- I may own some of the spoken about products/coins/ tokens below
- *None of this is financial advice *
- This insight is meant to be for newbies just as much for incumbents in the space, so you’ll notice I am a little elementary on explaining common phrases often defining some commonly used crypto terms or contrasting concepts between Trad-FI & DeFI
The adoption curve for cryptocurrencies has been growing exponentially, ignited by a colossal thrust from last years ‘DeFi Summer’. DeFi Summer of 2020 turned a new page for the Crypto space as we started to see real growth — truly exponential growth, over such a short period for DeFi related tokens.
But, what is DeFi? How do you get started? What should you look out for? To help in this regard, we have spent time and effort navigating a foundational introduction into the emerging DeFi space. Our focal lens has critically selected some of the most promising cryptocurrencies DeFi has to offer.
In 2021, as an investor exploring DeFi, you might begin to feel a great deal of excitement, as you start to comprehend that a new era for Finance could be upon us. So, for DeFi investors, it has never been more critical to gain an edge when approaching the new sector of DeFi. Due to the vast amount of information, complexity, and infancy of the DeFi industry. It is easy to become overwhelmed by a fast-moving sector that operates in 24-hour markets. So, identifying an approach to tackle this fast-moving space is necessary. This brief insight helps by swapping out speculation & looking at real drivers of growth.
Decentralised Finance (‘DeFi’) is a system that takes from the concepts & instruments in Traditional Finance (‘TradFi’), then builds them on Decentralised infrastructure & systems. These systems and infrastructures, in other words, are built on top of a Blockchain — an emerging technology. The goal of DeFi is to create and provide global access to Finance. Whilst being more transparent and resilient than traditional financial systems.
The unique aspect of this technology is that it utilises Smart Contracts. These are contractual agreements executed with code, without an intermediate to facilitate agreements between two parties.
These contracts help DeFi & the DeFi Applications become
- Permissionless, meaning they are open access.
- Truslestless, meaning there is no single point dependency on a centralised entity.
These are features of DeFi & dApps because they are built using Blockchain technology, which offers:
- Immutability (Security)
History of DeFi
After Bitcoin introduced a new peer-to-peer financial payments system in 2009. Ethereum shortly after brought us Smart contracts. This in turn meant organisations would then start to build on Ethereum and use their Smart contract functionality, one of the first being MakerDao. It can be disputed that DeFi first started with the first DEX: OASISDEX (2016) then after emerged DAI, a stable coin (2017), then UNISWAP (2018), or COMP (2018).
Although the glamour of DeFi really started to blossom in the period when the Crypto community across platforms like Twitter, Reddit & Youtube coined the phrase “DeFi summer”. This period was essentially the genesis Block for DeFi. MakerDAO ($MRK) & Compound $COMP, projects built on the Ethereum, ignited this hot period for DeFi. Maker, which formed the DAI stable coin was perhaps one of the most important projects in kicking off DeFi acting as an early pioneer.
Currently, around 50% of DeFi is built on top of Ethereum and has the largest share of TVL. However, this is gradually being chipped away by the growth of alternative Blockchains such as Avalanche, Solana, Fantom. They offer smart contracts with benefits such as faster and cheaper transaction costs.
DeFi has meant positive narratives towards Crypto have developed; this is because the speculation gap between what a cryptocurrency ‘could do’ in the future and what it does now has closed massively. As incentives for buyers to own Crypto can be driven by fundamental metrics like revenue & profit made by projects, compared with the past, where it was driven by a greater degree of speculation.
Growth in DeFi
The DeFI user base is exponentially growing as investors start to think optimistically & acknowledge the financial rewards of investing in DeFi. Data shows that towards the end of June, 2.91M Ethereum addresses alone interacted with DeFI, a 65% increase on the previous quarter, according to ConsenSys. DeFi offers consistent revenue-generating models that DeFi investors can look at, driven by the fees that protocols receive.
The size of the DeFi market can be measured by looking at Market Capitalisation (Market Cap). The Market Cap of the 100 DeFi coins currently stands at $135 billion, around 5.6% of a total market cap of approximately $2.5 Trillion.
Total Value Locked (TVL) is also a popular metric to illustrate this growth in DeFi that represents the total amount Staked across a given Protocol. Which essentially means the number of crypto currencies’ active’ in earning interest.
According to DeFI Pulse, DeFi on Ethereum has grown roughly 1125% from the start of 2020 & 450% from October last year, currently at around 95 billion TVL.
TVL across all chains has seen a 36,000% increase since the start of 2020, & year on year (YOY) 2180% increase.
3 Drivers of TVL in DeFi
- Borrowing & Lending
Interest rates help dictate the demand & supply for borrowing and lending, as it is the cost of borrowing and reward for lending. This functions very similarly to how it would in a traditional Banking system. In DeFi, there are subtle differences, such as being non-custodial, averagely offering a lower cost to borrowing and higher reward for lending. This is influenced by attractive yields & interest for making a deposit.
A Central Bank does not dictate rates for DeFi Protocols. DeFi interest rates are independent of a central authority, meaning interest rates in DeFi are more flexible and reflect the supply and liquidity in the system.
Collateral is essential to understand, as it represents something pledged as security until repayment of a loan. When you want to borrow in DeFi, you use your Crypto as Collateral to borrow against other Crypto, but this is often over collateralised. This is used as security in the case of default of repayment of a loan.
- Staking: Yield Farming, Liquidity Providing (LP)
Yield Farming & Liquidity Providing are all forms of Staking to earn additional interest. Typically through providing liquidity to DEXs. It involves depositing assets for interest, often paid in the tokens of the protocol. But, due to its decentralised nature, there are more opportunities to earn interest rather than just sitting in a bank.
Trading in DeFi involves the buying & selling of cryptocurrencies in a non-custodial manner without setting up an account and sending ID & address documentation. Known as ‘Know Your Customer (KYC)’, this makes them permissionless as trading venues. DeFi Exchanges that facilitate these trades are an alternative to trading on Centralised options.
Exchanges were the first significant revenue business model for Crypto, and this has been a very similar case for the first early-stage DeFi projects.
Blockchains that Enable DeFi
Centralised Finance (CeFi) & Decentralised Finance (DeFi)
There are currently more users of CeFi than DeFi, but this can change due to things like lowering the costs of making trades and deeper liquidity on platforms.
Liquidity is the volume to enable trades on the market — higher liquidity can mean lower slippage. Slippage refers to the difference between the actual price and the price you pay when executing a transaction on an exchange. For traders, slippage adds to the cost of traders, which is particularly something. Traders like to avoid.
Participation in the DeFI ecosystem can be tricky & costly for new time DeFi investors trying to use DeFi Apps (DApps). The process of setting up a wallet might be tedious as it’s your responsibility to handle your Security. Managing your Security is crucial as you have custody of your funds in the wallets you use to log in to dApps. Typically, a Centralised Exchange has control & custody of your assets, meaning you put trust in an Exchange to manage those risks.
In addition to this, there is also a question of cost. You can incur a high gas cost executing a transaction on chains like Ethereum. The cost of a transaction on the Ethereum Blockchain, measured in ‘Gwei’, is also called ‘gas’. These costs have been extreme of late, which can ‘price out’ some participants.
See below chart. This chart begins after the upgrade of ETH-1559 on July 8th implemented to help reduce transaction costs, which are still at 8–12(USD) a transaction, about 0.003 ETH and around 140gwei.
To be a DeFi investor, investing in DeFi related projects is possible without interacting directly with the DeFi protocol. You can, as an investor, do this through Centralised exchanges, which can prove to be easier than directly interacting with DeFi. Therefore, you have the reassurance that reputable CEX’s conduct research and then vet projects before listing.
Below are 3 DeFi Protocols All 3 have a growing user base with robust unique features.
AAVE is DeFi’s closest protocol to a Bank. It uses a money market system to enable borrowing & lending. It has a native token called $AAVE, which rewards users in staking rewards and governance on its protocol.
How it works
In a traditional borrowing and lending system within a Bank, a lender is matched with a borrower. The Bank acts as the intermediate, managing this. However, on AAVE, the protocol enables automatic, automated loans via smart contracts, which cuts out this middle-man.
For AAVE process works by Lenders depositing their Crypto into liquidity pools. These Liquidity Pools are essentially pools of funds that enable depositors to earn an interest based on their deposit, which will be lent out of the Liquidity Pools.
Borrowers pay the interest rate. This, however, depends on the availability of assets in a liquidity pool. Meaning, the rates fluctuate in accordance to meet demand and supply levels. Higher interest rates are used to incentivise lenders to deposit more & at a lower rate, the supply of assets is high.
In the traditional banking system, loans granted are under collateralised. However, with AAVE, the loans are over collateralised, meaning users need to deposit Collateral higher in value than the amount they borrow.
A reminder that Collateral represents something pledged as security; in the case here, Crypto is held until repayment of a loan, in case of default. It is implemented across the Crypto market because it is volatile. So, AAVE takes precautions to employ a liquidation process if the collateral value falls under the collateralisation amount.
- Price: $304 USD, 707% (YOY)
- Market Cap: $4bn
- TVL: $16bn
Uniswap is the most extensive Decentralised Exchange (DEX) & Automatic Market Maker (AMM) in DeFi. An AMM is a concept born out of DeFi.
How it works
Instead of using a classic order-book model of matching buyers and sellers to determine the price and execute trades, Uniswap uses a math equation ( x * y = k.), pools of tokens, and ETH to do the same job.
Through utilising any ERC-20 asset (Tokens built using Ethereum), users effectively provide liquidity to these pools (becoming LP’s) for each token offered to trade and then earn fees in $UNI in return.
$UNI is Uniswap’s Governance token; its only function is as a Governance token to vote Uniswap Proposals put through by the community.
- Price: $27 USD, 909% (YOY)
- Market Cap: $14bn
- TVL:$ 4.9bn
The largest & most liquid Decentralised Derivatives Exchange (DDEX), built on Ethereum Blockchain. Offering perpetual & dated futures, margin trading and spot markets, aiming to be the best option for trading tools in DeFi.The token $DYDX is associated with the protocol and was given in an ‘airdrop’ to past exchange users. It is used for governance, mining rewards, staking pools and trading discounts.
Derivatives make up a considerable slice of the Crypto market pie; their volume now matches that of top CeFI spot traded markets seen on big CEX providers like Coinbase; dYdX’s $5.9 billion in 24hours to Coinbase’s volume of $3.4 billion, one week ago.
The demand for DEX & DDEX’s is likely to continue growing as it becomes the only solution for some Crypto investors to invest & trade. Recent regional bans for buying and selling spot Crypto in China and the ban on Trading of Crypto-derivatives in the United Kingdom had significant positive knock-on effects for other providers. Participants from these regions will look for suitable alternatives to trade products that are now against the law in these regions.
How It works
By standard DeFi design, dYdX is a lending and borrowing protocol. Although, dYdX goes a step further, becoming the go-to solution for Ethereum’s decentralised margin trading. It boasts liquidity on par with some of the largest CEX’s in the market.
Users Deposit funds into their Margin or Spot Account to start lending funds to the protocol, or borrowing, ETH, DAI, and USDC currently supported. Users trade from their accounts directly afters their deposits from their wallets. In which the deposit from these wallets is then used to trade against different pairs. Users can withdraw their funds again back into their wallets.
Like most DeFi financial products, dYdX is readily available for anyone to use, with its users’ assets managed & run without intermediates by utilising Smart contract applications.
- Price: $22.4 USD, (YOY) N/A
- Market Cap: $1.25 Billion
- TVL: 980 Million
Timeline Of DeFi
How do I get started with DeFI?
Directly set up a wallet. A cryptocurrency wallet installed on your browser, Or Sign up to a CEX that offers DeFI tokens.
Is DeFI safe?
It depends on the protocol and the degree of quality to produce the code to make smart contracts. It’s possible for Bugs, which could result in compromising security, through hackers.
What is a DeFI wallet?
DeFi wallets are used to access DApps and the web3. Are non-custodial and key-based. The non-custodial trait implies that users could send and transfer funds to ensure that only they can access the funds.
Is DeFi regulated?
DeFi is currently subject to existing regulation laws. This can be subject to regulatory frameworks that apply to cryptocurrency projects, although those do not regulate the specifics of DeFi.
None of This Writing is Financial Advice.