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DeFi Complete Guide: How it Works & Applications

DeFi Complete Guide: How it Works & Applications
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You can’t trade crypto for long without hearing about DeFi. What first started as a trend now has a market size of $100+ Billion. After growing five-fold in one year, investors now expect it to reach $800B by late 2022.

That’s twice bigger than Ethereum’s market cap. And about two-thirds of Bitcoin’s. DeFi is the fastest-growing market by comparison.

And you’re still on time. But what is DeFi anyway? Why is so much money going into here?

The DeFinition

Since DeFi is everywhere, you probably already used it without knowing. Exchanges like Uniswap, staking features on Binance, crypto loans. All possible only because of this technology.

“Decentralized Finance is a broad term used to include all the blockchain applications for finance.”

In crypto, decentralization is synonymous with public (permissionless) blockchains. Instead of one entity, you have multiple users controlling the network. There’s no need to trust each other, as the blockchain is transparent and built for the community.

In finance, decentralization means there’s not a single company controlling the platform. Instead, there’s a blockchain smart contract (explained later) that involves multiple users to make decisions based on a contract (the protocol).

Thus, DeFi offers financial services without intermediaries. 

Besides decentralization, it has the same features as banks (if not more).

DeFi VS CeFi

To understand what makes it different, let’s compare Decentralized to Centralized Finance (CeFi).

First things first, crypto does not equal DeFi. If it’s regulated by a company, it’s CeFi. That includes banks, private lenders, exchanges like CoinBase, crypto-payment services (like Crypto.com), and anything requiring ID verification.

CeFi is the traditional financial system. A bank offers you financial services and charges you for using them. Centralized Exchanges(CEXs) do the same.

CeFi works because of trust. You trust one company to perform an action AND keep your money. And because you trusted, the money is no longer yours unless the entity decides to return it. 

Even though they do, they might use it on countless other activities for their own interest. There’s no transparency, only trust.

DeFi doesn’t involve trust because there’s 100% transparency. After the company launched the platform, only the smart contract can execute the trades. And while they still charge fees, users have full control of their money.

The DeFi Ecosystem

DeFi has a broad, complex definition. It’s hard to explain without all the jargon words that belong to it. Especially when all DeFi platforms use them.

Before we put everything together, here are the seven most common terms of DeFi (made simple):

Yield Farming

When it comes to investing, yield farming represents over 90% of DeFi apps. It simply refers to any strategy involving passive income in crypto.

The yield is what you get from your investment: interest, token rewards, platform fees. Farming suggests the exponential growth you can achieve by lending crypto for interest.

The three strategies for yield farming are:

  1. Staking. You lend a token for at least one week to get interest
  2. Liquidity. You lend tokens to a decentralized exchange to get yield. After you lock your funds for 24h, you can get it back anytime. If many people provide liquidity, there’s a lower risk-reward.
  3. Margin/Leverage. In crypto, you can only borrow less than what you lend. Margin farmers lend money to borrow more, so they can lend more. This way, they multiply their interest income (and also the risk).

Total Value Locked (TVL)

Self-explanatory. It’s the sum of all crypto when staking, adding liquidity, and lending. It’s the total of all user yields in the platform.

If you lend $100, stake $200, and add $300 liquidity (another loan type), the TVL is $600. If ten people do the same, it’s $6,000. If you stake $200 and nothing else, it’s a $200 TVL.

It’s the amount put on the platform. If the TVL is $600 and you take back $100, the new TVL is $500. But why calculate TVL?

When compared to the market cap, TVL shows you the liquidity and risk of the platform. For example, PancakeSwap’s ratio is 0.22 ($4B market cap/$18B TVL), which means there’s liquidity and “low-risk” yield farming. The lower, the better.

APY & APR

Annual Percentage Yield is the yield (already defined) you get in a year. Unlike APR (percentage rate), it includes compound interest.

APY and APR aren’t that useful since the rates change every day. Due to crypto volatility, they might be 100%+ today or -10% tomorrow. Only when enough people lend crypto, the rates are somewhat consistent.

Even though it’s annual, you can still collect interest every day (1/365th). Either withdraw or reinvest.

DEX & Aggregators

Decentralized exchanges (e.g., Uniswap) is a dApp that uses DeFi technology. It’s an automated marketplace where users can trade directly. Rather than having a company hold the funds, DEXs use AMMs and liquidity pools (more on that later).

DEXs trade over 10,000 currencies, and you can add custom tokens. When a new project launches, DEX traders can buy it in the first minute. They don’t wait for CoinBase or Binance to add the token months later.

The only thing DEXs don’t have (yet) is stop-limit orders.

Aggregators are DEX search engines (e.g., 1inch, Yearn Finance). They automatically collect quotes from major DEXs and give you the lowest one. You can swap tokens there (for a fee) or go to the lowest DEX displayed.

Liquidity Provider

Unlike CEXs, DEXs don’t include wallets. Because they don’t store your coins. Instead, they execute trades with money lent by others (while keeping their loans safe).

Suppose you want to swap USD 100 for BTC. Someone has lent the platform $100 of both coins and now makes passive income. When you buy $100 of Bitcoin, liquidity providers earn from APY, DEX reward tokens, and the fees you pay.

Now, if you lend $100 to a $1000 pool, there’s a higher risk-reward than if you lent to a $10 billion pool.

The risk is volatility. If the token you lend changes its price, you may not get the same amount back.

Automated Market Maker (AMM)

AMMs for DEXs are like the order books of traditional exchanges. When you swap tokens in a DEX, the AMM automatically sends you a ratio from the liquidity pool. So you can trade anytime at any price, even when there’s no one trading at your price.

If a liquidity pool requires you to lend 50–50 (USD-BTC), the AMM algorithm changes the token price to balance that ratio. If you wanted to buy all the Bitcoins of a DEX, each BTC would become more expensive.

Arbitrage traders profit from these changes, closing the gap between pool prices and market prices.

Layer 1 & 2 Solutions

Even though you can trade +10,000 coins on DEXs, +90% of them belong to 2–3 networks: Bitcoin, Ethereum, and Binance. As you add more coins, users, and transactions, these “Layer Ones” get slower and more expensive.

Layer 2 is a blockchain built on top of the existing one. It achieves lower fees, fast transactions, and high scalability (without losing security). E.g., DEXs like QuickSwap build on Polygon, which is a Layer 2 network for Ethereum.

Trading on Layer 2 apps may cost you ~$0.15, while Layer 1s like Ethereum would charge $150+ in fees.

DeFi In Action

Now, how do all these interact in the DeFi ecosystem?

The DeFi term includes dApps and aggregators, but mainly DEXs. Unlike CEXs, DEXs execute trades with AMMs and liquidity providers.

Investors can estimate risk-reward by comparing the market cap and TVL. When yield farming, they can stake, leverage, or lend to liquidity pools for daily APY. Preferably on layer-2 apps for better speed and fees.

If you’ve read this far, not only do you understand this process. You now know more about DeFi than most traders. The question is: Should you invest in DeFi?

DeFi Benefits

If DeFi is multiplying its market size every year, it’s because there is intrinsic value. At least in early 2020, yield farmers were earning 100% to 1000% APY. Besides gains, here are three reasons for its growth:

Investment Flexibility

DeFi investors profit the most from price stability. That means either the coins don’t move (e.g., USD-GBP) or they change the same way (e.g., LTC-ETH), AKA correlated. As long as they do, yield farmers profit in all market directions.

(For example, staking rewards increase when prices fall.)

Non-DeFi traders? They only profit when the coin goes up. Yield farmers can profit when it goes up, down, and sideways.

That doesn’t mean it’s easy. But with strategy and analysis skills, it’s possible. 

If the platform you use has lots of liquidity (lenders), that will lower the risk.

Higher Efficiency

DeFi applications run on (transparent) smart contracts. Essentially, they are lines of code that execute with transaction fees (like Ethereum gas, AKA Gwei). So you don’t need intermediaries.

But you still need the funds for the approved transaction. That’s why we pay a fee to DEXs for using their liquidity pools. But when trading on Layer 2s, you reduce transaction time and fees to the minimum. 

Also note: Yield farmers profit both from high APYs and coin prices. High APY earns you more coins, and a high price increases their value. They can afford to lose on any of both as long as the other breaks even.

Automation

Centralized exchanges have limited liquidity. They can only offer swaps for a few hundred coins. If they suddenly get too much volume, they can manipulate the platform:

  • Put the exchange website in maintenance mode
  • Disable withdrawals for all users
  • Delay buy/sell orders for hours

On the other hand, DEXs have liquidity for +10,000 coins. No one can interfere with the platform, so you can trade what you need anytime. 

If there’s a lot of volume, transactions do get overpriced. But you can always use DEX aggregators to find a cheaper one.

DeFi Limitations

While DeFi has promising features, it’s not all that great for investors. Just because there’s APY, that doesn’t guarantee profits. And if you do, sometimes you could earn more if you just held the coin.

Here’s why DeFi investing isn’t what it used to be:

Variable Returns

DeFi platforms reward liquidity providers proportionally. To get the best yield, you need to find a good opportunity (like UniSwap in 2019) with low TVL. And low-TLV platforms are risky.

Let’s assume you lend $1000 to a $10,000 pool at no risk, +100% APY. You own 10% of that pool. And as you collect your yield, more yield farmers discover and join this opportunity.

A bit like Bitcoin. Once it’s booming, everyone wants a piece.

So the pool grows to $100K, and you now own only 1%. If you were getting 100% APY, it’s now 10%. It can happen within a month.

You do get more in fees and liquidity tokens, but it’s still not 100% APY. All successful farms gain liquidity until they eventually offer no interest.

Scalability

High-yield sounds easier than it is. If you play it safe with large liquidity pools, the APY rarely goes above 5%. Only the coins that need the most liquidity offer the best rates.

Typically the smaller, volatile ones.

Yield farming is hard to scale for investors because of the price-yield dilemma:

  • If you just lend high-yield coins (e.g., 1000%+), you’ll probably lose even more on price losses. The coin is so small that there might be no interest in trading it. For example, a 1000% APY coin worth $0.0000011 could fall by 70% overnight (and may not exist in a year).
  • If you look for price stability, there isn’t much to yield. Except for staking.

If you can find high liquidity AND APY, you will enjoy high interest for a few months until it falls below 5%. To maintain high APY, you constantly need to look for opportunities. Which aren’t always there.

High Entry Level

DeFi isn’t easy to get for beginners. Not only because of the tech but because there are not as many applications for everyday life. It mostly targets pro investors, lenders, institutional investors, exchanges, and financial companies.

What about the masses?

It’s a matter of time until DeFi gets more adoption. But what do you think will happen sooner, financial services? Or shopping, play-to-earn games, sports fan tokens, digital collectibles, VR…?

That doesn’t make it a bad investment. Even though DeFi expands rapidly, it’s not nearly as fast as if it involved mass adoption. That’s not going to happen in just a few years.

The Future 

At least in crypto investing, DeFi has a promising future. Whether you invest in financial projects or gaming NFTs, they all need a decentralized blockchain to work. That includes projects like Phantom, Curve.Finance, Aave, Chainlink, Cardano, Polygon, Uniswap.

As a long-term holder, you cannot go wrong with these. They are here to stay. 

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