Sep 11, 2022 at 09:05Contents
What is DeFi? DeFi is an independent financial system without state control, protectionism, corruption, or unnecessary intermediaries. It is based on decentralized applications that replace the usual financial institutions. The development of the system is stimulated by free competition: the best products that have proved reliable and attract the most significant number of users achieve success.
The DeFi industry began to grow at a staggering rate in 2020. According to Defipulse, it had more than $20 total value locked (TVL) in September 2020, compared to $10 billion as of January 2020 and just $125 million at the end of 2017. Today TVL is almost $43 billion, but in November 2021, it was over $100 billion.
The secret to DeFi’s success lies on the surface. Anyone, regardless of citizenship or where they live, can participate in creating and using DeFi’s products. The protocols and economic models of the services are open to review and audit.
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You don’t have to be a millionaire to invest in DeFi and open a brokerage account. Most platforms have virtually no lower limit – you can start with a few dollars by installing the necessary apps on your computer or smartphone. At the same time, the investor does not lose control over their money and can get it back anytime.
The economic and technical basis of DeFi
The DeFi industry began to grow at a staggering rate in 2020. According to Defipulse, it had more than $20 total value locked (TVL) in September 2020, compared to $10 billion as of January 2020 and just $125 million at the end of 2017. Today TVL is almost $43 billion, but in November 2021, it was over $100 billion.
The secret to DeFi’s success lies on the surface. Anyone, regardless of citizenship or where they live, can participate in creating and using DeFi’s products. The protocols and economic models of the services are open to review and audit.
You don’t have to be a millionaire to invest in DeFi and open a brokerage account. Most platforms have virtually no low
Ethereum is the most popular blockchain for developers, but DeFi services are also available on other blockchains: EOS, Waves, Tron, NEO, Polkadot, and Binance Smart Chain.
Technically, it looks like this. A user sends an existing crypto asset (e.g., ETH or USDT) to the DeFi-platform’s smart contract address. In return, he receives the platform’s internal tokens (e.g., on Compound – cETH and cUSDT). These tokens can be used to trade or generate passive income. The user can always take back the original asset by making transactions in reverse order. If he receives income, he will receive a larger amount of the original asset in his wallet when he sells the platform tokens.
Tokens move between DeFi platforms through standard blockchain transactions. The user can withdraw tokens from one platform and invest them in another, retaining full control over their finances, which is not available in banks or exchanges.
This independence has a downside: only the owner of the tokens is responsible for their security. If he loses the keys to the wallet or hackers steal them – the assets will be irretrievably lost. That’s why a DeFi user needs to understand how smart contracts work and the basics of information security.
Popular DeFi applications
DeFi’s infrastructure is made up of several types of platforms or applications described below.
Stablecoins in DeFi
Unlike classic stablecoins tightly tied to an underlying asset (usually the US dollar), DeFi operates algorithmic stablecoins. Algorithmic stablecoins based on the CDP (collateralized debt positions) mechanism were the first to appear. The token price is synchronized with the underlying asset using a smart contract that issues or liquidates special “stabilizing” tokens. This is how the DAI of the MakerDAO project and the JUST of the USDJ project work.
A newer and more original model has the Neutrino USDN stablecoin, issued on the Waves blockchain and secured by reserves in the WAVES coin of the same name. Its price is stabilized to the dollar with the NSBT (Neutrino System Base Token). The main feature of USDN is the possibility of staking, that is, issuing tokens through the LPoS (Leased Proof of Stake) mechanism. If a user locks his USDN into a smart contract, he will make a daily profit in tokens through staking.
Decentralized lending platforms in DeFi
Such platforms are designed for P2P lending in crypto-assets. The borrower pays, and the lender receives interest determined by the balance of supply and demand for a particular asset. People can borrow stablecoins XSTUSD, USDT, DAI, USDC, ETH, WBTC, and other popular ERC-20 tokens. Maker ($7.9 billion), Uniswap ($7.04 billion), and Curve Finance ($4.9 billion) are the leading platforms in terms of blocked assets.
Decentralized exchanges in DeFi
Decentralized exchanges (DEX) trade tokens from DeFi and other projects present on the underlying blockchain. Each transaction is captured as a transaction on the blockchain. This reduces the speed and liquidity of transactions, but users retain control of their assets. DEX usually does not require an account – a cryptocurrency wallet address replaces it.
The largest decentralized exchanges on the Ethereum blockchain are Uniswap and Curve.finance. On the Waves blockchain, there is the Waves Exchange, which combines the functions of traditional and decentralized trading.
Asset tokenization in DeFi
Another trend in the DeFi industry is tokenizing real-world assets: metals, stocks, currencies, and the creation of synthetic products based on them. Tokenization platforms lower the entry threshold for users with small capital and allow trading of traditional and crypto assets in one place. They could become competitors to the traditional derivatives market (futures and options). Holders of cryptocurrencies do not need to exchange them for fiat money to start trading.
Right now, tokenization platforms are in the early stages of development. For example, these are the derivatives exchange Synthetix and the Yearn.finance project.
DeFi project valuation and token types
The valuation of a DeFi project depends on two weakly correlated components: the capitalization of the own token and the total value locked (TVL) in it.
The projects’ tokens are usually the classic ERC-20 token or its analog. Their number can be constant (LEND, YFI) or change according to the established algorithm (COMP, MKR, BAL). Changes in the project’s smart contracts must receive the votes of the majority of the holders of these tokens.
The government token does not directly affect the platform’s day-to-day operations and does not generate passive income. Its price is formed mostly speculatively on centralized exchanges and is highly volatile.
Transaction tokens duplicate crypto-assets locked to smart contract addresses. They are created when deposits are made to the platform and are redeemed if the user withdraws the underlying crypto asset. For example, on Compound, these are c-tokens: cBTC, cETH, cUSDC, etc.
These tokens do not participate in smart contract management but are a source of income. Their value is equivalent to the value of the original asset, and their total value determines the real amount of investment in the platform.
How to invest in DeFi?
There are several models for earning income from investing in DeFi:
- Interest on deposit is the easiest way to earn passive income. It simply requires placing crypto-assets on a platform similar to Compound. Interest is dynamically calculated based on the ratio of the volume of loans to the volume of supply.
- The active method of investing is “farming” (yield farming) – the constant search for the most profitable way to place tokens. It requires the investor’s time and knowledge of the market but can significantly increase income. One type of farming is liquidity mining – placing tokens in “liquidity pools” and getting additional rewards (COMP on Compound or BAL on Balancer).
- Buying DeFi project government tokens. Prospective project tokens have already shown thousands of percent growth within a few months. They usually have no intrinsic value, and their issuance does not require collateral. Therefore, they are subject to high volatility. Trading them can generate speculative income, but long-term investments carry high risks.
- Staking – generating crypto-assets using the PoS consensus method. In the DeFi industry, it is available for some ERC-20 tokens (SNX, KNC, etc.), as well as BNB on Binance Smart Chain and USDN on Waves. There are staking pools that provide a single interface for staking different assets. Staking yields vary depending on the current share of tokens involved in the process.
These are 4 easy ways to earn on investing in DeFi.
Regulation and prospects for DeFi
Special regulation for the DeFi sphere does not exist in any country. Even the status of cryptocurrencies is not yet defined anywhere. In countries where there is regulation and taxation of crypto-assets, such as Japan, Australia, the U.S., some EU countries, etc., DeFi revenues will be treated within the existing legislation.
Even without regulatory uncertainties, the future of the DeFi industry is not predetermined. Cryptocurrencies have allowed people to manage their money without the control of governments and intermediaries, and ICOs have opened up projects to an alternative funding source. DeFi offers, for the first time, a full-fledged independent financial ecosystem with all the necessary platforms and services.
However, the DeFi industry will face serious competition from the traditional financial sector: fintech companies, open banking applications, and central bank digital currencies (CBDCs). And after the first hype dies down, it still has a long way to go in terms of maturation and standardization.
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