In today’s Exponential Investor:
- What is DeFi?
- Is DeFi really the future?
- Four ways to invest in DeFi
What is “DeFi”?
DeFi, short for decentralised finance, is an umbrella term for peer-to-peer financial products available on crypto networks.
The term “decentralised” means a network with no central point of failure or control. Think about it like this…
The Bank of England determines monetary policy in the UK. The Monetary Policy Committee (MPC) has nine members. These nine people determine the bank rate and influence the financial futures of millions of British people.
Nine people determining the impact on the livelihoods of millions.
That is a very concentrated, centralised, power imbalance.
DeFi aims to eliminate that concentration and centralisation of control and influence to the wider network of peers.
DeFi is built on banking concepts found in traditional finance systems. That is, it allows a fully functioning financial system using financial tools such as collateralised lending, borrowing, insurance and payments.
In DeFi, value is typically exchanged through crypto. This is sometimes volatile crypto like bitcoin or Ethereum, or sometimes it can be through the use of “stablecoins” pegged to fiat currency like USDT, which is pegged to the US dollar.
In allowing participants to BYOB (be your own bank) DeFi opens up finance in many areas such as:
- 24/7 cross-border payments and remittance
- instant payment settlement with low transaction fees
- Borrowing and lending
- Higher interest crypto savings accounts
- Market making.
DeFi puts power and control over money and finance into the hands of the individual. It doesn’t discriminate, it is open, accessible and provides alternative finance options to people anywhere, anytime.
How does it work?
DeFi at its core is peer-to-peer technology. That means it’s an open-source financial system using smart contracts.
Each DeFi network has a set of smart contracts which automatically execute when triggered. This helps create an interoperable, self-governing network. For example, in DeFi exchanges, smart contracts automatically match, verify and settle transactions between buyers and sellers of a particular token.
When a transaction is executed using smart contracts, the action is recorded and made publicly available on the blockchain. Counterparty risk is also reduced, because the contractual obligation for a transaction is built into a smart contract, which lies out of the participant’s control. Finally, coded automation of smart contracts means they can be executed instantly with no friction.
Most DeFi protocols operate on the Ethereum blockchain due to its infrastructure. It easily accommodates smart contracts and decentralised apps, which many DeFi networks are built upon.
Although DeFi uses traditional banking ideas, such as borrowing and lending, it has its own mechanisms in place that you can’t really find in the TradFi world.
For example, DeFi platforms use a concept called yield farming. This is when users stake or lend crypto assets to a DeFi network in order to generate returns (or rewards) in the shape of crypto tokens. This process can be pretty complex, with users required to lock up funds in liquidity pools underpinned by smart contracts.
In this instance, DeFi networks can offer more favourable yields to attract liquidity to the protocol, which it needs to fully function. However, the yield offered is dependent on several factors, including the demand for a token, and the amount of collateral provided when borrowing.
Could DeFi be the future of finance?
It has the potential to become a widely recognised alternative financial system. As crypto adoption and acceptance accelerates, it’s likely that DeFi use will grow alongside it.
The fact it can help users gain total control of their finances, generate wealth and improve financial efficiency, makes for an exciting proposition.
However, DeFi still has a long way to go, and it has a lot to answer for in terms of its usability and financial stability.
DeFi is complex for the crypto novice, and it brings several unknowns.
Obtaining certain DeFi tokens requires several stages, including coin conversion and setting up wallets. Understanding the range of options on a platform, such as staking, yielding and token swapping, can also cause confusion and prevent it from being used to its full potential.
The technology is still at a nascent stage and has several vulnerabilities relating to crypto price volatility, liquidity mismatches, security breaches and its ability to absorb shocks.
For example, Anchor protocol, a decentralised borrowing and lending platform, fell victim to the Terra Luna crypto crash earlier this year.
The crash saw Terra lose its unofficial “peg” to the US dollar following market manipulation, causing the value of ANC, Anchor’s protocol token underpinned by the Terra blockchain, to drop 99.2%. At the same time, liquidity locked up in the platform lost the majority of its value, sparking panic and chaos across the Anchor ecosystem.
These events served as a reminder of the risks of DeFi, which doesn’t have the safety net of regulation.
Nevertheless, the absence of things like centralised control and oversight is helping to open up innovation in the DeFi space, although it will stand for nothing if the security and usability of DeFi doesn’t improve and encourage mass adoption.
How to invest in DeFi?
You can invest in DeFi in several ways.
One way is to take the stock market route and invest in publicly listed companies that are looking to tap into the power of DeFi.
Two examples of the kinds of companies on stock markets include:
- Coinbase (NASDAQ: COIN) – one of the most widely recognised, publicly listed companies with a DeFi “focus”
- Riot Blockchain (NASDAQ: RIOT) – one of the world’s largest bitcoin miners.
There’s also the option of investing directly into DeFi projects, typically by purchasing their tokens. Two more examples of these kinds of DeFi projects are:
- Uniswap – a decentralised exchange that allows users to swap tokens on a peer-to-peer basis. Its native crypto token is the UNI token
- Yearn Finance – allows users to engage in decentralised lending and earn APY via its native token, YFI.
These are just four examples of ways to get into DeFi. It must be said though, it’s a risky, early-stage area of investment. You should ensure that you do the appropriate research into any investment before you decide to buy.
Direct investment into crypto requires an understanding of the market, how to practically get and store your crypto and to avoid scams in this space. It’s not something to blindly throw money at and not something to even invest more than you’re prepared to risk and potentially lose.
If you’re keen on getting into DeFi, then our suggestion is to read, learn, understand more about the industry, the risks, and how to smartly get involved before you dive in. In fact, to start on that journey, here’s three more resources we’ve prepared to help you understand DeFi and how you can get involved:
If you’ve got any more questions on DeFi, write to us and ask a question. We’re always willing to help people learn about the power of DeFi and how we think it’s going to change the world.
Until next time…
Editor, Exponential Investor