Are you someone who has ventured into cryptocurrencies only recently? Then you must have stumbled upon a category of crypto tokens known as DeFi, short for decentralized finance. But what does it mean? Let’s find out.
What Is DeFi?
DeFi is a broad term that includes a lot of different functionalities and applications. Such applications involve no regulatory body or central bank or any one person for that matter and are completely decentralized and void of any control by a single entity.
“Decentralized Finance or DeFi means removing any intermediary that acts or grants permission for doing any financial activities. The existing financial ecosystem falls into the centralized finance category, including centralized banks such as the RBI (Reserve Bank of India) which decide the inputs around the repo rate. DeFi is a peer-to-peer financial service that works purely on a Blockchain platform with little or no intermediaries,” says Gaurav Dahake, CEO and co-founder, Bitbns.
What Is DeFi-Based Lending?
This is a segment of DeFi which is rapidly growing. Normally, when you buy crypto tokens and plan to hold them for some time, there is no utility of these coins in the interim. By using DeFi lending protocols, you can put your crypto holdings to obtain a loan. These loans are easier to get and more affordable than the ones you take from traditional banks.
For instance, when you go to a bank to apply for a loan, the bank will check your credit history, conduct a KYC (know your customer) process and then look at the value of the collateral, if any.
On the other hand, the lender and the borrower come together on a DeFi lending platform and execute smart contracts. The borrower gives his crypto as a collateral and obtains a loan from the platform, while the lender gives his fiat money to the platform to earn some interest.
“With decentralization in place and no intermediaries involved, it becomes easier for buyers, sellers, lenders, and borrowers to interact peer to peer rather than a company or institution facilitating a transaction. For example, if a farmer can sell his produce directly to the end-user with no intermediaries involved, his margins would drastically improve and get fresh access to a new buying community,” says Dahake.
DeFi-Based Yield Farming Applications
This is one of the most promising use cases for DeFi. What happens here is that users earn tokens by locking cryptocurrencies in smart contracts running on the exchange’s trading platforms. These types of applications save the user time and money. This protocol essentially means that a crypto holder can farm for more crypto tokens by using the existing tokens.
There are a lot of different strategies to do this type of farming, however the most popular one is one where a platform like Yearn.Finance consistently moves the user’s tokens between a number of lending platforms in search for a higher return on a blockchain like Ethereum.
“Yield farming allows staking of crypto assets to generate high returns or rewards in the form of additional cryptocurrency. It incentivizes liquidity providers to stake or lock up their crypto assets in a smart contract-based liquidity pool. These incentives can be a percentage of transaction fees, interest from lenders etc. These returns are expressed as an annual percentage yield,” says Tarusha Mittal, member of Blockchain and Crypto Assets Council (BACC) and COO and co-founder of UniFarm.
How Do DeFi-Based Yield Farming Applications Work?
Yield farming applications work on a simple logic. Users lock up their crypto token holdings and earn interest on them based on pre-existing smart contracts. It is similar to staking crypto tokens but the difference lies in the operating mechanism.
Yield farming operates using several smart contracts and liquidity providers (LPs). LPs are users who are primarily in the system to provide money or liquidity to the smart contract system in exchange for a reward. The rewards earned by LPs can also be reinvested into other smart contracts. Ethereum blockchain is the most popular underlying technology for these types of applications. The rewards which LPs get are also a type of ERC-20 token. ERC-20 is the proposal identifier number in the list of official protocols for the proposals for improvements to the Ethereum blockchain network.
LPs provide funds into a liquidity pool. This pool is then used for creating a marketplace where users using smart contract systems lend, borrow or simply exchange their crypto tokens by paying a fee. Part of this fee is then given (in the ratio of the funds provided) as rewards to the LPs.
“Just like any other sector, there are both pros and cons associated with it; impermanent loss is one such risk. Under this, the price of assets locked up in a liquidity pool changes after being deposited and creates an unrealised loss. Another risk is that of DeFi rug-pulls where DeFi developers create a new token and pair it to a leading cryptocurrency such as Tether or Ether and set up a liquidity pool. But always remember, like any other investment it is important to Do your Own Research (DYOR) to avoid any risk,” says Mittal.
What Is The Future Of DeFi?
It is surprising to know that DeFi, a new segment in the crypto ecosystem is worth billions of dollars. As of December 30, DeFi was worth $96.68 billion, showed DeFi Pulse tacker. Coinmarketcap data showed that DeFi-related crypto trades were worth $15.45 billion on December 30. The amount of money locked away in DeFi is decided by the “total value locked” metric.
Such a huge amount of money flowing into the DeFi crypto ecosystem begs the question: what is its future potential?
“DeFi is all about code. With the help of smart contracts, your money is programmed to perform various functions. It creates a unique opportunity for anyone with a computer and internet connection to participate in the global economy,” says Sumit Ghosh, member of Blockchain and Crypto Assets Council (BACC) and CEO and co-founder, Chingari.
Also, the DeFi sector is currently attracting, a lot of funding. Recently, DeBank, a DeFi portfolio tracker which can currently track up to 17 chains, closed a funding round worth $25 million, at a valuation of $200 million, from investors including Sequoia China.
Just as with any new financial technology, DeFi too comes with some risks. “There are various risks in DeFi as it is at an early stage of infrastructure development. The first is smart contract risk—the technology can have bugs and you can lose your money. The second is market risk—the assets you lock in for lending can depreciate in market value,” says Santosh Yellajosula, member of Blockchain and Crypto Assets Council (BACC) and chief ecosystem officer, Xfinite, a decentralized entertainment ecosystem built on the Algorand blockchain.