What You Need to Know About DeFi

How Does Decentralized Finance Work?

What is DeFi?

Decentralized Finance, commonly called DeFi, has significantly grown in popularity and interest in the last few years.

DeFi provides an alternative to the traditional financial system of centralized entities like banks, stock exchanges, and brokers.. DeFi is based on two principles: (1) DeFi is open to everyone, (2) DeFi is trustless, meaning you can use it without relying on intermediaries or centralized entities.

The basis of every decentralized application is smart contracts. Originally, smart contracts  were run on Ethereum - which still has the highest concentration of dApps and Total Value Locked - but have since expanded onto new blockchains. Smart contracts are pieces of code which can execute transactions when certain conditions are met. Since these are hard-coded, transactions are executed trustlessly, without a human intermediary.

The Ethereum blockchain first popularized DeFi, but gas fees and transaction times became issues as demand rose. . These issues of scalability and affordability with Ethereum’s pivot to Proof-of-Stake in 2022.

New blockchains like Solana, Avalanche, and Aptos were created  to satisfy the increase in demand, each with their own active DeFi ecosystem. DeFi offers crypto users additional ways to earn, as well as the possibility of a more decentralized, private world.

How Does DeFi Work?

In the broadest sense, DeFi works by replacing fiat currencies with cryptocurrencies, and centralized entities with decentralized applications based ons smart contracts. In tandem, this enables a parallel financial services industry  with many of the same functions as traditional finance.

In centralized finance (CeFi), financial institutions guarantee your transactions in various ways, i.e. your credit card company powers a purchase at the grocery store or your bank promises to pay interest on your deposits.  While this can feel seamless, there is an inherent assumption that they aren’t using funds maliciously. DeFi removes the need for that assumption, by shifting the responsibility to hard code which is publicly verifiable on the blockchain.

Smart contracts can hold, send, and refund funds based on certain conditions. Once the smart contract becomes live, it cannot be altered. For example, smart contracts that are designed for loans are programmed to release the borrowed funds once the borrower has locked away their own funds as collateral. The contract is also programmed to release those locked funds to the lender if the price of the collateral falls below the loan-to-value ratio, or if the borrower defaults.

Smart contracts are also public, meaning anyone can inspect and audit them. They tend to come under the scrutiny of the community right away. They help identify bugs and possible issues. Reputable projects will often hire dedicated security services to audit their smart contracts, to reduce the risk of an exploit.

The DeFi Ecosystem

Under the umbrella of DeFi, there are a multitude of ways that you can utilize your crypto on different dApps. Let’s take a look at some of the most popular things you can do:

Lending and Borrowing

When it comes to borrowing, generally there are two ways:

1. Peer-to-peer: a borrower is matched with a specific lender
2. Pool-based: borrowers borrow from a pool funded by lenders

There are no credit scores in crypto, so decentralized lending relies on collateral locked in a smart contract as a guarantee for loan payment. The lender automatically receives this collateral if the loan is not repaid. Collateral can come in the form of different cryptocurrencies as well as NFTs on some platforms.

As a borrower, you can use your borrowed crypto to trade with, to lock in other protocols, or even use as collateral for another loan. For lenders, you can lock your funds and receive interest on your balance.

MakerDAO was the first to create the basis for borrowing and lending on Ethereum. With this protocol, you can lock in collateral in ETH and generate DAI in return, which you can use to save on their OASIS platform or to trade with. The underlying concept is the same for many other lending and borrowing DeFi platforms.

Stablecoins

Crypto is notoriously volatile, so the introduction of stablecoins helped create a way to temper that volatility. Stablecoins are coins whose value stays pegged to another asset, such as dollars or the euro. Stablecoins make it easy to earn on your crypto, because you can lock them in a protocol and earn interest on them, or use them as collateral for a loan.

Decentralized Exchanges

Decentralized exchanges (DEXs) allow users to exchange tokens via  smart contracts. DEXs are a popular way to trade tokens, as well as earn interest on locked assets. Many DEXs use liquidity pools to facilitate trading. In essence, lock their own tokens in a  pool, which is used for other swaps. This means there is no need to match each individual buyer with a corresponding seller; they can simply exchange with the pool. Those who lock their tokens in a liquidity pool, known as liquidity providers, receive a portion of the trading fees, as well as liquidity tokens on some exchanges. We wrote a detailed article on DEXs that you can check out here,

When a user wants to make a trade, they put an order in the pool, and the liquidity for the instant trade is provided by the locked funds. Total Value Locked (TVL) represents the amount of assets currently locked in a specific protocol and is an important factor in DEX protocols. TVL is used to measure the overall health of a DeFi protocol; the higher the TVL, the more smoothly the protocol is likely to run.

Trading

As with centralized exchanges, you can trade your crypto to make a profit. There are DeFi protocols that even allow margin trading, which is using borrowed funds in order to increase your position on another asset. Decentralized trading markets are open 24/7, and users always maintain control of their assets.

What is Yield Farming?

Yield farming is the process of leveraging different DeFi protocols in order to maximize the rate of return on your funds. Yield farmers switch between a variety of different strategies and protocols in order to get the highest returns. Once you understand how to use the different elements of the DeFi ecosystem, you can put that knowledge together to earn maximum yield on your assets across protocols and transaction types.

If certain tokens are generating more yield, yield farmers will swap their tokens. They will also move funds between different protocols that offer better returns. Yield farmers utilize the DeFi ecosystem to the fullest.

If you’re interested in learning more about yield farming, we have an in-depth article on the topic. To summarize, there are three main elements to yield farming:

Liquidity Mining

Liquidity mining is the process of distributing tokens to the users of a protocol as rewards for locking their funds in the liquidity pool. This adds additional incentives for users to lock their tokens in the protocol because they earn these liquidity tokens on top of their return of the trading fees. Users can take these tokens and use them to generate more yield from the protocol.

Leverage

Leverage refers to the process of using borrowed funds to increase the potential returns of an investment. Yield farmers can deposit their coins into a lending protocol to borrow other coins, which they can then use to borrow even more coins. This allows them to leverage their initial capital several times over, and start earning more returns.

Minimizing Risk

DeFi comes with inherent risk, but some protocols and strategies  are riskier than others. Leverage can generate huge returns, but loans are susceptible to liquidation. Some loans are overcollateralized, but if the price of the collateral drops drastically, the loan could be liquidated and the farmer loses their collateral. There are also risks in terms of underlying technology like smart contract risks as well as attacks on liquidity pools that drain them. Yield farmers can decide how much risk they’re willing to take. For example, providing liquidity comes with a relatively lower risk, but unless you re-invest your returns, the reward is lower.

Yield Farming Strategies

. It’s important to note that strategies can become obsolete in an instant if there are protocol or incentive changes. Hence,farmers tend to switch between protocols and strategies depending on which ones generate the most profit at the given moment.

Lending and Borrowing

Yield farmers can deposit stablecoins on one of the lending platforms and start earning returns on them. If farmers are rewarded with liquidity provider tokens, they can use them to generate more yield on the protocol. In a different vein, they can also use the deposited funds as collateral to get more tokens, but this of course comes with the risk of liquidation.

Providing Liquidity to Pools

Another strategy farmers employ is providing capital to liquidity pools in exchange for a portion of the trading fees. If liquidity mining is an option on that protocol, farmers can get even more rewards. These extra tokens will increase the farmer’s APY.

Staking LP Tokens

Some protocols allow users to stake the liquidity provider tokens they receive as an extra incentive for providing liquidity to a pool. By staking the LP tokens, yield farmers can receive even more rewards in terms of protocol tokens.  

Yield farming is relatively new and comes with its own risks, but it’s a great example of how crypto users can utilize the decentralized finance ecosystem to generate high returns. It’s proof that DeFi’s main ethos --  being a trustless, permissionless alternative to the centralized financial system - can be achieved, and can also be quite useful..