DeFi 101: How to Participate And Reap Rewards
Since DeFi first attracted the attention of the crypto ecosystem in the so-called DeFi summer two years ago, the concept has remained popular. Its adoption and usage, usually measured as a function of Total Value Locked (TVL), continues to rise dramatically: before the bearish markets set in, TVL rose by 240% in the last year to over $210 billion according to data from DefiLlama. For investors, not only has DeFi offered a means to invest in promising projects, but it has also helped tens of millions of them generate alternative, steady sources of income through a host of activities.
This allure of solid, low-risk returns is what continues to draw many investors out onto the ice. In this article, we shall define DeFi and delve into the ecosystem, some strategies to participate and earn rewards, and the risks, all of which are important for both private and professional investors considering investing in this space.
The Move From TradFi to DeFi
Let's begin by discussing the swift transition from traditional finance (TradFi) to decentralized finance (DeFi) over the past few years. Simply put, DeFi seeks to eliminate the middleman in processes originally performed by banks and financial institutions such as borrowing, lending, and market making. It enables investors to directly interact with one another on a peer-to-peer (P2P) basis by providing liquidity or loans for trading and taking on those roles/functions in exchange for fees, albeit while bearing the risks.
The most prominent factors used to describe TradFi include the fact that it is trust-based, as you must trust your bank as the only counterparty; that large barriers to entry remain, as countries like Nigeria still have almost half its population unbanked, and that TradFi institutions are often expensive, slow, and unfriendly to customers (most Nigerians have had a handful from commercial banks). This is in stark contrast to the DeFi world, which is built on smart contracts and eliminates the need for banks and all the formalities therein. Agreed-upon terms are recorded on and executed via blockchain mechanisms. What’s more, unlike TradFi, DeFi is the bank that operates 24/7/365.
The Building Blocks of DeFi
Looking at DeFi, there are layers that pile upon one another form a new digital service offering, much like building a house. Using the house as an example, the foundation is the underlying blockchain technology, which could be Bitcoin or Solana (layer-1 protocols). With blockchains, certain trade-offs will be required depending on which is used.
Then, on top of the foundation, we have our walls, represented by the respective protocols, also known as decentralized applications, or DApps, that provide services such as decentralized exchanges (DEXs) like Julswap or PancakeSwap, lending protocols such as Maker or Aave, and derivatives liquidity protocols such as Synthetix.
Next, you must build a roof over your walls, which is why there are "pools." When using a DApp, you can select which token to provide to pools. For example, when using Aave's service, you can choose to only lend USD Tether (USDT) stablecoins. Alternatively, you can only act as a liquidity provider for Binance Coin (BNB) and USDT trading pools on PancakeSwap. Consider going to a bank and saying you want to take a loan; you must also specify the currency in which you want to borrow. In the following section, we shall examine these activities in greater depth.
Finally, you have aggregators such as wallets like Ledger and Metamask, DEXs like 1inch and Sushiswap, and Centralized Exchanges like Kraken and Binance to plant a flag on top of your roof. These exchanges combine the services of various platforms into a user interface, making it easier to use. It is not uncommon to find crypto enthusiasts refusing to use centralized exchanges as they believe it contradicts the entire point of decentralization and self-custody of your private keys, which is your gateway to your assets.
We are comparing DeFi to the structure of a house not only for easy understanding, but also to demonstrate that if the foundation, or blockchain, has cracks, the entire building is at risk. As a result, when planning to invest in DeFi, consider the overall stability of the house rather than just the floor you are standing on.
Making Money with DeFi: How to Reap Rewards
Simply put, you can invest in DeFi projects/protocols by purchasing tokens and expecting capital gains when the prices of these tokens increase. Alternatively, you can use these platforms as a medium to earn from the various activities that DeFi offers. DeFi as a financial system is so rewarding that you can have your cake and eat it by investing in high-conviction projects money through the following activities:
Instead of getting a bank loan, you can get a loan through a DeFi protocol, which involves fellow investors providing the funds to be lent to you, or in essence, peer-to-peer lending. In exchange, the investors receive interest on the loan as a yield. When you take loans from your bank, you are often subjected to very hideous terms and short repayment tenures. When that is not the case, as a lender, there is the risk of your debtors defaulting or absconding altogether. In DeFi, all of this is mitigated as you can put your crypto assets up for lending and receive guaranteed rewards. You may also borrow to invest.
Getting started with crypto lending takes these easy steps:
- Register on a centralized or decentralized exchange and demand a loan, specifying the amount to borrow.
- Depending on their crypto lending rates, the exchange calculates how much interest is needed.
- Deposit the collateral into the exchange and apply for the loan.
- The exchange verifies your collateral and when the lender approves the loan, the funds are deposited into your wallet.
- Register on a centralized or decentralized exchange and select a specific interest rate.
- Offer your crypto funds up for borrowing and receive bonds in return.
- After approving the borrower’s loan, you receive more bonds once the interest is paid.
- Once the loan is paid or repayment time is up, the lender can return the bonds to redeem their funds.
- Smart contracts on the exchange execute the conversion of bonds to crypto.
Staking rewards you for participating in the consensus mechanism of a blockchain using staked tokens such as Avalanche (AVAX), Binance Coin (BNB), or Ethereum (ETH), effectively becoming a network validator. This is known as a proof-of-stake mechanism, and it is used to secure transactions and the network by blockchains such as Binance Smart Chain, Avalanche, and, soon, Ethereum 2.0. How staking works is that when these assets are staked (locked), they are used to confirm other transactions on the blockchain (consensus mechanism). In exchange for this, you earn tokens on top of your staked tokens.
To get started with staking, follow these steps:
Invest in a cryptocurrency with proof of stake. Select the cryptocurrency in which you want to invest, then purchase some coins.
Join a cryptocurrency stake pool; A group of investors that pool their resources to increase their chances of winning prizes is known as a staking pool. Additionally, a staking pool manages its servers, saving you from having to use your personal computer. Think about the costs involved while selecting a staking pool. Although they might vary greatly, anything above 5% is too expensive.
Finally, pick a moderately sized pool. Though you won't be able to validate as many transactions, smaller pools can give you a higher yield per transaction. In contrast, the largest pools will receive a sizable overall payout, but your portion might be small.
Start earning by adding your coin from your wallet to the pool.
3. Provision of liquidity
When you buy and sell stocks on the Nigerian stock exchange, for example, financial institutions like banks serve as brokers, providing liquidity in the form of shares or cash. These activities have been disrupted in DeFi by automated market makers (AMM) which run and operate as decentralized exchanges on automated code. To form a market, users known as liquidity providers (LP) combine two tokens in amounts that make them of equal value into a pool. They receive trading fees from the trades that happen in their pools. These fees accrue in proportion to their share of the total liquidity in return for contributing their cash. These pools include crypto vs. crypto trading pairs like BTC/BNB, stablecoins vs. stablecoins like USDT/USD Coin (USDC), and crypto vs. stablecoins like FTM/DAI.
For example, to earn Sushi tokens by providing liquidity to the ETH-DAI Liquidity pool, follow these easy steps:
- Deposit equal portions of DAI and ETH to the ETH-DAI liquidity pool.
- Receive ETH-DAI liquidity provider tokens (LPTs) from SushiSwap.
- Deposit these LPTs to the ETH-DAI staking pool.
- Receive the SUSHI token as a reward for staking.
In addition to receiving the SUSHI token for staking your LPTs, the ETH-DAI that was first deposited would also receive a percentage of the exchange fees collected on that liquidity pool.
4. Yield Farming
Assume you lent money to a liquidity pool, such as SushiSwap, and began receiving your first SUSHI rewards. You don't want them to be idle. You could put them to work again through one of several opportunities and reap additional benefits. In a nutshell, yield farming is the activity of constantly putting your tokens to work — money never sleeps — to chase higher and compounding yields across protocols, pools, and others.
All of these activities provide an annual percentage yield (APY) or fee share split that varies depending on: the platform used, such as Curve or Compound; services such as staking or liquidity provision, and underlying tokens, such as BTC or USDC. These gains can take the form of deposited tokens (referred to as "Supply APY") or the platform's native token (referred to as "Rewards APY"). For example, the SushiSwap protocol will give you SUSHI tokens, while the Aave protocol will give you AAVE tokens. Some of these platforms distribute governance tokens, which give owners the right to vote on the platform's direction, such as the option of becoming an activist investor.
With yield farming, it is important to keep in mind the concept of impermanent loss. When you lend money to a liquidity pool and the value of the assets you deposited changes from when you deposited them, this is known as an impermanent loss. The more significant the change, the greater the extent of temporary loss. In this instance, the loss represents a reduction in dollar value from the time of deposit to the time of withdrawal.
Let us take the example of Jake, someone who has lent funds to the ETH-DAI pool. Jake adds one ETH and one hundred DAI to a liquidity pool. The token pair that is deposited must have an equal value in the specific automated market maker (AMM). This indicates that the cost of ETH at the time of deposit is 100 DAI. Jake’s deposit was valued at USD 200 at the time of deposit.
Additionally, let us assume that there are 10 ETH and 1,000 DAI in the pool, which was sponsored by additional LPs like Jake’s. Therefore, Jake owns a 10% portion of the pool. Consider an increase in the price of ETH to 400 DAI. Arbitrage traders will deposit DAI to the pool during this time and take away ETH from it until the ratio accurately represents the current price. Keep in mind that AMMs don’t have order books. The ratio between the assets in the pool is what determines the price of the assets in the pool. The pool's liquidity (10000) remains constant, while the ratio of its assets varies.
The proportion of ETH to DAI in the pool has changed if ETH is currently 400 DAI. Due to the work of arbitrage traders, the pool presently has 5 ETH and 2,000 DAI. Jake decides to make a withdrawal. He is entitled to a 10% part in the pool, as we know from before. Thus, he can withdraw 400 USD, which is 200 DAI and 0.5 ETH combined. Since making his 200 USD deposit of tokens, he must have made some earnings. What if he had just held on to his one ETH and one hundred DAI? These assets' total current market worth would be USD 500.
Jake would have made more money HODLing ($500) than by depositing into the liquidity pool ($400). This is what we mean by impermanent loss. Given that the initial contribution was only a tiny sum, Jake’s loss in this instance wasn't very significant. However, keep in mind that impermanent loss can result in substantial losses (including a significant portion of the initial deposit).
The Landmines to Watch Out For
This could be an entire article in and of itself, so we’ll keep it simple and stick to some key highlights. First, use the house analogy to have a conscious awareness of your risk assessment across the layers and interdependency. With a focus on the protocols, or your counterparty risk, there are some specific levels you will want to review and ask critical questions on:
Is the team known or an anonymous group? You want to be investing in projects with known team members. What is their technical and practical background? Are there any large/well-known backers of the crypto community?
Have there been any hacks, are there third-party smart contract audits available, and do they have security bounty prizes posted?
Are governance tokens distributed? What is the current total value locked, and how are asset and active user growth numbers? Is the project managed by a community-supported decentralized autonomous organization (DAO)?
Is there a treasury that will make investors recoup their investments if there is a hack? Is there any insurance in place?
What are the APYs, and are they ridiculously high? — Is the APY stable, how much trading liquidity is in the pool, and is there a risk of temporary loss, lockup periods, or transaction fees? When you actively "use" your tokens to generate income, you are generally "hot" on these protocols/exchanges and thus more susceptible to hacks or counter-party risk. There are institutional providers, such as Copper, that provide secure custody not only for buy-and-hodl investors but also for token staking at a cost. These security and custody issues are a key distinction between investing in DeFi by purchasing tokens that can then be tucked away in cold storage and operating a strategy that is constantly and actively generating income.
To summarize, we have been witnessing and will continue to witness the creation of a new trillion-dollar industry right in front of our eyes. However, one last word of caution: Keep an eye out for too-good-to-be-true deals/APYs, as there is usually a catch, for fees that can suddenly balloon, diminishing returns on an active strategy and making smaller investments unattractive, and be cautious with the general safekeeping of your assets, as principal loss is possible.
If you're new to the game, start with some practice money and work your way up, testing and learning as you go. If you want to participate but don't want to deal with the hassle, you can also invest in professional managers who will design, implement, and monitor these strategies in an institutional setting. However, in your due diligence process of selecting a manager, you should use the same nuanced assessment approach you used earlier.