Defi 101 A Beginners Introduction
What is Defi?
DeFi is Decentralized Finance. And it's not that new of a topic having first sprung up with the creation of Bitcoin in 2008/9, Bitcoin being the OG Decentralized Finance product. The official term only started coming up around 2016/17 with the emergence of Dapps and stablecoins on Ethereum. Since then,-098 DeFi has been gaining momentum, building functionality and cultivating an enthusiastic and thriving ecosystem of entrepreneurs, developers and financial players. Today a large portion of DeFi tools mirror traditional financial tools but in an open and permissionless way. (and with better memes).
Why do we care?
It's a hot topic at the moment, and not without reason. The goal of DeFi is to try to reconstruct our existing banking and financial system: It's Finance 2.0 built on Web 3.0.
Using DeFi tools we are able to open ourselves up to more possibilities in the market by breaking down barriers to entry for participation. In contrast to CeFi (traditional/Centralized finance), all you need to access this new financial system is a web3 connected wallet. Allowing anyone access to these financial tools without any intermediaries or the headache of tiresome paperwork, thorough KYC, and regulatory jump loops. This not only makes DeFi more accessible, but also riskier as we Wild West our way through new ways to make money, and just as easily, lose money.
It may also be important to consider the potential FUTURE regulations when thinking about DeFi - at the moment it's moving too quickly for regulatory bodies to keep up and implement frameworks in real-time. The technology is new, it's very much still in the “move fast and break things” of its development. I don't think even the ecosystem as a whole fully understands yet the full potential of what these new tools they are building may end up being used for in the future.
The current DeFi Ecosystem
How big is DeFi? At the time of writing this article, there is currently $14.09 Billion USD locked in Defi (see below). This is phenomenal growth since even just earlier this year in July when it was sitting at just $3.6 Billion (as liquidity mining was just taking off).
The Defi community is expansive and creative. As discussed in my presentation, there are *similar* echoes to the crypto hype in 2017 with a lot of money being made and a lot of money being lost, reckless investment decisions, unstable projects, exciting innovations. In my opinion, there will probably be 3 or 4 big players who end up capturing the majority of the DeFi market (currently Maker, WBTC, Compound, Uniswap and Aave are sitting as the top 5), but the race is far from over with new projects and innovations still springing up overnight every day.
What DeFi tools exist at the moment?
In the image below, you can see a snapshot of the DeFi Ecosystem as of December 2019, the reference taken from CryptoDiffer. I chose this image as it provides a good and simple birds-eye view of the different types of tools and projects that make up the DeFi ecosystem - displaying how much potential there is for growth and new players.
I'll explain the basics of a few of the main types of tools currently being used and developed in DeFi to show how they are currently mirroring traditional CeFi functions:
Lending platforms - Borrowing, lending, and earning interest using cryptocurrency. (Examples: Compound, Aave)
Decentralized exchanges (DEX) - Online exchanges that enable users to trade cryptocurrencies directly, without having to trust any intermediaries (Example: Uniswap)
Stablecoins - A cryptocurrency, pegged to the price of an outside asset (most commonly the US dollar) to reduce fluctuations in price.(Examples: DAI, USDC)
Prediction markets - Users can bet cryptocurrencies on the outcome of specific events (Examples: Augur)
Wrapped bitcoins - An ERC20 token pegged 1 to 1 with Bitcoin (Example: WBTC)
Other examples include asset managers (like Balancer), synthetic asset builders (UMA), no-loss lotteries (Pool together) and many more.
Let's take a step deeper into DeFi
Now that you have the basics, we can start exploring some deeper creative concepts that emerged out of DeFi's inherent trait of being a high composability system. You may hear DeFi referred to as “Money Legos”, this is because all of the available elements and tools can easily be assembled in various combinations giving them new functionality and competitive edges - again reiterating the potential for exciting new developments to spin out of this industry.
A good article explaining how different protocols can fit together was written up & explained by Totle. If you want to dive into how this works I'd suggest giving this article a read.
Liquidity Mining
Liquidity mining is the process of depositing/lending your ERC20 tokens with a mining mechanism to provide liquidity for a product's fund pool in hopes of making a return.
The main reason that Liquidity mining became a thing is that new protocols starting up don't inherently have liquidity of their own to get started.
So protocols started creating their own native tokens and offering it out to users for free in exchange for them providing liquidity on their platform. (Please note that this is not buying, it's essentially you earn a token by locking up one or more other tokens, e.g. adding ETH and DAI to a pool and earning UNI)
By doing this, users get free tokens and a platform that previously had no intrinsic value, now has the liquidity to work and kick-off a thriving ecosystem. This liquidity is freely exchangeable back and forth and there are no vesting periods attributed to these tokens.
So, why would people exchange their crypto for tokens in an unknown protocol? Sometimes there is economic incentive to keep these protocol tokens (increasing value/governance), sometimes we're still just figuring it out.
Yield farming
Taking it a step further, we hit Yield farming - which is essentially Liquidity mining with extra steps.
Yield farming in DeFi refers to the process of putting crypto tokens to productive use in a DeFi market to earn interest.
This can be done using money markets, liquidity pools or incentives. For example, by continuously wrapping your tokens up in different liquidity pools, users are able to generate returns on their initial investments, either through transaction fees, token rewards, or simply capital growth.
A meme example to better explain this:
The Risks of DeFi
The joy of this super novel and fun technology is that it doesn't come without its risks.
As with traditional finance, bad investments in themselves can cause severe losses.
SinceDeFi is so new, it's still difficult to tell which products will be around for years and which may only last a few days. Over the last few months, 2020 has shown further risks when investing in DeFi. Some we were familiar with (hacks), some were new (rug pulls), and some were a lot more complex and unexpected (impermanent losses).
Other factors that are causing people to lose money are misinformation, trusting badly audited protocols, investing in unaudited protocols and so forth.
If you are new to crypto and new to DeFi it is 100% OKAY for you to feel uncomfortable diving straight into the deep end investing in the Sushis, Yams, Pickles or whatever other DeFi vegetable sprouts up over the next few months. Unless you're one of those that enjoys the gamification possibilities and treat the protocols for what they are right now, risky and volatile, you may stand to lose more than you gain.
I know that the FOMO can be real,but that being said, many people currently playing around with DeFi are doing exactly that, PLAYING.
We are still figuring it out and laying a foundation for future users to access these tools in a more user-friendly, accessible, safe and regulated way. As it stands, we are by no means ready to take over as the new financial system of the future, but hopefully, in a few years, we will be closer.
If you are interested in learning more about DeFi, or would like to bounce some ideas around about a DeFi product that you have in mind, I'd like to offer a free 30min consultation with me or someone from my team. Simply book a timeslot with us on our website or here. We've been fortunate enough to have built some pretty cool DeFi products for our clients over the past year and always look forward to hearing what new ideas are out there that we can help bring to life!
Terminology Index:
Commonly used words & terms you may have come across in DeFi or the above article:
DeFi - Decentralized finance (Finance 2.0)
CeFi - Centralized Finance (Traditional Finance & FinTech)
Money Legos - Composability of DeFi products: you can stack them all on top of each other to work together in unique ways
Stablecoins - Cryptocurrencies that peg their market value to some external reference
Liquidity - The availability of liquid assets to a market
Rug pull - DeFi projects that get lots of liquidity really quickly and then just disappear without a trace, with all the liquidity
Crop rotations - A farmer moves all of his collateral from all existing protocols and wraps it up in new combinations
In further articles we can dive into some more advanced concepts covering:
AMM - Automatic market makers, a smart contract that you can buy/sell/interact with it without having to interact with another person (bonding curves i.e. Uniswap)
Bonding curves - An AMM where the price to buy/sell is determined by a mathematical formula
Slippage - Predetermined in a BC at an exact set price, in a free market its still predictable, but less precise
Mempool - (a contraction of memory and pool) is a cryptocurrency node's mechanism for storing information on unconfirmed transactions. It acts as a sort of waiting room for transactions that have not yet been included in a block.
Frontrunning - Pushing a very similar transaction at a higher gas price
SLANG
Degens - Not necessarily technical people involved in DeFi
Degen Chads (See below)
Liquidity locusts - People following the biggest liquidity mining rewards in hopes of making some returns (Continuously searching protocols to find greener pastures).
Ape (v) - to enter a market with little to no research or even understanding of the market
Ape tax (n) when events, malicious or unintended, cause backfire to the early and often uneducated investors, especially if said issues are obvious.
Some suggestions on who to follow on Twitter:
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