Recently, in the crypto-industry, everyone is talking about DeFi — staking, crypto loans, profitable farming and other tools that may seem mysterious and dubious to an uninitiated person. Is DeFi an alternative to traditional banks, or is it just another hype sector in the crypto world?
What is DeFi About?
Decentralized finance (DeFi) is a collection of blockchain protocols that allows the provision of financial services without the involvement of traditional centralized intermediaries such as banks, brokers and crypto exchanges. Smart contracts are used to enforce the terms of each transaction.
The range of DeFi services is constantly growing and includes trading (swaps), loans, staking (analogous to deposits), risk insurance, derivatives, etc.
MakerDAO launched at the end of 2017 as the first app to gain widespread popularity. Since then, the total amount of funds allocated to DeFi protocols (TVL, Total Value Locked) has grown steadily.
How to Make Money in DeFi
DeFi investors are a special class of crypto users who come up with complex schemes to maximize profits.
For example, they place crypto in liquidity pools of decentralized crypto exchanges to receive liquidity tokens, which are then used in another pool to receive free tokens under the profitable farming program, and they, in turn, are placed as collateral on a landing protocol in order to borrow the third kind of tokens.
It takes a lot of time and practices these techniques, but the main ways to invest in DeFi can be summarized as follows:
The investor places liquidity (cryptocurrency) on a decentralized crypto exchange and receives a share of the commission from transactions. The commission is usually 0.25-0.30% and is divided among liquidity providers according to their share in the pool.
The more active trading is, the more commission income the protocol receives and the higher the profitability, but in many pools, it can turn out to be negative.
Crypto Lending (Issuing Loans)
The investor deposits liquidity in the lending protocol pool and these funds are issued as loans. This service is popular primarily among leverage traders who do not want to borrow funds from a centralized crypto exchange. The borrower must post collateral over 100% of the loan amount (sometimes 150% and even 200%); in case of non-payment of the debt, this collateral is automatically liquidated (sold), so that the creditor gets his money back anyway.
The yield depends on the currency of the loan and is constantly changing. The highest rates are usually on stablecoins – USDT, USDC and DAI.
Profitable Farming or Liquidity Mining
This is the most complex, but also the most popular tool used by projects to popularize their tokens. The standard scheme is as follows:
- An investor buys a token and places it in the liquidity pool of a trading or lending protocol – most often Uniswap.
- As a confirmation of participation in the pool, the investor receives special LP-tokens.
- LP tokens are deposited (staked) on a special smart contract.
Once launched, projects often pay large farm bonuses so that nominal returns can be as high as 1000%. Gradually, the number of tokens distributed every week decreases, but the yield remains at the level of 50-100%. It must be remembered that this profit is nominal, and the real income will depend on the price of the token.
The Most Popular DeFi Protocols
- MakerDAO is a lending protocol where you can get a loan in DAI stablecoins by providing collateral in other cryptocurrencies. Such loans are mainly used by margin traders to avoid borrowing funds from a centralized crypto exchange.
- Aave is another loan protocol that allows liquidity providers at Uniswap and Balancer to use LP tokens as collateral.
- Compound is a loan protocol managed by COMP token holders through decentralized voting.
- Curve Finance is a decentralized exchange for trading stablecoins.
- Uniswap is the most famous decentralized exchange with hundreds of pools, famous for a large number of scam projects.
- Token price volatility. This is the key risk of profitable farming: when farmers begin to massively sell off the remuneration received, the price often collapses, that means earnings depreciate. Essentially, there is hyperinflation: tokens flood the market.
- High commissions. Placing tokens on the protocol or withdrawing income, you will have to pay a blockchain mining fee. On the Ethereum network, it exceeds $20 (as of May 2021) regardless of the size of the transaction. Thus, the commission can “eat” all the profits. The alternative is to opt for the DeFi protocol on a cheaper blockchain like Binance Smart Chain.
- Fraud. The DeFi industry attracts many scammers who issue dummy tokens and lure investors with extremely high farm incomes. The standard scheme is to wait until the trading in the pool warms up and the token price rises, and then withdraw all liquidity and disappear with the money.
- A low value of projects. Most DeFi projects are nothing more than hype: copies of popular protocols that do not contribute in any way to the development of the industry. Such platforms do not last long, and their investors usually lose money.
How to Enter DeFi?
If you do decide to try defi-tools, despite the risks, you will need a cryptocurrency that is supported by DeFi protocols. This is normally Tether (USDT) – the world’s largest stablecoin in terms of capitalization.
In addition to crypto itself, you need a MetaMask wallet to participate in DeFi. There are many blockchain wallets on the market, but it is MetaMask that is supported by all protocols.
The purchased USDT must be sent to MetaMask, and then the wallet must be linked to the selected DeFi protocol. Typically, the application itself suggests doing this. After establishing a connection with the wallet, you can deposit funds on the protocol.
Practical use of protocols like Compound, Uniswap, and Aave is easier than it sounds. The difficulty of DeFi is not in the mechanism of allocating funds and generating income but in the choice of quality projects. The market situation is changing rapidly: a single tweet by Elon Musk can collapse the price of Bitcoin, and DeFi tokens usually follow.
Therefore, if you do decide to invest in decentralized finance, start with a small amount that you do not mind losing.