DeFi 101

If you’ve been around cryptocurrency for more than a few hours, you’ve probably seen a lot of chatter about something called DeFi. This buzzword has been thrown around like the new catchphrase at school that everyone says even though they have no idea what it means or where it came from. By the end of this article you will have a comprehensive understanding of what DeFi and why it is such a hot topic in cryptocurrency.

What is DeFi?

A simple comparison between DeFi and CeFi

DeFi is short for decentralized finance. Decentralized finance consists of an ecosystem of applications and protocols built on cryptocurrency blockchains, primarily Ethereum. These are all meant to provide the same or similar services found in traditional finance such as lending, borrowing, saving, and investing but using a decentralized automated program instead of a centralized third party like a bank.

This has many advantages but the three most important are: it is accessible to everyone (you do not need a bank account or fork over any personal information), what is going in these applications is often open-source and viewable by everyone (meaning that you can quickly detect bad actors and fix any errors in code) and last but certainly not least, the lack of a middle-man taking a cut means you can earn much more money when using these applications.

The returns offered by these DeFi projects varies from the classic 1-4% per year all the way to 2000% per year (albeit for a short period of time). This is an incredibly attractive prospect and is why the total amount of money currently circulating among these DeFi applications and protocols is around 7 billion USD at the time of writing.

DeFi applications and protocols have been around for about 2 years (some for longer, depending on how strict you are with the definition of DeF). Interest in the space has only taken off over the last few months however, primarily this year has seen many DeFi projects which were started 2-3 years ago finally begin to release their projects to the cryptocurrency market

Other buzzwords in DeFi

A screenshot from a YouTube video about cyptocurrency yield farming

Before we take you through a few DeFi protocols, it is helpful to note a few other buzzwords. The first is yield farming, and this just refers to finding the highest annual interest returns among and between DeFi applications/protocols. You have probably seen dozens of videos about this on YouTube as well as hundreds of awesome memes illustrating yield farming. Yield farming can get extremely complex as it often involves spreading your money across multiple DeFi apps.

The second is liquidity mining, and this refers to DeFi applications which reward users for depositing their funds into the protocol as a means of providing more liquidity (more trading volume) to the protocol, making it a better experience for those who use them. Liquidity mining rewards come from the fees users have to pay to interact with the platform (usually 0.1-0.3% of the money they are moving). 

The third and perhaps most important buzzword is DAO. This stands for decentralized autonomous organization and involves handing over control of the DeFi application to the users which hold the governance tokens (Ethereum-based cryptocurrencies) they receive as a reward for interacting with the platform. The insane 2000% interest rates you see usually come from the rapid USD appreciation of these governance tokens when the protocol is launched or when it starts getting serious attention.

List of DeFi protocols and applications

The top 10 DeFi protocols by locked assets according to Defi Pulse

While there are dozens of DeFi protocols and applications, we will only be focusing on a few of the most important ones (and by that we mean the most popular). These can be broadly categorized as either being DeFi lending protocols, decentralized exchanges (DEXs), DeFi aggregators, or decentralized oracles. Popular DeFi lending protocols include Compound, Aave, and MakerDAO. Popular DEXs include Uniswap and Kyber Network. Popular DeFi aggregators include Yearn.Finance and InstaDapp. Popular DeFi oracles include Chainlink and Band Protocol.

DeFi lending

Lending markets on Compound

DeFi lending protocols are exactly what they sound like. Users are able to borrow cryptocurrencies (mostly Ethereum-based assets) the same way you would with a bank, except there is no bank. The big difference here is that in order to borrow a cryptocurrency, you have deposit MORE (in USD) than the amount (in USD) you are borrowing. There is no fixed window within which you must pay the loan back, and often times the interest that you will owe will be quite high (between 5-30% per year). You also do not need to provide any personal documentation to withdraw a loan.

Some would argue this is pointless (and let’s be honest, it is pointless to the average person) but to experienced cryptocurrency traders, this allows them to trade with more capital and potentially gain more money. This is often referred to as leverage trading and it carries some risks. In these lending protocols, if the USD value of the collateral you have locked falls too low, your deposited funds get liquidated (sold off). Lenders are rewarded for depositing their funds into lending pools for borrowers to borrow, and get dibs on borrowers’ discounted collateral if and when it gets liquidated.  

This can be a bit tricky to wrap your head around so here is a simple example. Suppose Tim has 1000$ in Ethereum. He thinks that Ethereum will double in price tomorrow and he wants to maximize his gains. He goes on Compound and deposits his 1000$ in Ethereum to withdraw 700$ in Basic Attention Token. He sends the 700$ of BAT to an exchange and trades it for 700$ worth of Ethereum. The next day comes and Ethereum’s price doubles. He sells 710$ of his Ethereum gains for Basic Attention Token to pay back the loan in Compound (plus interested). Tim withdraws all of his funds. He now has 2690$ in Ethereum, 690$ more than if he had just held on to the 1000$ in Ethereum when it doubled.

Decentralized Exchanges

The Uniswap decentralized exchange

DEXs offer the same function as regular centralized exchanges such as Binance and Coinbase. The difference is that they do not require any sort of KYC documentation – anyone can use the exchange without limits on withdrawals or deposits. Also, there is no central point of failure, meaning that the exchange is (theoretically) more resilient to things like outages and surges in demand which often cause centralized exchanges to crash.

Both Uniswap and Kyber Network are built on the Ethereum blockchain, meaning that almost all of the trading on their platforms involves Ethereum-based cryptocurrencies. Many DEXs (and similar protocols) reward users for depositing (or staking) their funds on the platform. As mentioned previously, these rewards come from the trading fees charged by the platform. This is done to ensure high liquidity (fast trades) for people using the platform. Otherwise they could be stuck waiting to have their orders filled. Many DEXs also use oracles to source price data for the current exchange rates of the assets offered.

DeFi aggregators

A simple illustration of yearn.finance. Note that USDC is a cryptocurrency pegged to 1$USD.

DeFi aggregators automatically move your cryptocurrency between DeFi lending protocols, DEXs, and other applications to maximize your annual returns on your deposited funds. The most famous of these aggregators is yearn.finance, a protocol designed by a rogue developer to maximize the interest rates on his own deposited cryptocurrency which he made public to the entire community. The introduction of the governance token (YFI) saw interest rates go up over 2000% as the token appreciated in value from a few hundred dollars to a few thousand in a matter of days. It was given to users who interacted with the platform and gives them governance over the protocol.

A technical overview of how to get the YFI token

The introduction of DeFi aggregators has accelerated adoption of DeFi since they are much easier to interact with than many of the DeFi apps and protocols they interact with. Yearn.finance is incredibly simple to use and still gives interest rate returns of anywhere from 5-25% per year. Here is a simple example to understand how this is done. Yearn.finance gives you the option to deposit yTokens (tokenized versions of the assets you have deposited) onto another platform called Curve. There, you receive yCRV tokens as reward for providing liquidity to Curve. These yCRV tokens can then be deposited onto another platform called Balancer where you receive BAL tokens as rewards for providing liquidity there, and you can exchange BAL and yCRV for the YFI governance token.

This is just one example of the mind-bending economics going on behind the curtain with these DeFi aggregators.

Cryptocurrency oracles

The role of an oracle in cryptocurrency

The last element of DeFi involves a class of cryptocurrencies called oracles. This is a fancy term for a cryptocurrency which feeds external data into these applications which would otherwise be closed off from it. The most important data they provide is price data of the cryptocurrencies being used on their platforms. Some have accurately pointed out that oracles are extremely valuable to DeFi because without them very few of these applications and protocols would work properly, if at all.

This is a big part of why cryptocurrencies like Chainlink have seen exponential growth over the past year. It provides price data to almost every single major DeFi protocol in existence and that list continues to grow every day. The price of Chainlink went from under 1$ last year to nearly 20$ recently, and it seems that it may continue to appreciate from there (this is not financial advice!).

How Band Protocol works

The way these oracles work is quite simple. Individuals or organizations can submit data in exchange for the cryptocurrency of that Oracle (LINK for Chainlink and BAND for Band Protocol). Users in the community verify the quality of the data in exchange for a small reward (again in the cryptocurrency of the oracle) and if the data is found to be inaccurate, the user may lose their stake, may be barred from the protocol, or may even have to pay a penalty. This is quite a diluted explanation of an oracle, but you get the gist.

More DeFi magic

A use-case example for Aave’s Flash Loans

There are two more novel inventions within DeFi we think you should know about. These are Flash Loans from Aave and elastic cryptocurrencies such as Ampleforth. Aave, a lending protocol like Compound, developed something called a flash loan wherein a user can withdraw an almost unlimited amount of Ethereum-based cryptocurrency with zero collateral. The rub is that the entire borrowed amount must be paid back within a single Ethereum block (10-20 seconds) or all of the transactions involved are canceled.

Again, you might be wondering what the point of this is if you have such a short window to leverage this amount of money. The answer is the same as before: arbitrage. In other words, smart and diligent traders can borrow millions of dollars of a cryptocurrency and quickly trade it on another exchange where the price might be slightly different, and this will give them a huge return. One trader borrowed 3 million dollars worth of Ethereum and made nearly 400 000$USD with a flash loan.

A description of Ampleforth from their website

The last “DeFi” invention involves the introduction of elastic cryptocurrencies such as Ampleforth. These are cryptocurrencies whose supply increase or decrease based on demand. This is done to ensure that the cryptocurrency always maintains a value of 1$USD regardless of how many are circulating. These currencies are non-dilutive, meaning the percentage of the total supply of the currency you hold stays the same. This involves changing the balance of that cryptocurrency directly within your wallet. If you want to read more about Ampleforth, you should check out this awesome article.

We hope you enjoyed this crash course on DeFi. Stay tuned for more awesome articles and download our free app to maximize your cryptocurrency trades!

You might also like