DeFi 101 - Part 1: How to Participate and Operate Effectively
In the first part of this two-part series, we take a closer look at how DeFi distinguishes itself from traditional finance and discuss different ways of participating via lending and liquidity provision.
Since DeFi first attracted the attention of the crypto space in the so-called DeFi summer in 2020, the concept has remained extremely popular. Its usage, usually measured as a function of Total Locked Value (TVL), continues to rise dramatically — TVL rose by 240% in the last year to over $210 billion according to DefiLlama. For investors, DeFi has not only offered a means to invest in promising projects via tokens, it has also helped millions of them generate alternative, steady sources of income through a number of activities. What’s more, DeFi has been shown to be attractive in bearish markets.
This allure of solid, minimal-risk returns uncorrelated to crypto market movements is what draws many investors out onto the ice. Keep in mind that there is no such thing as a free lunch. In this article, we shall define DeFi and delve into the ecosystem, its strategies, and risks, all of which are important for both private and professional investors considering allocating capital to this space.
The Move From TradFi to DeFi
Let's begin by discussing the transition from traditional finance (TradFi) to decentralized finance (DeFi). Simply put, DeFi seeks to eliminate the middleman in processes traditionally performed by banks and financial institutions such as borrowing, lending, and market making. It enables investors to interact directly with one another on a peer-to-peer (P2P) basis by providing liquidity or loans for trading and assuming those roles/functions in exchange for fees, albeit while also bearing the risks.
The most prominent factors used to describe TradFi include the fact that it is trust-based, as you must trust your bank as the sole counterparty; that large barriers to entry remain, as many emerging nations still have more than half their populations unbanked, and that TradFi institutions are often expensive, slow, and unfriendly to customers. This is in stark contrast to the DeFi world, which is built on code and smart contracts and eliminates the need for trusted intermediaries; agreed-upon terms are recorded on and executed via blockchain mechanisms. With the spread of internet coverage and low-cost smartphones, accessibility has skyrocketed. What’s more, access to ordinary TradFi services are available 24/7/365.
While this all sounds fantastic, there is still a long way to go. For many, the subject remains complex and difficult to grasp. User interfaces and processes can still be improved and simplified, fees can vary, resulting in very high charges for small transaction amounts, DeFi hacks are on the rise, and being your "own bank" brings with it a number of operational challenges and risks.
The Building Blocks of DeFi
Looking at DeFi, you have various layers that come together to form a new digital service offering, much like building a house.
Using the house as an example, the first layer is the underlying blockchain technology, which could be Ethereum or BNB chain (layer-1 protocols). Certain trade-offs will be required depending on the blockchain used. The blockchain trilemma is a term coined by Ethereum co-founder Vitalik Buterin.
Consider a triangle with the corners representing security, scalability, and decentralization. You can only optimize two corners while compromising on the third.
This adds color to the nuanced perspectives that developers and investors must consider when deciding on an ecosystem. To address these issues, developers are working on either creating new "base layer" blockchains, such as Polkadot and their layer-0 approach, or introducing layer-2 scaling solutions on top of layer-1 blockchains, such as Ethereum, which uses zk-Rollups smart contracts for reducing costs.
Then, on top of the basement, we have our walls, which are the respective protocols, also known as decentralized applications, or DApps, that provide services such as decentralized exchanges (DEXs) like Uniswap or PancakeSwap, lending protocols like Maker or Aave, derivatives liquidity protocols like Synthetix, and others. A constantly growing and developing space.
You must build a roof over your walls, which is why we have "pools." When using a DApp service, such as a lending protocol, you can select which token to provide. For example, when using Aave's service, you can choose to only lend USD Coin (USDC) stablecoins. Alternatively, you can only act as a liquidity provider for Ether (ETH) and USDC trading pools on UniSwap. Consider going to a bank and saying you want to borrow money or trade stocks; you must also specify the currency in which you want to borrow or the stock you want to buy in which reference currency. In the following section, we'll go over these activities in greater depth.
Finally, you have aggregators such as wallets like MetaMask and Ledger, DEXs like 1inch and Thorchain, and Centralized Exchanges like MEXC and Binance to plant a flag on top of your roof. They combine the services of various platforms into a single entry point/user interface, making it easier to use. It is not uncommon to find crypto enthusiasts object to using centralized exchanges because it contradicts the entire point of decentralization and self-custody of your private keys, the password to your crypto wealth.
We are comparing DeFi to the structure of a house not only for simplification, while omitting some nuances and details, but also to demonstrate that if the foundation, or the layer-1 blockchain, has cracks, the entire house is at risk. As a result, when conducting your risk assessment, consider the overall stability of the house rather than just the floor you are standing on.
Making Money with DeFi: The Way to Go
Simply put, you can invest in DeFi projects/protocols by purchasing tokens such as PancakeSwap (CAKE), SushiSwap (SUSHI), or Maker (MKR) and expect capital gains through price increases due to a superior platform offering, user, and asset growth. Alternatively, you can use these platforms as a "operator" and earn money from the various activities available.
You can also have your cake and eat it too by investing in high-conviction projects and earning extra money through the following activities:
Instead of getting a bank loan, you can get one through a DeFi protocol, which involves fellow investors putting up the funds, or, in essence, peer-to-peer lending. In exchange, the investors receive a portion of the loan's interest as a yield. When you hold stocks with your bank, for example, they are most likely lending those stocks, for which you pay a deposit fee, to another financial institution, such as a hedge fund, for a fee, which can then be used for short selling and other leveraged trades. Obviously, you don't see any of that money.
Check out our more detailed article on crypto lending and borrowing here.
Provision of liquidity
When you buy and sell stocks on a traditional exchange, financial institutions serve as brokers, coordinating trades and providing liquidity in the form of shares or cash. These activities have been disrupted in the digital asset world by automated market makers (AMM) running and operating as decentralized exchanges on automated code. The missing liquidity is once again supplied by fellow investors, who will profit from the fees generated by these liquidity pools. These pools include crypto vs. crypto trading pairs like BTC/ETH, stablecoins vs. stablecoins like USDC/BUSD, and crypto vs. stablecoins like AVAX/USDC.
In another article, we will discuss other ways of participating in DeFi, and how enter offers amazing rewards for participation within its DeFi ecosystem.
This article is written by Chidera Anushiem as a part of enter.blog's bounty program. Do you have an interesting topic, series or subject you think would be fitting for enter.blog?
You can now submit your articles to enter.blog and get paid for your contributions!
Read more and submit your article here.
Crypto & Learning
Hungry for knowledge? Here you can get acquainted with blockchain, wallet security, DeFi and much more.
PUBLISHED 11TH MAY 2023
Avalanche Summit 2023 Recap
Avalanche Summit II attracted more than 3000 attendees and 300 speakers for a three-day event in the beautiful setting of Poble Espanyol in Barcelona. In this article, we take a look at the highlights and breakdown some of the most groundbreaking topics of this year’s Avalanche Summit.