DeFi search term in Google trends
Decentralized Finance or DeFi. A buzzword or a new piece of tech that is going to revolutionize the way we conduct financial operations? Since the start of the year, this word has started gaining traction. Looking at the Google trends chart we can see that it really started picking up from late May after which the interest rose to its all-time high made on the 9th of August.
Many crypto projects that are considered DeFi have increased in value by a significant amount. Similarly to that of the ICO craze of 2017 cryptocurrencies have been showing staggering returns in some cases of over 3000% from their launch. Some are calling this a DeFi bubble, while others are certain that the mere usability and immediate benefits compared to their traditional counterparts – banks and financial service providers, are driving the prices of these cryptos into the stratosphere.
Be it a bubble or a real use-case-driven interest we can see that the money inflow in the DeFi projects is constantly increasing. According to DeFi Pulse, the total amount of USD locked in DeFi has increased by 8x from late March when it was barely managing to maintain just below the 1B mark.
While in 2017 you invested in the idea described in the whitepaper and a promise that the token will be worth one day, DeFi crypto projects grant their holder with immediate returns guaranteed by the system’s design and not the market value.
In the upcoming paragraphs, we are going to go over some of the most notable and promising projects of decentralized finance that have drawn both attention and money in the previous period. Also, we are going to do a comparative analysis with some of their real-world counterparts, to construct a clear picture of their benefits and answer the question: What does DeFi mean for the future of investing?
How is investing in DeFi different?
Let’s first start by outlining the difference of DeFi investing – what it actually is and how it works. Decentralized Finance is the way people can start conducting and performing financial services in a fully trustless and permissionless way. Those services are similar to what traditional financial institutions offer: lending, borrowing, transferring, investing, trading, insurance, crowdfunding, etc. Basically, they provide financial products similar to what banks, funds, brokers, exchanges can offer.
What is different then? Besides offering e.g. higher interest-bearing money market accounts, a DeFi solution’s key distinction is that it’s decentralized. Investing in it means that you are investing in the predetermined piece of code underlying an ecosystem of smart contracts, digital assets, protocols, and dapps. There isn’t a central authority handling your money and there isn’t a customer service you can call. So why would that sound like a good idea?
Traditional (centralized) financial institutions have acted as a middleman between those who want to borrow money and those who are willing to lend it for interest. However, besides doing plain matchmaking, they served as a point of trust between two parties that guarantees that the terms will be met on both sides.
- First and the most obvious issue is that banks have specific terms and requirements for using these services – a lot of documentation about your financial history, minimum/maximum of funds you can use, contract termination with unfavorable penalties… You might say that those requirements are there to ensure that both sides meet their agreements and both borrower and lender go off contempt. But, more often than not, they are there to protect the bank and prey on those who are in hopeless situation and will do or sign anything to receive some funds.
- The second category can be summed up by saying that banks and financial institutions haven’t been keeping up with today’s world. Nowadays you can order your favorite shoes from across the globe and you will get them delivered in two-three days. You can send a picture in a near-instant, work remotely for an employer you have never seen, but ironically, transferring money from one place to another can take you a week. Not only that, you would also have to pay high fees. For larger sums, it is often required to make an appearance at the local bank branch, usually from 9 am to 5 pm and wait in line.
- Third and the most important one but definitely the most overlooked as it doesn’t have an immediate effect on people involved in the process is fractional reserve banking. In theory, the bank should conduct business as a central point between supply (lenders) and demand (borrowers). But what if there isn’t much on the supply side to meet the demand? Should the bank just stop making money on the commission? Well no, fractional reserve banking enables the bank to lend more than it has on its balance sheet. This reserve ratio requirement is determined by the country’s central bank and in the U.S for example it is currently 0 (zero). The bank effectively lends money that it does not have, thus creating credit. And because credit equals money by this process alone commercial banks introduce new money supply into circulation, growing beyond the amount of underlying base money originally created to represent the exchange of goods and services. Fractional reserve banking leads to currency debasement and in conjunction with money printing by the central banks, it leads to inflation and devaluation. For this purpose alone Bitcoin was created. It was created as a scarce resource that needs hard (computational) work to be produced and is limited in supply with a steady and immutable emission rate.
There are some significant problems derived from this kind of practice.
Unlike traditional financial institutions, decentralized finance provides the same type of service. However, instead of maintaining control and acting as a gatekeeper, it is fully autonomous, permissionless, accessible, transparent, cheap, and provides a better rate of returns. It manages to do so by using smart contracts to hold collateral instead of regular contracts and bank vaults, fund managers. It is a non-custodial system so trust with the funds’ management isn’t even a point to discuss.
The only trust that is needed is in the blockchain it was built on, and for the most part currently that is Ethereum. According to DeFi Pulse, at the moment out of the 39 listed projects, only 1 is on the Bitcoin blockchain and that is the lightning network. Besides this scalability layer for payments that have no underlying token, every other project is on the ETH network.
By being built in this way it cuts out the middleman, making the need for a central authority obsolete. It also lowers requirements (both financial and in paperwork), reduces fees, and increases viability for the end-user.
In the developed world accessibility to these services isn’t a problem (besides maybe not having a good credit score), but in underdeveloped nations, there is a serious issue with the unbanked population. DeFi enables users to access these financial services with only a computer or a smartphone and an Internet connection. With fewer requirements to enter, this system is more inclusive towards the most financially vulnerable category of the population.
DeFi Ecosystem – Products And Service
As already stated, DeFi provides substitutions for traditional finance and as such has its own ecosystem of products and services.
First and the most sought of service is definitely lending and borrowing especially considering that it’s the most important function of commercial banks. When it comes to these services there are numerous solutions that are now starting to compete with better rates, easier user experience, and overall ease of use.
One of the most popular projects out there that has single-handedly carried this niche into the mainstream with high yields is Compound. Although the project has been out in the market for quite some time now, it really started gaining traction with the release of its COMP governance token in June earlier this year. It enables its users to lend crypto for interest, or make a crypto deposit as a collateral to borrow against it. But the process of lending and borrowing i.e being active on the platform, allows you to reap the COMP token’s rewards . This is why we have seen an increase in its price from $65.45 from its lowest on the 18th of June to $330 only three days after. It’s currently sitting below $200 but it still ranks high and is sitting at the 35th place on CoinMarketCap indicating a high level of interest from market participants.
Compound’s place of being the number one platform for lending and borrowing has been recently challenged by Aave – which currently has $1.71B in USD locked, compared to Compound’s $788m. In the same period – from the 18th of June, the price of its LEND token increased from $0.1 to $0.8 at its highest peak and unlike in the case of COMP, it is still being traded around those levels.
Other notable projects are InstaDApp and dYdX, while you can use the LoanScan website to look for the best current rates and find the best opportunities as the APY are dynamic, depending on the supply and demand and also depend on the asset.
Holding your crypto assets on a centralized exchange can pose a serious risk. Besides being susceptible to hacks, the exchanges are often involved in trading against their users and have started to form centralized power points in what should be a decentralized ecosystem.
This is why decentralized exchanges have started to emerge. Unlike centralized exchanges where you have to deposit your digital assets into their wallet, effectively making them exchanges funds, decentralized exchanges are non-custodial. This means that your crypto never leaves your wallet, but it’s only directly exchanged. In this way, there is a faster execution, no KYC procedures and most importantly – it’s safer.
One of the most popular decentralized exchanges by user-friendliness is Uniswap. It conducts matchmaking without the order book and draws assets from the liquidity pool. The biggest disadvantage is that it’s only suitable for the Ethereum blockchain and its tokens.
The biggest one with over $1.35B in total funds locked is the Balancer protocol. It offers the creation of the customizable liquidity pool in which you can add assets and provide liquidity in exchange for trading fees. Similarly, Kyber Network provides a decentralized exchange with token holders contributing liquidity and managing reserves.
This lack of order book, margin trading and derivative financial instruments may not be suitable for professional traders. This is where dYdX platform comes into play as it lets users margin trade any supported asset. It has some shortcomings as well, which is why most recently we have seen a lot of hype surrounding the launch of the Serum DEX which offers these features, especially derivatives like custom contracts. Similarly, Synthetix is a decentralized exchange that enables users to create and exchange synthetic assets derived from fiat currencies, cryptocurrencies and traditional assets like gold and silver which are collateralized to back the synthetic assets.
Stablecoins have proven to be such a useful tool especially in times of high market volatility. Leading stablecoin – USDT (Tether) has thus risen to the 3rd place on CoinMarketCap at one point. However, there are many issues with a centralized stablecoin that is national fiat currency collateralized.
Legal liability, seizure of funds, banking issues, and accusations of market manipulation have been surrounding Tether inc. and its stablecoin USDT ever since the Bitfinex exchange got hacked. Decentralized stablecoins like everything decentralized are offering certainty of maintaining the peg to a stable value point like the US dollar through the mechanism of math.
MakerDAO is one of the most prominent examples with its stablecoin DAI. Users open what is called a Collateralized Debt Position (CDP) and deposit their crypto into the smart contracts which in turn grants them with the upfront set proportion of the stablecoin DAI. Effectively they engage in borrowing and are to repay their DAI with interest to get back their collateralized crypto.
The stablecoin is always overcollateralized to ensure the maintenance of the peg so that if the value of the underlying assets starts depreciating, it gets liquidated. There are other mechanisms as well like maintaining a vault and managing the Stability fee with the Maker governance token as Maker acts as a decentralized reserve bank.
A useful tool for managing your CDP’s and making sure you don’t get liquidated by a sudden influx of volatility is DeFi Saver. The app helps you maintain the appropriate ratio or increase leverage based on market movements.
Other interesting DeFi use cases include tokenized asset management that utilizes the current infrastructure. For example, yearn.finance acts as an aggregator that engages in various lending services such as Aave, Compound, dYdX, and Fulcrum and optimizes lending for you via their token. If you make a crypto deposit into yearn.finance, it will get converted to yTokens, which are periodically rebalanced to choose the most profitable lending service.
Similarly to yearn.finance, Set Protocol rebalances your tokens into a portfolio or a basket of different assets and trading strategies represented by its ERC20 token. In that way, those who are looking to take a more passive approach to the market, can just get the Set Token that capitalizes on volatility by rebalancing your holdings automatically into currently profitable strategies.
An interesting solution that includes real-world assets represented by a yield producing token is DeFi Money Markets. Users deposit crypto into the smart contract and receive an equivalent amount of wrapped tokens. The underlying asset is used to purchase real-world revenue-generating assets like real-estate, airplanes for rental, etc. This structure enables the platform to produce stable APY, unlike others that are dynamic and are always changing so holding assets for a more long term causes uncertainty.
What is the benefit of investing in DeFi?
Besides the benefits we have covered in the first part of the article: lower entry requirements , lower fees, faster execution, no hassle with either paperwork or waiting time, the mere beneficiality of products is a major one that drives the hype around DeFi.
Going back to the previously-mentioned example of the DeFi Money Markets asset management solution, they are offering a stable APY of 6.25% on stablecoins like DAI and USDC. Compared to the traditional money market accounts that provide very low interest at least and negative at most (Europe: -0.46%, UK: -0.67%, US: 1.5%, Japan: 0%) this is 5 to 6 times the amount.
Also besides the % yield, there are other factors to consider. While some other traditional investments like stock and bonds, or digital assets like other cryptos can offer higher returns on investment, there is a higher rate of risk associated.
Another argument to consider is technical execution. Traditionally , you are dealing with middlemen and bureaucracy, paying high commissions, or require a large amount of capital upfront. In contrast, if you already have a stablecoin sitting in your wallet you can easily make it work for you and earn passive income without ever needing to make a transaction between wallets. If you have bought BTC, ETH, or some other crypto and you are just waiting to appreciate its value, so you can sell it for profit, you can use the time and the opportunity and offer it to a liquidity pool to earn rewards.
Yet another benefit that is just starting to get exploited is the interoperability of DeFi, namely you can use different platforms and tokens to come with your own unique solution and percentage yield. People are just starting to experiment with these concepts and like LEGO bricks are putting together pieces of the DeFi puzzle to utilize its maximum and exploit some of the arbitrage opportunities out there.
All in all, DeFi is here to stay and although this current rise in demand and the space valuation might be a bubble, it’s driven by high yields and rate of returns. While still young, the DeFi space tools are emerging. At Crypkit we have created your all-in-one DeFi dashboard so you can stay on top of your DeFi holdings and track your investment across various platforms. Considering what’s last been said regarding the exploitations of the arbitrage opportunities and market inefficiencies it has never been more important to have a visual representation of positions so that you can maximize your profits. In the world of decentralized finance having a centralized dashboard can help you to get a better understanding of your investments.
We bring support for all of the mentioned solutions like Lending/borrowing platforms, DEXes, asset management, and other DeFi solutions into all-rounded tools to help you make better investment decisions.
DeFi means for the future of investing what Apple and Microsoft meant for computers – they bring users closer to the product and give them control over their experience.. They have revolutionized the way we interact with computers and DeFi is going to revolutionize the way we engage with the economy and our personal finance.