There has been a steep rise in disruptive cryptocurrency innovation over the past couple of years that has fast-changed the digital currency landscape. Today, one of the fastest emerging areas of the cryptoverse is decentralised finance, or DeFi.
It is the hottest and most impactful crypto trend that is upending the traditional financial system with the promise of a borderless, friction-free, decentralised, cheaper and faster alternative.
For the uninitiated, DeFi comprises a network of applications devised to replicate conventional financial products with cryptocurrency.
It works within a peer-to-peer ecosystem that does away with intermediaries needed to make decisions or approve transactions in the traditional financial system.
“DeFi is financial services, controlled not by humans or some entity, but by public smart contracts available on the blockchain,” says Viktor Prokopenya, a technology entrepreneur and founder of Capital.com and Currency.com.
“The functioning of the service is published on the public ledger, so that anyone can view them.”
This is typically why people say there is no legal entity behind DeFi, giving us the concept of entity-less financial services.
The DeFi market is booming as more enthusiasts, app developers and opportunistic cryptocurrency investors are drawn to it.
As of October 5, there is $55 billion worth of funds in DeFi-related contracts, a big jump from $15bn in 2020, yet significantly below its $180bn peak in November 2021, according to DeFi Llama.
While this year’s relentless cryptocurrency volatility may have slowed things down, experts say it is still early days for DeFi.
At its current growth rate, it is destined to become a major element of the digital economy as the world continues its pivot towards DeFi.
Investors looking to ride the latest cryptocurrency wave may want to dig into this handy guide to DeFi.
The inner workings of DeFi
Much of what DeFi applications do is underpinned by blockchain-based smart contracts that are used to design financial products that people can use without needing intermediaries such as banks or brokers.
Ethereum is the world’s first and most widely used smart contract platform. Developers can build financial applications on top of these blockchains.
“A smart contract is simply the programme behind the token and its code is published publicly on the blockchain,” says Mr Prokopenya. “They are considered a fundamental building block for DeFi.”
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These applications function autonomously and have a smooth interface with each other.
This gave rise to a DeFi ecosystem that allowed developers to create efficient, faster and highly profitable businesses, including exchanges, banks, insurance markets, derivatives markets, art markets, and robo-advisers, all working seamlessly and without human interaction.
“Ways DeFi is being used include through Decentralised Exchanges [DEXes], where the participants can exchange one token to another token,” says Mr Prokopenya.
DeFi apps are also attracting yield-seeking investors who can lock capital in smart contracts in exchange for returns of 15 per cent to 30 per cent.
DeFi: CeFi without the middleman
DeFi allows financial activities without an intermediary, effectively allowing you to be your own bank. Investors can use a DeFi platforms to earn yields, much in the same way as they do with their savings account — but without a financial institution involved.
This process is called staking, where “you lock crypto assets for a set period of time to help support the operation of a blockchain”, says Mr Prokopenya. “In return for staking your crypto, you earn more cryptocurrency.”
Just as banks do with fiat currency in centralised finance (CeFi), DeFi lending allows users to loan out cryptocurrency and earn interest as a lender.
“It is similar to holding funds in a savings account and earning interest over time,” Mr Prokopenya says. “That money is then lent out to other users or sent out to market makers, providing the investor with passive income.”
While interest rates fluctuate in both the CeFi and DeFi domains, the latter doesn’t require borrowers to pledge hard assets as collateral. Instead, DeFi borrowers provide crypto assets in a process that is entirely anonymous and without human intervention.
The reason DeFi generates higher benefits for users is that there are no bank branches, employees or other operational costs that CeFi must contend with.
The divergence between the two systems becomes more significant in the event of a loan default. Unlike in the conventional financial system, DeFi borrowers don’t repay with physical assets in the situation of a potential debt default.
Debt defaults are simply not allowed in DeFi.
When the price of cryptocurrency used as collateral falls dramatically, a preventive measure is activated. Cryptocurrency held as collateral is then liquidated to recoup the loan before the value of collateral falls below the loan value.
Bear in mind, though, that DeFi also possesses risks inherent with cryptocurrencies, including the prospect of intense regulatory scrutiny, extreme price volatility and the technology itself.
There is no provision or mechanism in DeFi for recovering assets lost due to technological or human error.
How to get in the DeFi game
Billions of dollars worth of cryptocurrency is locked into the DeFi ecosystem as funds continue to pour in. So, how do you plug into the DeFi bonanza?
DeFi is built with smart contracts that run on the Ethereum blockchain.
Thus, the simplest way to invest in it is to own Ether, or ETH, Ethereum’s native coin.
There are other DeFi-powered coins — such as Cardano (ADA), Chainlink (CHAIN), Aave (AAVE), Uniswap (UNI) and the Curve DAO Token (CURVE), among others — that can tie your portfolio to the fortunes of DeFi technology.
Not only do these coins offer exposure to various segments of the DeFi industry, but each token is also a ticket to ride the growth of their respective DeFi protocols.
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For example, if you invest in Ether, and the Ethereum protocol grows and attracts more users, it will boost demand for Ether, thus appreciating its price and the value of your investment.
Another way to play the DeFi field is yield farming, regarded as the most disruptive part of DeFi. It is a process of generating passive income by lending and borrowing on crypto lending platforms.
“You lend your money temporarily and because the business entity’s goal is to make a profit, you take a share in profit, earning passive income,” says Mr Prokopenya.
In addition to yield, some protocols offer an additional reward, in the form of a new token called the liquidity provider (LP) token, which the owner can hold, use on DeFi apps or sell for cash.
“The easiest way to begin is through staking and other passive income options,” says Mr Prokopenya, adding that it is a great way to “familiarise yourself with smart contracts, wallets and tokens with less risk”.
The road ahead
The continued convergence of blockchain technology and financial applications is expected to continue to expand the DeFi ecosystem. Supporters of DeFi say it is a more efficient alternative to the current CeFi system.
However, there may be some speed bumps along the way.
“This is new technology, so regulation is coming,” warns Mr Prokopenya. “It will also be brought into the sphere of tax regimes and there is now international consensus on this.”
All virtual asset providers will have to report transactions to tax authorities, which is a very significant move, he says.
Investors need to watch out for various cryptocurrency fraud schemes.
“The rule here is double check, triple check — be suspicious,” he says.
Fraudsters tend to exploit some technical risks inherent to the emerging DeFi system.
Yet, there is much for cryptocurrency investors to look forward to as the burgeoning DeFi economy opens doors to unique opportunities in 2022 and beyond.
It is a whole new way to gain access to the cryptocurrency market for both devout investors and those simply dabbling in it.
But be sure to research your investment thoroughly, do your due diligence and only invest what you can afford to lose.
Updated: October 27, 2022, 5:00 AM