April 6, 2021 7 min read
Opinions expressed by Entrepreneur contributors are their own.
With the European and global crypto markets going mainstream in 2021, the term DeFi — short for Decentralized Finance — seems to have seeped into the consciousness of the masses, at least those looking to invest in this yet nascent space. In this regard, it bears mentioning that the DeFi ecosystem has grown from strength to strength over the last 12 odd months, with the amount of money coming into this space increasing from $1 billion to $40 billion since Q2, 2020.
From a conceptual and operational standpoint, one can see that DeFi projects are designed to function in the same way as their centralized finance (CeFi) counterparts. This is to say that they enable users to lend and borrow funds, speculate on the price movements of various assets, earn interest rates and so on, much like traditional bank accounts except without a bank intermediating the transactions, thus removing the associated cost overhead and delays. Transaction rules, on the other hand, are enforced by the software, leaving no room for human error or oversight.
The onset of DeFi has been beneficial to both the crypto maximalists as well as the traditional investors looking for yield. The reason is that the so-called stablecoins are as eligible to participate as the traditional crypto. Stablecoins are the cryptocurrencies pegged 1:1 to conventional currencies and are backed by the respective reserves. Some of the most widely used ones are USDT and USDC, both of which are pegged to USD and can be acquired from most cryptocurrency exchange providers. Accessing DeFi through these eliminates price risk stemming from the volatile nature of cryptocurrencies.
The DeFi difference and how it can work to your advantage.
From the get-go, it is important to understand that before the advent of DeFi, crypto owners did not have access to any decentralized avenues for lending, farming, staking their assets. Centralized options were also few, far between and of questionable reliability. However, with this space continuing to grow, there are now a plethora of ways through which token holders can see their assets multiply.
The simplest and most convenient means of earning passive income through DeFi is by depositing one’s crypto into a platform that provides users with an APY (annual percentage yield). The core difference here is that while most banks provide users with interest rates ranging between 0.2 percent to 0.6 percent at max, DeFi returns can go as high as 15 percent.
As the name seems to quite clearly imply, the concept of “Yield Farming” entails the generation of a passive income stream via the use of a variety of different crypto assets. In its most basic sense, Yield farming can be compared with traditional finance offerings such as bank deposits, fixed-term deposits, and even government bonds wherein investors lock in their fiat assets with a financial institution, allowing for increased liquidity. This liquidity in turn generates growth for the institution, thus allowing for steady interests to be paid out to investors.
Similarly, yield farmers can make use of DeFi money markets, liquidity pools, etc to draw in steady returns for themselves. For example, an individual locks up 10,000 USDC (US dollar-pegged stablecoin) into a DeFi protocol, providing it with instant liquidity. In return for locking up these funds, the person is rewarded with fees generated by the underlying DeFi platform. These reward tokens can then once again be deposited in other liquidity pools, allowing users to constantly accrue a flow of income by continually switching between different protocols.
Popular platforms worth considering.
Uniswap: The name UniSwap has almost become synonymous with the term “passive income,” at least across the global crypto landscape. The protocol provides users with a tangible avenue through which they can earn returns on their assets by becoming liquidity providers (LPs).
In their most basic sense, LPs are those individuals that deposit an equal USD amount of two tokens, known as a pair, to a liquidity pool. Whenever these tokens are moved — for example, borrowed by a third party — the fee that is generated from such a transaction and is shared with the LP depending upon his/her stake in the pool.
UniSwap is perfect for those individuals who may be in possession of “idle crypto assets” and looking to invest their funds in a platform that is relatively risk-free and easy to make use of.
Aave: This is a platform to lend and borrow assets. You put assets in a pool — for example the USDC pool — and anyone who needs to get USDC can come and borrow some, by collateralizing the loan. Depending on demand they’ll pay roughly between 2 percent and 80 percent APR, while you’ll get between 0.5 percent and 75 percent APY for lending into the pool.
While providing to liquidity pools such as Uniswap involves some degree of risk (the “impermanent loss”) depending on the pair of assets you are dealing with, Aave is really the simplest product to understand: deposit 1 asset, get paid a certain interest percent in that asset.
Though on paper, the concept surrounding yield farming looks extremely attractive, it is not free of its share of risks.
The very first risk — the thing which resulted in the most money lost in 2020 — is greed. “Rug pulls” and “exit scams” were the No. 1 risk in terms of money stolen last year. A good reminder to do your own research!
The second type of risk, tech risk, means that if there is a bug in the smart-contract you are using, you could lose all your money, and that’s why you want to make sure they have been independently audited. For the same reason, you are best advised to not “put all eggs in the same basket” and deposit across several protocols.
There have also been a lot of attacks associated with “price oracles.” This is somewhere between a tech risk, a design risk and a financial risk. An “oracle” is the service through which a DeFi protocol obtains real-time price data. Those can potentially be manipulated or tampered with, especially since these instruments are totally automated and there is no way to audit or verify the accuracy of the data provided by these platforms. A lot of “attacks” in 2020 were executed through manipulating the price information of assets and getting a lot of tokens for cheaper than one ought to from a service.
Lastly it is no secret that the crypto market at large is the subject of daily price swings, causing the value of many assets to jump up and down wildly. In this regard, if the value of a cryptocurrency that is being farmed dips to extremely low levels, users could incur heavy losses compared to the currency they use to go shopping. Two hundred percent APY on something whose price is dropping by 300 percent a day isn’t going to make you rich any time soon. That’s a financial risk, and the conclusion is to choose your assets wisely.