Decentralized Finance (DeFi) enables you to access a variety of financial services, from the basic sort that your regular bank would offer to the complicated instruments used by Hedge Funds and Investment Bankers, only with cryptocurrencies instead of traditional fiat currencies.
Staking your cryptocurrency in smart contracts, essentially locking your funds in an account indefinitely, allows you to earn interest known as an Annual Percentage Yield (APY), a term borrowed from traditional finance (tradfi).
As a thank you for staking funds and providing liquidity, each Defi project offers a token that has value only in the context of that project. That token allows you voting rights on the DeFi protocols' direction and has speculative value.
In just two years, DEFI tokens have shown significant increases in value. Likely the reason why you're here to learn how to gain from these increases. Let's dive in.
Before we get started, let us first address several terms you are likely to come across in this piece:
- Financial institutions are your traditional banks
- Centralized exchanges are crypto exchanges that are operated by a managing company
- Decentralized exchanges are crypto exchanges that are not managed by one company and typically work in a peer-to-peer manner.
- DeFi is decentralized finance and refers to the industry in which regular users can engage various financial services requiring only an internet connection.
How smart contracts work in the DeFi space
A smart contract is a digital agreement that automatically executes once the predetermined criteria have been met. These computer codes are facilitated by blockchain technology and rely on the blockchain that they are built on.
At the moment, your bank account from financial institutions might give you the right to a certain amount of monthly interest at a fixed rate. The deal is reached through a formal application procedure - which can take many days - that is handled by a mix of people and software and is acknowledged in writing. Once successful, the bank account is opened and you have access to the services.
A smart contract, on the other hand, uses a programming language (e.g. Solidity on Ethereum) to map out the mathematical aspects of an agreement - how much interest is due when and where it should be paid - while the underlying Ethereum blockchain executes the contract for a fee, making it transparent and unchangeable.
In this basic regard, Defi protocols restore the type of savings and investment possibilities that were formerly available only to traditional finance (tradfi), with the crucial distinction that it eliminates the middleman entirely.
Unlike in tradfi, with DeFi projects users interact with code and can avoid dealing with people and lengthy application processes entirely. DeFi allows users to tap into these wealth-generating opportunities in a democratized and inclusive manner.
On the downside, this means that there is no guardrail, so users must be comfortable with the degree of autonomy and trust in the execution of the smart contracts.
The ups and downs of the DeFi ecosystem
Defi projects typically offer significantly greater returns than those provided by tradfi APYs, which tend to be positioned around zero (some banks still offer negative interest on savings). Decentralized Finance on the other hand offer single to double-digit returns, a huge attraction for those looking to increase their capital.
Additionally to the higher returns, DeFi tokens have also seen a rise in value, with some entering the top 20 and top 10 biggest cryptocurrencies based on market cap.
There is, of course, a trade-off when it comes to the seemingly endless benefits of DeFi. Although Defi standards have several interesting and unexplored possibilities, they come with their own set of risks that you need to be aware of:
- Smart contract costs: smart contracts require fees in order to execute, which in times of network congestion, can be exorbitant. Look for Ethereum alternatives to reduce these costs.
- Smart contract vulnerabilities: not all smart contracts are created equal, and should your DeFi protocol not take the correct measurements or make an error in the digital agreement, your funds could become compromised.
- Users are entirely in control: created in the same decentralized nature of cryptocurrencies, there is no fallback should you lose your private key or make an incorrect transaction.
Ensure you vet various DeFi protocols before wngaging
In general, more established Defi protocols with a higher total value of assets secured within them (also referred to as Total Value Locked, TVL) are safer. This is due to the fact that their code has been more thoroughly audited and "battle-tested".
Newer platforms will typically offer higher APYs in order to entice investors and build up liquidity. While this may sound lucrative, always ensure that you've done your research in order to understand exactly how the protocol operates and who is behind the project.
Here are a few things to look out for:
- Has the protocol's code been professionally audited?
- How long has the project been live?
- What is the platform's TLV? (The higher the better)
Finding your top Defi protocol
There are a number of "well-established" DeFi platforms that have proven reliable and trustworthy in recent years. While the risks are still prevalent, these are the top options when looking to enter the DeFi space with the leading DeFi protocols.
How to use DeFi protocols (Get started in DeFi)
In order to engage with DeFi protocols and join the other liquidity providers, you will need a web wallet such as MetaMask. You will need to transfer funds from a centralized exchange, for example, you can use your Tap account to easily transfer ETH or other supported crypto assets directly to your MetaMask wallet, from where you can connect this wallet to the DeFi platform of your choosing. You will not be able to use funds from a traditional financial institution.
Once connected, you can then deposit funds into a lending protocol on any DeFi application and pay the incurring network fee. Any subsequent activities such as staking, unstaking, withdrawing your yield, will likely also cost a fee relevant to the cryptocurrency network you are using.
Understanding the risks associated with DeFi
While we've stressed that using tried and tested DeFi platforms provide a higher level of security, there are still risks associated with the DeFi space.
Below are some more steps you can do in order to secure your cryptocurrency assets and decrease the chance of losing your funds.
- Consider insurance
- Research the team behind the project
- Choose simple yield generation strategies
- Don’t invest more than you can afford to lose
Decentralized finance is one of the most innovative and promising areas in cryptocurrency. It is also a harsh environment, however, that demands some expertise before stepping in.
Before you place any funds into Defi protocols and become one of the many liquidity providers, ensure that you've fully vetted the project and considered the pros and cons of what it has to offer. Also ensure that you understand how the platform operates, i.e. if it says it offers 20% APY, seek to find out how they do so.
The DeFi space can be both lucrative and devastating, so make sure you know what you're doing and good luck out there.
Disclaimer: This article is intended for communication purposes only, you should not consider any such information, opinions, or other material as financial advice.