With Decentralized Finance, a new and independent financial world is developing on the internet. Many see the so-called DeFi sector as an opportunity to break free from banks and financial institutions. Others hope to make a quick buck. But how does DeFi actually work? What can go wrong – and where do you start?
It has been over ten years since the mysterious Satoshi Nakamoto introduced the digital currency Bitcoin and blockchain technology to the world. Many are now convinced that who Nakamoto is will probably never be revealed. And that is not even necessary. Because Bitcoin and the blockchain have already left a lasting mark on the world – and they still do. Even if, as people like to joke, the blockchain is a solution in search of a problem and distributed ledger technologies have been passed around for years by start-ups as a panacea for all kinds of problems: database technology has turned into one of the most important building blocks of digital evolution. Perhaps even a revolution.
Under the term Web3, the new database structures are propagated by tech pioneers and developers like Tim Berners-Lee, Jack Dorsey or Vitalik Buterin as the next stage of development of the internet. And as one that will only become visible slowly but will then break the power of large platforms like Facebook, Google and AWS and give internet users back control over their data. The key to this will be the decentralization and openness of the new systems. Users should decide whether and where they deposit their data. They can use services without revealing their names or e-mails and become providers of storage and computing power in the networks themselves. This is also made possible by the blockchain, which is not only stored, maintained, and secured on one or a few hundred servers, but possibly on hundreds of thousands of (private) computers. This makes the services almost uncensorable and difficult to switch off.
With Web3, however, not only the large providers of social media and cloud services are to be dethroned, but also financial institutions, banks, and payment service providers. Decentralized Finance – or DeFi for short – is the name of the movement that hopes for a global economy without borders and middlemen. Hundreds of thousands of mainly young crypto enthusiasts around the world are working on this new digital infrastructure. And quite a few of them have already made a lot of money with it. However, DeFi is currently anything but safe or secure. As with Web3, the responsibility for DeFi is to be handed back to the users. And with it, the consequences of errors and mistakes.
What is DeFi?
DeFi has only been possible for a few years – since the Ethereum blockchain added another important function to the principle of executing and storing simple transactions known from Bitcoin, i.e., moving values. Ethereum made so-called smart contracts possible. These are small contracts or protocols that are written in the blockchain and can be linked to complex programmes. These are executed completely automatically if the conditions specified in the corresponding contract are fulfilled. Several other protocols, such as Algorand, Polkadot and Kusama, Tezos, Radix, Cosmos, or the Binance Smart Chain, are trying to take the principles introduced by Ethereum further and make it cheaper for users to use, which is often expensive due to network fees. The race for the so-called Layer 1 protocol, i.e. the dominant blockchain technology in this new financial world, is still completely open.
With the help of the small smart contracts programmes, many more units of value – so-called tokens – have emerged, but also management, exchange and investment mechanisms that can function like an automated company – a Decentralized Autonomous Organization, or DAO for short. Multi-layered ecosystems are thus possible on and with a blockchain, which open fully digitalized financial services with cryptocurrencies and tokens – in parts also across different blockchain systems. All of this can take place completely detached from the classic banking and financial system. A classic user account is also not required for most DeFi services. Instead, users log in Web3-style with their digital wallets such as Metamask, Ledger, Coinbase Wallet or Polkadot.js, each of which supports different blockchains.
Stake and lend
The options for investing and earning tokens in this decentralized financial world are diverse – but sometimes also incredibly complicated. The simplest option is so-called staking, which can usually be done directly via the official wallet of a blockchain. For selected cryptocurrencies, however, this is now also possible on several crypto exchanges such as Coinbase or Kraken. In this case, the respective cryptocurrency is invested for a limited period. These deposits are then used to establish legitimacy and consensus in the network. Stakes are to these blockchains what computing power is to the Bitcoin blockchain. They underpin vital functionalities that keep the network running. Therefore, users are credited with an interest rate for their deposits, which can be up to 20 percent depending on the system – in some cases even more.
Liquidity staking works very similarly to normal staking. Here, users usually create fixed token pairs for a certain period, the native cryptocurrency of a blockchain in connection with a so-called stable coin or the token of a service that runs on this blockchain. This is then done in so-called pools on platforms such as Sushi Swap, PancakeSwap, AAVE , Curve Finance, Yieldly, Karura and others that offer decentralised exchange services for cryptocurrencies. With their paired deposits, users ensure that the platforms remain liquid for the corresponding trading pairs of tokens and are rewarded for this – often with a share of the fees and the exchanged tokens. The returns from this can vary widely. In some cases, investors are promised over 150 per cent in returns.
One experiment in staking is currently OlympusDAO. Here, a group of developers is trying to create a world digital reserve currency with the token OHM. “This works on the same principle as national banks do,” say the creators, “With reserves.” Except that with OlympusDAO, the reserves are to consist of a huge number of different cryptocurrencies – starting with the stable coin Dai. On exchanges like SushiSwap, users can swap their cryptocurrencies for OHM, which in turn can be used like any other cryptocurrency but can also be deposited in OlympusDAO itself as a stake. In this way, the user ensures the availability and value stability of OHM, which, if the creators have their way, will eventually match that of the US dollar.
Staking can therefore basically be compared to a savings account or fixed-term deposit. Other types of DeFi also have parallels to traditional investment options. These include the classic lending of money. This is possible on platforms such as Compound, AAVE, Celsius or OASIS. Here, users can deposit various cryptocurrencies such as Ether, Tether, Dai and many others into a pool. These deposits, together with the tokens of other users, are managed and lent by a protocol. However, anyone who borrows tokens must have deposited tokens themselves as collateral. The volume of these loans on such platforms often exceeds several hundred thousand euros per day. Depending on the cryptocurrency deposited, they sometimes offer several percent return.
The term yield farming has become established for earning interest with deposits on lending and liquidity pools. There are some crypto enthusiasts who develop complex strategies to get the most out of their investment. They often deposit their tokens specifically on different portals, borrow cryptocurrencies at a certain percentage at the same time and then invest them in other protocols or portals that promise a higher return. This is often a risky venture, as interest rates sometimes change within minutes. In the meantime, however, there are new services like Alchemix , which seek to reduce the risk of such transactions by automatically generating returns from the deposits that will continuously repay the loans.
Not always easy to understand
While some DeFi protocols work in a fairly comprehensible way, others initially seem incomprehensible or even like arcane crypto magic. For example, the platform Yearn Finance, whose homepage is filled with columns with initially incomprehensible designations such as yveCRV-ETH, Curve cvxCRV and yvBOOST-ETH, some of which promise returns of up to 50 percent. Behind them are so-called vaults – or dynamic financial strategy aggregators – that are managed by protocols in a semi- to fully automated way. Here, investments are converted into certain tokens, invested on other services, rewards are collected and reinvested again. Users can have a say in exactly how this happens with the Vaults and which strategies are executed if they hold the YFI token issued by Yearn itself. The higher the YFI value, the greater the voting rights. Other DeFi services such as Dracula Protocol or Badger Finance also rely on similar concepts.
In general, community participation is one of the key features of DeFi. Services like Rari Capital – which is already being called DeFi 2.0 because of its increasingly democratizing functionalities – now offer so-called FUSE pools in addition to the familiar investment pools. Here, users can create and manage pools themselves, i.e., develop their own strategies and protocols to create small money markets that work entirely according to their own specifications. Pool owners can determine which cryptocurrencies are included, the basis on which deposits are lent, what fees apply and what other services the pool relies on. Such pools can be open to everyone or just a small group that can invest together as a result.