How to Navigate DeFi
Anyone who has been following the crypto market over the last year or so would have definitely come across the term decentralized finance (or ‘DeFi’ for short). But what does the concept really entail? In its most basic sense, DeFi tech cuts out the need for financial intermediaries completely - primarily via the use of self-executing pieces of code called smart contracts - as opposed to centralized platforms like brokerages, exchanges, or banks.
From a conceptual perspective, DeFi projects work in exactly the same way as their centralized finance (CeFi) counterparts, i.e. they allow users to lend or borrow funds from others, speculate on price movements on a range of assets using derivatives, trade cryptocurrencies, insure against risks, and earn interest in savings-like accounts.
However, one of the key differences between the two avenues is that while centralized digital asset platforms require hundreds of full-time employees to oversee their day-to-day operations, projects like Compound, AAVE, dYdX (amongst many others) need 0 full-time employees, thus highlighting the fact that these platforms are totally transparent and automated in their overall design and functionality.
The rise of DeFi
The term ‘DeFi’ - an obvious play on the word Defy - first came into existence all the way back in August 2018, even though MakerDAO's stablecoin-based lending platform, which was launched in 2014 is credited as being the first such application. The goal of the technology was to help enable the creation of a financially inclusive ecosystem that could provide millions of individuals with direct access to quality monetary services, all while eliminating the need for any middlemen.
And while many DeFi projects continued to gain traction behind the scenes over the course of 2018 and 2019, it was only in 2020 that the ecosystem finally took off. In this regard, one can see that between June of last year and February of 2021, the total volume locked (TVL) — a metric that indicates the cumulative money locked across all DeFi platforms — rose from $1.07 billion to a whopping $42.7 billion.
The DeFi difference and what it means for the average customer
Straight off the bat, before the advent of DeFi, there were no real decentralized avenues for crypto owners to lend, swap, borrow, farm, stake their assets. However, within the last 12 months alone, we have seen the emergence of many DApps that can replace/complement many of the common conventional CeFi platforms that most people have become accustomed to using.
In terms of how a majority of these DeFi platforms work, crypto holders (who may have idle assets lying around or looking to dabble in this technological avenue) can choose to pool their tokens into any one of the many decentralized lending or swapping ecosystems in existence today. As these pools grow in volume, they become capable of issuing loans to individuals looking to borrow assets — all through the use of automated smart contracts which completely eliminate the scope of any human error such as mismanagement of funds, accounting discrepancies, etc. Also, it goes without saying that interest sums are issued to liquidity providers directly in relation to the stake they have in each pool.
Interest rates across various DeFi platforms (source: Defirate)
Lastly, since there are absolutely no middlemen involved in the entire equation (and the borrowing is pretty speculative), the amount of interest that one can draw can be potentially quite high, as can be seen from the chart presented above.
DeFi considerations
The DeFi ecosystem is still in its infancy and therefore, there are a few issues that are still quite glaring. For example, the annual percentage yield (APY) being offered by most decentralized lending platforms is largely variable today. So if you deposit a particular crypto at 11% today, the rate may be 2% tomorrow and so forth.
However, fixed rates, much like those offered by traditional financial institutions, are coming — and in some cases, such as Aave, are already there if you are borrowing — but most protocols still make use of a dynamic rates model for both lending and borrowing which can go from quite low to amazingly high.
This flexibility in rate is a bit annoying for the lender looking for previsibility in returns but a smart way to incentivize liquidity to move from pools that have too much to those which need more. The desire to “hunt” for the best rates is what brought about the birth of “aggregators” such as Rari Capital or Yearn Finance.
Also, while most lending platforms use over-collateralization to reduce their overall credit risk, this does not completely eliminate the issue, especially since a whole lot of crypto assets are notoriously volatile. As a result, a vast majority of DeFi platforms have no real method to recover from system-wide insolvency that may arise as a result of collateral assets experiencing massive volatility swings. On the subject, one can also see that collateral assets that back loans on DeFi platforms are subject to high-levels of variations - primarily in terms of their liquidity & stability of price. It’s also why some platforms, like Maker, accept stablecoins as collateral, since those tend to be a lot less volatile, removing some of the risks from the ecosystem.
Finally, while the number of incidents associated with the digital asset industry have decreased significantly over the last couple of years — with the amount of crypto being compromised due to theft and hacks dropping from $4.5 bln in 2019 to around $1.9bln in 2020 — it is worth noting that most of the issues that were witnessed last year were in relation to DeFi protocols, wherein nefarious agents were able to perform “rug pulls” and other exit scams in a pattern eerily reminiscent of the ICO Craze. These scams came to be not because the smart contracts of the protocols in question were badly coded (even though that also happened) but the vast majority of problems were witnessed due to dishonest people looking to make a quick buck, thus doubling down on the need for investors doing their due diligence before putting their money into any such platform.
About The Author
Mathieu Hardy is Chief Product Officer at OSOM Finance. Trained as a cultural anthropologist with a good dose of macro and behavioral economics. Curious about how the digital realm was offering a new playground for social sciences, Mathieu started to work in IT change management and quickly turned to digital business model innovation. At OSOM he found ample opportunities to leverage technologies in order to re-think business models for a more human-centered finance.