DeFi: What's it all about?

Moving on from the technical side of Crypto and the technology behind it, today’s post is going to delve into one of the most prolific and talked about applications of Crypto: Financial Services. Within my first post this is something that I did touch upon in relation to the transfer of funds, but DeFi is much more than just that, it opens up the realm of easy lending and borrowing, the ability to earn passive income, the purchase of insurance and derivative trading. All of which is going to be covered here.

To begin with, what is DeFi and what does it mean?

Well put simply DeFi stands for Decentralised Finance, direct access to financial services which gets rid of the middle man and hassle of centralised banks. With the use of Blockchain technology financial contracts get locked onto the blockchain (in the form of smart contracts) which cannot be changed or altered once all the details have been confirmed. Do note that although not all Cryptocurrencies support the use of these smart contracts the amount that do is reasonably high, totalling 120 at the time of writing with Ethereum, PolkaDot and Cardano (going fully online August 2021) being the biggest and most widely used Cryptos that have Smart Contracts.

To put simply a smart contract is an agreement between two parties in the form of computer code which runs on a blockchain, which cannot be changed and can be viewed by anyone at any time.

Borrowing: Tripes and Joys

With traditional banking if you wanted to take out a loan a lengthy application of filling out forms is required for the banks to assess your credit score and risk level before lending to you. Furthermore, you must have some form of collateral (something of equal value put up against the loan) to back up the loan amount in case you fail to pay back the repayments of the loan.

A problem for many is that they have the collateral and ability to pay back the loan payments but have a bad credit score, preventing them from obtaining the loan from a bank, a common problem especially for those in the developing world. DeFi bypasses this problem entirely by only requiring someone to have the right amount of collateral.

Decentralised Apps (Dapps) such as Compound finance, allows anyone to access their services and connect their funds to the application. You can then freely use their funds as collateral to then take out a loan for number of different cryptos. You can choose to borrow a Crypto which has the best interest rate and set the length of time you wish to borrow the money and that’s it. A simple and quick process if you’re in need of quick funds.

Borrowing may not be for you, that why on DeFi apps you can lend your money on the platform as well, allowing you to earn passive income by lending out the funds and earning interest on it. Interest rates on these platforms are on average around 2-5%APR, much higher than leaving your money in a bank and saving it, whose rates are a measly 0.1% per annum (or less!).

Currently the biggest and most popularly used DeFi apps are Compound Finance, UniSwap, CreamFinace and AAVE.

Yield Farming

I introduced the idea that DeFi can be a form of passive income, and that is what yield farming is. The concept of this relates back to staking coins, mentioned in my last blog. Yield farming is where “you lock up funds, usually on a Decentralised Exchange, which involves lending out your Crypto via DeFi protocols in order to earn a fixed or variable interest on your funds while also providing you with an exchange’s own DeFi tokens as a reward.” (Decrypt / Esat Dedezade, 2020)

It is called yield farming because Yield Farmers constantly rotate their “farms” (i.e., funds) in search of the highest-yielding opportunities” (Fang, Hor, Azmi and Win Win, 2021), to help them generate more passive income. ?For example, with my 2ETH I may begin staking it on the Compound Finance APP at 5%APR which is also rewarding me with its native DeFi token COMP. A month later I discover that Yearn.finance is offering a higher interest rate of 7%APR, so I decide to transfer my 2ETH (plus what I earned from interest) over onto Yearn.finance and stake it on their platform. Overall increasing my passive income without any barriers or restrictions from third parties.

However, don’t be mistaken into thinking staking and yield farming is a risk-free activity, like with any financial investment financial loss can be incurred through price fluctuations and “gas fees” (the fee charged by each Crypto blockchain for moving funds), Ethereum in particular over the past year has seen fees rise rapidly, hitting an all-time high of $4,372 on 12th May 2021, following the rising price for Etherium (James, 2021). Additionally, protocol hacks and software errors to the smart contracts is another potential area of risk. But there is something that can be done to offset this risk within the DeFi realm which will be covered in my next section.

Insurance

Although there are many areas of risks to Crypto, there are some forms of DeFi insurance which can negate certain risks from outside system hacks and smart contracts errors. Decentralized insurance acts as a safety net for the DeFi ecosystem. From wallet insurance to smart contract insurance, the comfort of knowing that your assets are protected in the case of a bug or a hack creates peace of mind for Crypto investors who are investing large sums of money (Campbell, 2021).

The top trusted Defi Insurance platforms out there today are Nexus Mutual and Etherisc. Both of which use risk pools to manage the risk of the insurance policy. The concept of risk pooling is where insurance premiums are paid by a large group of people to subsidizes the losses of large insurance claims while also reducing the premium price paid by each individual (Fang, Hor, Azmi and Win Win, 2021). ?

Smart contract bugs, errors and hacks can cause serious financial losses and are something which cannot be predicted. For more institutions to enter into DeFi they need to be convinced that it is safe. Therefore, demand for insurance is going to grow; Nexus Mutual is the largest DeFi insurance platform as of right now (Aug 2021) with a total active holding of $525 million. Currently the main two types of insurance covers are Protocol Cover (DeFi protocol hacks and smart contract bugs) and Custody Cover (risk of funds getting hacked or when withdrawal is halted). One of the great things about Nexus Mutual is that it’s covers are applied to centralised exchanges such as Binance and Coinbase, the two most widely used and trusted Crypto exchanges (Fang, Hor, Azmi and Win Win, 2021).

If you wanted to buy insurance through Nexus Mutual, you must first become a member, as Nexus Mutual was registered as a mutual company in the U.K, in which a mutual is governed by its members and only members are allowed to do business with the mutual, in this case claim insurance. And unlike traditional insurers, claims are decided through members voting on whether a claim is valid or not. For a claim to be valid, proof needs to be provided that at least 20% of your funds, under Protocol Coverage or 10% of your funds under Custody Coverage have to have been lost (Fang, Hor, Azmi and Win Win, 2021).

Insurance is another clear use case where DeFi is making a financial product easier to gain access to and more transparent in the way claims and pay outs are conducted. It is of course not the only way to reduce risk in investing and trading in Crypto, there is another financial product which can be used and is offered in DeFi.

Derivative Trading

Firstly, let me establish what a derivative is for those not familiar with it: within centralised finance a derivative is a financial security with a price that comes from one or more underlying asset instruments that reduces capital risk. The derivatives itself is a simply a contract between two or more parties based upon an asset or assets price usually being stocks, bonds, commodities or currencies. Check out Investopedia for more details.

Within DeFi this idea has been taken and applied to the price fluctuations of Crypto assets and also real-world assets such as gold and silver. Synthetic assets and Perpetual contracts are a couple of the different types of Derivatives that you can find and buy within the DeFi space. Each of them is going to be briefly explained and covered in this section.

To begin with we are going to take a look at Synthetic assets through the example of the Synthetix’s protocol which is the largest DeFi Derivatives exchange out there today, with a total lock-up of $1.45 billion (Aug 2021).

Image rights belong to DeFi Pulse

Put simply Synthetic assets are financial products that represent the same price or effect as another asset, allowing you to bet on their price movements of an asset and make money off of it, without actually owning the real asset. These types of products are called Synths, and on Synthetix there is no middleman or sign ups for acquiring these Synths, like with the other products mentioned, all you need to do is connect your Etherium Crypto wallet to the app and have a Synth token in your wallet. Another function of Synths is they can be traded frictionlessly between one another, meaning you can have synthetic Silver and swap it directly to synthetic BTC (of equal value) with no barriers. And now your Etherium wallet has access to any real-world asset (Indexes, Fiat Currency, Commodities). (Lau et al., 2020)

Data from Synthetix.io

The second type of Derivative and the most popularly traded within DeFi, is ?Perpetual Contracts, ?an advanced financial instrument for price speculation on an asset’s price movements without the need to hold the asset itself (Why Use Perpetual Contracts (and How Do They Work)?, 2021). It is essentially betting on an assets price movement and making a profit or loss depending on whether your predictions was right or wrong. One other characteristic that differentiates Perpetual contracts from other derivative contracts is that there is no expiration date on the contract. However, a maintenance margin is required to keep your position open (minimum account balance), otherwise your position will be liquidated (position is closed and funds lost).

Perpetual Protocol and dY/dX are the two-leading protocols in DeFi that do Perpetual Contract trading. On both protocols’ users can open up to ten times leveraged long or short perpetual contract positions (leverage meaning to borrow money from the exchange to trade at a larger position multiplying returns and losses). Meaning that low levels of capital is required for opening a position to receive high returns while also giving you full control of your own funds and the opportunity to participate in previously inaccessible markets or markets that did not exist.

Perpetual Contracts and Synthetics have been simplified on DeFi protocols and exchanges for the user’s convenience and are financial products that are no longer reserved for the elites, due to barriers to entry costs being greatly reduced for the masses.

Wrap-up

Hopefully from this blog you now have an understanding of what the term DeFi means, the concept of Smart Contracts and the different examples conventional financial product application that have been applied and adapted for Crypto use. With all four financial services covered in this blog: Borrowing and Lending, Yield Farming, Insurance and Derivative trading, DeFi simplifies the access to these services, eliminates the cost barriers of entry and some of the red tapes that you would encounter when dealing with centralised institutes such as banks and brokerages. With lending and borrowing, previous bad financial history can by passed, freeing individuals to financial opportunities that may have been restricted to them before. The returns from savings through the use of yield farming can truly be maximised to provide a passive income. ?Insurance through DeFi is more transparent and fairer for policy holders, insurance corporate greed is taken out of the equation. And derivative trading in DeFi has simplified the access to different types of derivatives for Crypto traders.

This only touches the services of what can be done using DeFi, if you are interested in finding out more CoinGeko, Coinbase and Binance have great resources you can access for free to further educate yourself.

Continuing my Breaking down Crypto series, the next post is going to take a look at some of the different types of Dapps out there to highlight other real world use cases of Crypto and Blockchain technology, which moves away from Financial services.