What is Decentralized Finance? DEFI Explained

  • For centuries together, the growth of finance has been rather vertical and not lateral.
  • Just like how banks give loans, the DeFi ecosystem is expected to function as a lending and borrowing platform.
  • Yield farming can be described as a way to make more crypto money with your existing crypto money through lending.

When the bitcoin was introduced in 2009, it was expected to revolutionize payments and the concept of currency. More than a decade after its inception, when we look back at all the offshoots that the underlying technology has manifested itself into, the results are rather surprising and awe-inspiring.

The technology that lies under the hood of the bitcoin is the digital, decentralized, immutable, secure, and transparent ledger called the blockchain. The blockchain has crept into almost every sphere of activities that involve transactions, authentication, and recordkeeping.

The humble beginnings of DeFi can be traced to the year 2016 when the MakerDAO was introduced.

At the heart of this technology lies the concept of decentralization. It basically means that there is no central point that can be considered the epicenter of all activities that happen on the network. A direct offshoot of this decentralization is the elimination of censorship and controls from regulatory bodies. It would also mean that the entire ecosystem is extremely secure as there is no single point of compromise.

All these concepts and advantages present an interesting case for powering finance.

Building a case for decentralized finance

For centuries together, the growth of finance has been rather vertical and not lateral. Probably, a few decades ago, we were transacting with coins and paper cash but today, we transact with credit cards, debit cards, and Internet banking. However, the currency that lies under these transactions and the banks that manage them have been the same… not just across decades but rather across centuries.

Decentralized finance a.k.a. DeFi intends to reinvent finance as we know it. A decentralized finance ecosystem is essentially a network or rather an array of different decentralized applications built on the top of a blockchain in an endeavor to facilitate different kinds of financial activities.

DeFi is relatively new and it is competing to dethrone a globally established financial ecosystem that people have become extremely familiar with. DeFi has the credentials it takes to become mainstream but it will need to undergo quite some evolution before it actually does. For example, all the transactions on DeFi are extremely secure and transactions can be performed at a global scale. There is no need for a central authority like a bank. This translates into globally accessible finance and financial services for anyone even if they do not have an account with a bank.

How all can DeFi work?

The humble beginnings of DeFi can be traced to the year 2016 when the MakerDAO was introduced. It was built on top of Ethereum and is powered by Ethereum smart contracts. To this day, Ethereum is the Numero Uno blockchain for DeFi as it, unlike the bitcoin, was built for smart contracts.

We must now digress a bit to talk about smart contracts. A smart contract is a small program that is designed to get executed only upon certain conditions being met. It serves as a cryptographic lock for all the crypto assets and processes. A perfectly programmed smart contract can be considered the epicenter of security in the blockchain world. The smart contract also plays a vital role in making processes fast, efficient, and foolproof.

As we have seen above, a new financial system needs to provide at least everything that the current financial ecosystem offers.

Just like how banks give loans, the DeFi ecosystem is expected to function as a lending and borrowing platform.

One of the biggest disadvantages with crypto coins is volatility and it has been effectively addressed by using stablecoins. With DeFi, it is possible to create an algorithmic stablecoin.

In addition, the DeFi ecosystem is also expected to provide services with respect to margin trading and insurance. In all these cases, with the elimination of intermediaries, third parties, and effectively, the cost associated with them, you can expect low premium and high-efficiency when it comes to the fulfillment of insurance claims..

Perhaps one of the most obvious manifestations of DeFi is the decentralized cryptocurrency exchange. A decentralized exchange, as the name implies, is a platform that facilitates exchanging of crypto assets in a completely decentralized way. The entire ecosystem is permissionless and trustless and it does not, at any moment, compromise on the custody of coins.

For any exchange, one of the key attributes that need to be addressed is liquidity. Liquidity, in the context of a crypto exchange, refers to the volume of transactions that happen on the exchange. This is one territory where centralized crypto exchanges decisively triumph over their decentralized counterparts.

The way decentralized crypto exchanges work

There are two different types of DEX: the one that works based on order books and the other that works based on the liquidity pool. The order book exchange is simple and straightforward. Instead of matching a buying order and ascending order like how a centralized exchange does, the centralized crypto exchange matches the buyer and a seller. If a centralized exchange functions like eBay, decentralized exchange functions like Craigslist.

The other type of decentralized cryptocurrency exchange – the liquidity pool exchange – opens up a plethora of opportunities for earning and at the same time, also mandates different protocols to govern the functioning of the ecosystem.

Let us now look at the different elements of a liquidity pool, the ways to earn money in this ecosystem, and the choices of protocols that we have in this space.

DeFi yield farming

To put it simple and straightforward without including the nuances and complexities, yield farming can be described as a way to make more crypto money with your existing crypto money through lending. The earning is facilitated by smart contracts. For lending your fund, you earn some fees in the form of crypto.

Although the strategy seems simple, it becomes contrastingly complicated practically. Yield farmers resort to moving cryptos between marketplaces and are also extremely secretive about the strategy because if it becomes open and known, it might become less profitable. Yield farming is alternatively referred to as liquidity mining.

To understand yield farming, we will need to dive deeper into the liquidity pool. It is a smart contract that is responsible for locking a humongous amount of crypto funds. These funds, however, can be generated from nowhere. Therefore, the liquidity pool has to depend on users to add those funds. These users are fittingly referred to as liquidity providers.

Since these liquidity providers make an effort to generate liquidity, they get a reward that may come from the fees generated by the underlying Defi platform, and in rare cases, some other sources.

Most liquidity pools that make their payments have multiple tokens. The liquidity providers invest these tokens in other liquidity pools to earn rewards there. This domino effect of deposit and earning rewards is what makes yield farming a profitable strategy.

Why yield farming?

Liquidity, in the case of centralized ecosystems, can be facilitated by the governing/authoritative body. This is what happens on centralized crypto exchanges. However, in the case of decentralized systems, there is a need to enhance liquidity that might not be readily available. In fact, it is the absence of liquidity that acts as a deterrent for traders from participating in decentralized exchanges.

Liquidity pools adequately take care of this need for liquidity. A large number of crypto funds in the liquidity pool enable traders to get the asset they want to trade without any dependency on buying/selling orders. One of the best ways to keep these liquidity pools funded is to make people with crypto assets contribute to it. Yield farming functions as an incentive to these liquidity providers, not only enhancing the appeal of the decentralized ecosystem but also positioning it as a lucrative earning opportunity in this space.

More often than not, the returns in yield farming are annually calculated. Some payment methods take into consideration the effect of compounding a.k.a. reinvesting the returns.

Although yield farming has its share of risks, it is one of the best-suited methods of making a profit in the crypto world, especially for users who have lavish capital to deploy. The profitability of yield farming, the payment of the returns, the risk, and the vulnerabilities can all be attributed to the protocol that governs the DeFi ecosystem.

There are different types of DeFi protocols. Here, we will focus on three of them: Curve, Uniswap, and Balancer.

There are different types of DeFi protocols.

Curve

Curve, by definition, is a liquidity aggregator. It is a decentralized exchange that promotes liquidity creation. It has grown to be one of the biggest players in the Ethereum DeFi space. Just like every other protocol, Curve was not completely decentralized when it launched. The founder of Curve has stated that it is an exchange exclusively designed for stablecoins and bitcoin tokens on Ethereum.

Curve uses a market-making algorithm to enhance the liquidity of its market, effectively making Curve an automated market maker [AMM] protocol. Curve has the potential to provide 100 times to 1000 times better market depth than its competitors Uniswap and Balancer. Liquidity providers are incentivized by yield farming profits, and the payment varies in proportion to the volume and the amount of deposits witnessed on a daily basis. There are some tokens that can yield about 5.5% annual interest and some, as high as 11%.

Curve has been so successful that its native token CRV has been steadily increasing in circulation, and unlike the usual distribution mechanism like an ICO, CRV will be distributed through an incentive program. The fully diluted market cap of CRV stands at a staggering $4,606,987,000.

Uniswap

Very much like Curve, Uniswap is also a decentralized protocol for providing liquidity on Ethereum.  Uniswap works by storing massive amounts of Ethereum tokens locked behind a smart contract. This reserve allows the protocol to provide services that aren’t readily available in the market. This also facilitates the trading of Ethereum standard tokens even without the availability of a buying/selling order.

What makes Uniswap distinct is its algorithmic equation. Instead of depending on the buying and selling orders to determine the market, the algorithm defines the rate of swapping based on the balances of both tokens and the demand for that particular swapping pair. These oracles are one of the most unique features of Uniswap, making the entire protocol immune to manipulation of data that can come from centralized sources.

Balancer

Balancer is yet another decentralized finance protocol based on Ethereum, and as you may have guessed, with the purpose of automatic market-making. From the overview, it might look quite similar to Uniswap and Curve. However, what makes Balancer special is its support for up to eight assets per market. It also facilitates custom trading fees that can be set by the creator of the liquidy pool.

Balancer also gives users an option to trade crypto assets with a smart order routing system at very low fees… In a decentralized fashion. Unlike centralized crypto exchanges, the price of the tokens is based on their deviation from the set weighting.

Balancer has its own native governance token called the BAL. The responsibility of the token holders is to help guide the protocol to its fullest potential. The planned supply of the token is set to be 100 million coins over time. Currently, the market cap of the token stands at $235,847,000.

Multi-utility tokens

The world of decentralized finance is not confined to exchanges and exchange protocols. It opens up a plethora of opportunities including but not limited to letting users bet on crypto assets, stocks, precious metals, and various other kinds of assets represented as ERC20 tokens.

All these are facilitated through a token trading platform called Synthetix built on Ethereum. The purpose of the platform is simple and straightforward. It lets users create real-world assets to be bought and traded using crypto coins. Just like any other DeFi product, Synthetix also started as a stablecoin before becoming a decentralized app.

The tokens in this platform might have the same price as the real asset behind it but it does not completely embody all the powers of the asset, for example, voting rights. The native token of Synthetix is SNX and similar to MakerDAO – SNX is locked up to create sUSD as a debt against collateral. As you can infer, there is a need for Synthetix to continuously communicate with the real world to get prices of different assets.

Synthetix uses an innovative incentivization model that rewards users from the inflationary monetary policy of the system. To create a new Synth, The system demands a 750% staking as SNX. This will ensure limited availability, contributing to the increase of the token value.

What we have seen with respect to DeFi is just the tip of the iceberg.

Conclusion

The growth of DeFi, the constant innovation in DeFi protocols, the creation of defi  yield farming platforms, and the demand for decentralization will only contribute to increased instances of yield farming in DeFi. Yield farmers will constantly endeavor to reinvent their best yield farming strategies to ensure that they get the best returns and at the same time, not dilute the market.

Once the decentralized finance ecosystem grows to eliminate all its shortcomings, high-yield farming will probably be a very common way to earn big profits when it comes to yield farming in decentralized finance.

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