a bid to reduce volatility. Smart contracts are used to manage the peg to the external currency.
- Peer to Peer (P2P) Lending Platforms: Instead of a financial institution managing a loan, a smart contract automatically does the job.
Investing in DeFi
Well, you might be excited about these developments and thinking about how you can get involved.
Here are a few ways for you to carefully consider.
1. Buying DeFi Tokens
One way to do it is to trade the native cryptocurrencies of DeFi projects.
For example, PancakeSwap’s token is CAKE, Maker’s token is MKR and DAI and so forth.
As such, you can trade these tokens on exchanges.
But, you will need to carefully do your due diligence on these DeFi tokens and look out for those with legit use case like governance, staking etc.
2. Liquidity Mining/Yield Farming
Yield farming, also known as liquidity mining, is another way to invest in DeFi.
Simply put, you are depositing your cryptocurrencies into these DeFi projects like Compound and Uniswap to provide liquidity for the projects.
In exchange, you are rewarded with cryptocurrency tokens.
To understand this concept, I have broken down the terms for you.
- Yield: The word yield means to provide or produce. For example, a durian tree bears durians during the durian season. When applied to yield farming, cryptocurrencies you plant (deposit) into DeFi projects yields a return of more cryptocurrency tokens.
- Liquidity: DeFi projects like Uniswap, Sushi, and Compound are DEXs that require a pool of cryptocurrency assets on standby to facilitate the trading, borrowing and lending of cryptocurrencies between people. Having liquidity means that you are holding those assets. The more liquidity a DeFi protocol possesses the better the experience for users as they will enjoy better spreads.
- Mining: In the context of DeFi, mining refers to the process where you provide the liquidity in the form of the non-native tokens (e.g. stablecoins) that the project needs (mining equipment) to mine the project’s native cryptocurrency token (diamonds as a reward).
3. DeFi Lending
Alternatively, you can lend your cryptocurrencies to other people in return for interest on your loan.
These DeFi platforms work like how your P2P exchanges work save for one key difference.
Instead of a third party, you are providing loans in a trustless manner as the smart contracts will manage the loans automatically.
Here is a diagram that breaks down how it works:
If a borrower defaults, the cryptocurrency asset will be automatically liquidated to pay the lender.
But, with that bears a risk as most cryptocurrency assets as still very volatile.
Examples of these lending platforms include Aave [LEND] and the Maker protocol.
Risks of Investing in DeFi
If you looking to put your money into DeFi, I would recommend caution as the risk of losing all your capital is very high.
Although many believe that DeFi has the potential to transform the world of finance, the industry is still in its infancy and there is not telling which DeFi projects will survive.
To use an analogy, you are directly investing in early-stage start-ups and products with high failure rates.
It is very hard for beginners to discern whether a DeFi project will be successful or flop.
Examples of DeFi projects that failed include meme coin YAM, Hotdog and Pizza which saw investors losing the majority of their capital when the projects crashed and burned.
Also, another risk with DeFi projects is are that smart contracts are not failable.
A bug could result in access to assets being blocked or worse the funds lost. As the rules are baked into the smart contract, the bugs can be almost impossible to fix which increases your risk.
There has also been no shortage of DeFi projects being hacked. Earlier this month, DeFi project Rari Captial was hacked and the hackers made off with the 2,600 ETH (S$9.9 million SGD) in the project’s liquidity pool.
An important thing to take note of is that is little to no regulation and oversight of the DeFi ecosystem.
There is also no insurance or government protection available for investors. So if something goes wrong with the DeFi project, you are left with little to no recourse.
Thus, getting invested in DeFi is highly complex and only recommended for advanced users.
Although the returns are mouthwatering, it comes with corresponding risks to your invested capital.
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