The information in this article does not constitute financial advice. All readers are urged to do their own research before making any financial or investment decisions, especially with novel financial instruments such as decentralised finance, where investors run the risk of losing some or all of their money.
When you’re new to the world of crypto, all this talk of DeFi, lending protocols, and asset farming can be a little overwhelming. Many people are asking ‘what is Defi’ and ‘how does DeFi work’.
In this article, we will break down the idea of Decentralised Finance into simple terms that everybody can understand.
Decentralized Finance gives everybody in the world access to financial instruments such as loans (where you can borrow money for a certain period of time) or high interest savings (where you get rewarded for simply depositing your assets onto a certain platform).
Some people in the world already have access to these instruments via their bank, but many others still don’t.
These individuals may be ‘unbanked’ (comprising 1.7 billion people of the global population according to a 2018 World Bank report which usually happens as a result of them not having access to documentation that banks demand (such as state ID and / or a credit rating), or they simply may not want to play by the self-serving rules of the increasingly outmoded financial system.
People who find themselves in these categories will inevitably also be presented with significant barriers to accessing financial instruments such as mortgages and loans, and research has shown that where such barriers are present, life-altering poverty tends to become rooted and worsen over time.
Banks may also discriminate against people who live or work in multiple countries, preferring to refuse access to financial services instead of running the risk that increasingly common, flexible life decisions are flagged up as fraud.
Other potential problems for economic migrants are refusal of service to blocked nations, extortionate international transfer fees, hidden exchange fees, and sluggish processing times.
In the world of Decentralised Finance however, all that a person needs in order to access this brave new digital world is a phone and an internet connection, and access to these two things is proliferating worldwide.
In DeFi, no ID documents are required, which means that for the first time ever, worldwide citizens have access to permissionless banking and financial services.
Loans for example can be secured without a credit rating, using algorithmic mechanisms such as over-collateralization, which is basically depositing more money than is taken out, to ensure that the platform doesn’t crash should users not be able pay back the amount that they borrowed.
This method was pioneered by the Ethereum-based DeFi protocol MakerDAO, and similar products can be found on protocols such as Aave and Compound, which are also Decentralised Applications built on the Ethereum blockchain.
Another great feature of DeFi is that it makes it easier for users to put their money to work, especially useful in a time when bank interest rates tend to be lower than 1%. The staking of cryptocurrencies on DeFi platforms can offer much larger returns, partly because most cryptocurrencies are deflationary in nature (their overall supply decreases over time, thus creating the potential for the price of the asset to increase). These staking rewards are dynamic however, and, like with the price of cryptocurrencies, can change greatly from day to day. That’s why if you’re not an experienced crypto investor it may be better to seek crypto investment advice, before interacting with DeFi products using cryptocurrencies.
A more simple option would be to buy stablecoins (non volatile cryptocurrencies that are pegged to the price of government currencies such as the US dollar) on user-friendly, centralised exchanges (such as Kraken) and deposit these stable coins into a centralised lending and saving app such as BlockFi.
Although centralised platforms present their own, internal security risks (see point 5 on our previous article which explains the difference between centralised and decentralised exchanges(8)) the plus side of centralised exchanges for new users is that they retain executive custody of your account and password, and can provide customer support in the case of problems.
Once you have deposited your stablecoins into a lending application such as BlockFi, you can expect a guaranteed profit of around 8-9% per year. BlockFi is regulated by the financial security laws of the US government, so any hacks or exploits will (in theory) be the responsibility of the company.
What many people find is that, once they have got over the initial hump of entering the crypto world and see how simple it is to move money around, they begin to develop the courage to use slightly more complicated protocols. But again, it’s always wise to seek professional advice before doing this.
For those who are more crypto-literate, over-collateralised loans can provide a quick and easy-to-access way to leverage crypto investments during a bullish market.
For example, an investor could use a protocol such as Maker to deposit 10 Ethereum tokens, take out a stable coin loan of up to 66% of their initial deposit, and then use these dollar-pegged crypto coins to buy 6 more Ethereum tokens.
If the price of Ethereum continues to go up, this process was a winner. If the price of Ethereum drops, then the initial collateral amount starts to get eaten up, which is why it’s always wise to post a collateral much lower than the maximum amount available. That way, when the price starts to drop, you can shore up your loan by adding more ETH (or in the case of Maker, ETH-based stablecoins) on top of it.
With DeFi, as with anything else, the trick is not to extend yourself further than the level of your confidence and understanding.