Welcome to the New World of Decentralized Finance (DeFi) — Why You Should Pay Attention
While mainstream media has been focusing on Bitcoin, a parallel financial ecosystem is developing on Ethereum. Decentralized Finance, or DeFi, will disrupt how banks and financial institutions operate. The have never faced competition like this before.
Not a day goes by without another bank or financial institutions announcing new services related to Bitcoin. As the Bitcoin market capitalization rose to a trillion dollars, it has effectively become “too important to ignore”, as Deutsche Bank wrote. While Bitcoin is the largest cryptocurrency by market capitalization and on track to become digital gold, most of the financial innovation in the crypto space is currently happening in another corner of the market, that of DeFi.
Expect to Start From Scratch
Forget (almost) everything you know about the legacy financial system, in DeFi you will have to learn a new lexicon. You will have to understand concepts such as Decentralized Exchanges (DEXes), Automated Market Makers, Impermanent Loss, Yield Farming, Rug Pulls and Flash Loans.
A Flash Loan, for instance, is a mind-blowing concept. It is an unsecured loan that is originated, disbursed, and repaid at the same time! Why would anyone ever use that you may ask? One of the use cases is the exploitation of price differences of an asset on two different DEXes. If an arbitrageur spots a price difference, but doesn’t have the capital to profit from it, this arbitrageur will borrow a flash loan. Since everything is done through smart contracts, the loan will only disburse if it has the absolute certainty of getting repaid. To do so the smart contract will execute within the same block i) the disbursement of the loan, ii) the acquisition of the asset on DEX A, iii) the sale of the asset on DEX B, and iv) the repayment of the loan. You can’t do that with traditional finance.
A Flash Loan is an unsecured loan that is originated, disbursed, and repaid at the same time
While the Flash Loan concept is a fascinating one, it is DEXes and lending markets that have taken off since summer 2020.
The DEX Revolution
The monthly volume traded on DEXes since the beginning of the year exceeds $50 billion per month. Volumes traded on Uniswap (the largest DEX) are already larger than on Coinbase (the largest US-based cryptocurrency exchange). While centralized exchanges rely on order books, with buyers and sellers submitting their orders, DEXes rely on liquidity pools. There is no bid/ask spread in DeFi, just one price (but there is slippage risk for large orders). Anyone can provide liquidity to any trading pair. The way it works generally is that you provide 50–50 liquidity between the two assets of the trading pair. In exchange for providing liquidity to the pool you receive a share of the transaction fees paid by the DEX traders. This can be enormously profitable, but also risky. Before providing liquidity to a trading pair, make sure you familiarize yourself with the concept of impermanent loss.
The lending market in DeFi has been growing exponentially since the summer 2020, recently reaching $50 billion in Total Value Locked (TVL) in smart contracts. In DeFi, if you want to borrow you first must deposit collateral in the form of a crypto asset. Based on the value of this collateralized asset and its volatility, you will be able to borrow a percentage of its value in a crypto-asset or stablecoin (a type of cryptocurrency pegged to a fiat currency, like the US Dollar) of your choice. The collateralized asset is locked in a smart contract until the loan is repaid. If the value of the collateralized asset gets too close to the loan amount, the collateral can be liquidated to repay the loan. Everything happens through smart contracts without any human interaction. In DeFi, there is no credit score or long approval time. If you have the right level of collateral, the loan is approved instantly.
Why Should You Care?
Yields on US Dollar savings account are currently around 0.5%. Yields on crypto-dollars in the DeFi world are between 7% and 15% as of early April 2021. Interest accrues daily and changes in real time with supply and demand. This level of yield should be enough to grab the attention of many investors. Too good to be true? Why isn’t everyone doing it then?
First of all, DeFi markets are not available to traditional financial players. Banks or hedge funds may either not be allowed to interact with these markets for regulatory reasons, or they simply may not have the technical ability nor the risk appetite to venture into this new world. Another reason why these yields are high is that few financial institutions currently accept cryptocurrency as collateral, which limits the options of rich crypto investors to access debt financing or leverage. The consequence of these barriers to entry is that it’s currently mostly retail investors or unregulated family offices that can invest in this market. It is likely that yields will go down once larger players enter this space.
Another barrier to entry is the technical savviness required to use DeFi platforms. As with most things crypto, the user experience (UX) is still a challenge. For DeFi, it is more complicated than just buying and holding Bitcoin or Ethereum on an exchange. You need your own cryptocurrency wallet and you have to interact with smart contracts. This is out of reach to 99.99% of the population. Another reason why returns are so juicy.
Central banks destroyed the savings account by pushing interest rates to zero, DeFi brings it back to life. Have a look at platforms like Compound or Aave, two of the largest lending platforms already managing billions of dollars.
Central banks destroyed the savings account by pushing interest rates to zero, DeFi brings it back to life
Decentralized Hedge Funds
The last few months saw the emergence of decentralized hedge funds. Platforms like Yearn or Harvest pool resources of investors and maximize yield farming by providing liquidity to the most profitable protocols. Everything is done through smart contracts in a transparent manner.
These decentralized hedge funds crowd source the design of yield farming strategies. Anyone can submit a yield farming strategy. Strategies are reviewed by the platform users (token holders) who eventually vote to add them or not to the list of strategies used by the platform. If a given yield farming strategy is added to the platform, the creator of this strategy automatically receives a share of all profits generated by it. What this means is that programmers no longer need to work at hedge funds to implement trading strategies with hundreds of millions of dollars, they can do that from their home using DeFi platforms.
By allocating capital dynamically where yields are higher, yield farming platforms have been routinely generating 20% to 30% yield on crypto dollars. All this is not risk free, however, as you add the platform risk on top of the risk of the underlying DeFi lending protocols. If you want to learn more about Yearn, currently the largest of these platforms, you can read a very good article on it here.
Permissionless But Not Free
In DeFi you don’t have to create an account with any centralized entity. You simply interact with smart contracts through your cryptocurrency wallet. The market is open 24/7 and you can seamlessly move assets from one protocol to another in just a few clicks and a few minutes. It wins by KO against legacy financial markets on this front.
While DeFi may be seamless to use once you master tools like Metamask, it is certainly not free. As DeFi exploded in popularity, so has the number of transactions on the Ethereum blockchain. This congestion on the network has in turn resulted in high fees to complete transactions. Technical solutions such as Roll Ups (ZK and Optimism) are coming soon to Ethereum, but fees will remain high for a few more months until those are implemented.
Whether you are in the field of finance, curious about financial innovation, or looking for new ways to invest, DeFi is a field you can’t ignore. Look into it, research it. It’s a new world emerging in front of our eyes.
The information in this article does not constitute any form of financial advice or investment recommendation related to DeFi protocols. The mention of DeFi platforms in this article does not constitute any endorsement of any kind.