If you have ventured into crypto-twitter lately, you have probably stumbled upon discussions about DeFi and terms like ‘yield-farming’, ‘YAM’ and ‘yearn’. If this left you scratching your head, you are not alone.
They say, the next big thing often starts out looking like a toy. And this just may be true of DeFi.
So what is DeFi?
DeFi stands for “Decentralized Finance”, which aims to recreate the traditional financial system with less, well, middlemen. Many of the traditional actions in the markets such as lending, borrowing, structuring derivative products, and the buying and selling of securities, can now be done through a decentralized open-source network. The vast majority of these applications are currently created on Ethereum, but in principle, other platforms with smart contract capabilities could work too.
What are some common functionalities of DeFi?
To start off, DeFi would not exist without stablecoins. Unlike common cryptocurrencies like Bitcoin which are known for their volatility, a stablecoin is pegged to a fiat currency such as the USD or the Chinese Yuan. Recreating lending contracts and other financial products in a volatile asset is impractical, therefore most DeFi contracts incorporate stablecoins at the core of their functionality. Common types of stablecoins in the market today include USDT, USDC, TrueUSD, Dai and Paxos.
At the time of writing, the total value locked in DeFi contracts is approximately $8 Billion.
There are a few main categories dominating DeFi today.
Borrowing and Lending
DeFi allows a user to programmatically take out a loan, without an applications reviewed or even a bank account. In some DeFi applications, the borrower does not need to go out and find a lender. Instead, the lender is the smart contract itself and interest rates are calculated algorithmically based on supply and demand. In other applications, a fixed interest rate is guaranteed in exchange for loaning your coins to the contract.
DeFi allows borrowers to stake their digital assets as collateral, which are locked within a smart contract until the loan is repaid. Due to the nascency of the space, collateral requirements can be very high, making them impractical.
Examples of DeFi lending platforms include Compound, Aave, Maker.
A commonly used term ‘Yield Farming’ is derived from a new functionality created by Compound on June 15th, where users were rewarded with tokens by participating in the token economy and providing liquidity to the protocol. This trend has since caught on by other DeFi protocols.
Trading of securities and cryptocurrencies is typically done through platforms run by a third party. But what if a machine could seamlessly create a fair exchange through a smart contract? DeFi exchanges eliminate middlemen and can act as a custodian of funds and digital assets in a peer-to-peer exchange.
Examples of decentralized exchanges include Curve, Uniswap, Bancor, Kyber and Synthetix.
Notably, over the last few days, Uniswap’s daily trading volume surpassed that of Coinbase, one of the most popular U.S. crypto exchanges with 1200+ employees. It is no small feat for Uniswap, which is largely automated and requires no centrealized team for their operations.
Asset Management Protocols
A recent category of DeFi products creates frameworks for users to pool funds for investments akin to robo advisors, automated funds, and asset aggregators.
Examples include Yearn.Finance, Melon, Set protocol, Zapper.fi and Insta.dapp.
Decentralized Prediction Markets, Options and Insurance
This next category is all about betting on something happening or not happening in the future, and includes decentralized prediction markets, on-chain options and insurance, in a fully automated matter. Today, these platforms are often used to insure against a bug in a smart contract. In the future, these platforms will be used to insure against accidents and natural disasters.
Examples include Augur, Polymarket, Opyn and Nexus Mutual.
Synthetic Asset Bridges
This is a really popular one! Assets like Bitcoin may be great for a certain functionality such as store of value, but are difficult to use as collateral. Think of it as gold stuck in a vault, difficult to move, secure and collateralize. Creating a digital representation or right to Bitcoin allows it to be used in financial contracts. These platforms are becoming so popular that Bitcoin is currently being tokenized faster than it is being mined.
Current platforms acting as synthetic bridges include BitGo ($386M in tokenized BTC) and REN ($200M in tokenized BTC), with Keep Network launching soon.
Finally, DeFi also promises to combine different smart contracts with ease. For example, you could invest $100,000 at 5% interest, and then automatically reinvest that interest into another asset through a DeFi robo-advisor, or use it as collateral for a loan.
Who is Investing in DeFi?
Aside from gamers and fanatics ‘yield farming’ late into the night, there are several funds who are making institutional investments into DeFi. Some notable investors in the space include DG Lab Fund, ParaFi Capital, Framework Ventures, 3Arrows, Mechanism, Coinfund, as well as veteran crypto investors Polychain, Pantera and Multicoin Capital.
Chatting with Ben Forman, Managing Partner at ParaFi Capital, I asked why he chose for his fund to focus on DeFi:
“It’s not surprising many have dismissed DeFi as the latest fad in crypto. The next big thing often begins looking like a toy. DeFi protocols offer a way to build financial products with global distribution. You’ve seen a sandbox of innovation, unbounded in terms of participation and capital flows. With any new technology you see a lot of experimentation and a lot of failure. Failure is the cost of innovation. But important not to throw out the baby with the bathwater — there is staying power to the underlying architecture behind DeFi networks. The use cases are encroaching on legacy financial infrastructure to the point that they’re becoming difficult to ignore.”
While some investors are seemingly multiplying their money overnight, DeFi reminds us of the ICO-mania of 2017-2018. Higher returns mean even higher risks in DeFi. Many of these projects are still speculative, carrying with them smart contract, collateralization and volatility risks. As always, do your own research.