DeFi explained

Bitwala Academy

DeFi explained

After ICOs, Hardforks and Airdrops, “Decentralized Finance” (short “DeFi”) is the most up-and-coming trend and hottest buzzword in the world of crypto.



“DeFi” essentially promises to enable anyone to perform the basic “normal” financial transactions (besides payment) on a permissionless (“decentralized”) blockchain - most commonly lending and borrowing - as well as the possibility of earning interest on your crypto. This alone should already be enough to garner significant attention.

DeFi fulfills the eternal crypto-mantra of “banking the unbanked” or even “unbanking” its users by relying on a web of smart contracts to facilitate transactions and enforcing them.

We will be looking into the main use cases, explain roughly how some of the protocols work and dive into some of the more intricate aspects of this realm.

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Lending

With DeFi, the times of parking your money on interest-free savings accounts are over. Put your crypto into a lending protocol such as e.g. Aave and start seeing your interest pile up! Using Aave, you will receive an “a-token” (eg aDAI for DAI or aETH for ETH) that represents your deposit.



Other protocols have different tokens but it’s always important to keep in mind that these tokens are your cryptographic receipt, so don’t sell or send it away. Aave will lend your money to traders or investors (see: Borrowing) and collect the interest these borrowers pay via Aave’s smart contract. When you withdraw (by “cashing in”) your token, you will get back your deposit plus the interest that you accrued during the period for which you had your funds locked up.

Fun fact: When you visit the Aave website, you can see your interest accruing in real time!



Risks: Do not ever sell or trade your a-tokens because you will lose access to your deposit. If your native currency is not the US Dollar, then you are susceptible to FX rate fluctuations. If the crypto you lend out is in high supply but short demand, interest rates will be lower than with others. Additionally, most protocols are in very early stages, and there might be bugs or exploits the developers have not foreseen. Please do your own research and only invest what you can afford to lose!

Borrowing

DeFi offers a quick and permissionless way to hodl your crypto and still make use of your funds if you see a trading opportunity or are just a bit short on cash. To take advantage of this opportunity, you can deposit $250 in ETH into a service like Compound or Aave, and take out a loan for ~40% of your “security deposit”. Apps like oasis.app or DeFiSaver have a very nice interface for this.



This opens what is sometimes called a “CDP” (“Collateralized Debt Position”), meaning you owe a Debt (e.g. 100 DAI) on the deposited collateral ($250 in ETH). You can pay back your debt or increase your collateral at any time! When you no longer need your DAI, you just send it back (including the interest owed) and in turn receive your ETH to your wallet.

Everytime you return to your CDP and connect your Metamask wallet to the dApp, you can check how healthy your loan is:



Risks: When the collateral’s price drops below a certain threshold (the “liquidation price”) your debt is “deleted” (more correctly: your collateral is automatically liquidated) and you keep your DAI. Most protocols are in very early stages, and there might be bugs or exploits the developers have not foreseen. Please DYOR and only invest what you can afford to lose! You can read all about it on bitwala.com/defi/borrowing


Trading on Liquidity Pools

There are a number of ways you can trade crypto. On centralised exchanges, you deposit fiat or crypto and add your order to the order book. (e.g. “Buy 1 ETH @300EUR”), or, If you’re deciding to buy ETH at any price (“Buy 1 ETH Market”), your order will be matched against the best matching order in the orderbook.


Liquidity Pools allow you to trade between almost all pairs that could possibly exist via your crypto of choice and/or stablecoins. The namesake mechanism to facilitate this is to “pool” the liquidity of hodlers and let anyone trade (or, more correctly, “swap”) in this pool, paying a small fee for each trade (often in the .3% to .5% range).



The pool acts as a “CCP” (“Central Counter Part”) for all trades, so you can be sure to always get one trade for the complete amount you want to buy or sell in a single transaction. If you are interested in providing liquidity to earn a part of the fees, see our upcoming video and blog post about “Liquidity Providing”.

Risks: Most protocols are in very early stages, and there might be bugs or exploits the developers have not foreseen. Please do your own research and only invest what you can afford to lose!

Liquidity Providing

Decentralized Exchanges like Uniswap and its competitors offer users to trade in these liquidity pools. However, instead of trading yourself, you can also add your crypto to the trading pool and earn a share of the trading fees. You almost always have to deposit both currencies that the pool contains, so e.g for the ETH/AMPL pair on Uniswap, you’d have to deposit equal amounts of each ETH and AMPL.



You will get an “LP” token (short for “Liquidity Provider” token) that represents your share of the pool. As is custom, you can withdraw your liquidity (and the fees accrued from your share of the stake) from the pool by returning that lP token to the DEX. All trading fees stay within the pool, so the more people trade, the bigger the pool becomes.

If you are not satisfied with the offering of trading pairs, you can even create your own pool by supplying an initial amount of liquidity and hope other market participants would trade on the pool:

You can earn even more interest when you hand over your LP tokens to a Yield Farmer (see: “Yield Farming”).

Risks: Volatile prices may lead to uneven development in the value of either of the two currencies you deposited (see: “Impermanent Loss”). Do not sell or send away your token (unless “Yield Farming”) or you will not be able to withdraw your funds! Most protocols are in very early stages, and there might be bugs or exploits the developers have not foreseen. Please DYOR and only invest what you can afford to lose!


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Yield Farming / Liquidity Mining

Some liquidity pool protocols offer a different kind of incentive to add liquidity to their trading pools (see: “Liquidity Providing”). The tactic of offering enhanced rewards by the pools is called “Liquidity Mining”.

The incentive often comes in the form of Governance Tokens (e.g YFI, COMP, MKR, CRV, see “Decentralized Governance”) which allow you to vote on rules and fee distribution within the protocol. These tokens often are traded at considerable prices on the markets, where you can sell them to increase your profits. Here’s where yield farming comes in - automating this process for you! Caveat: There are new Liquidity Mining and Yield Farming protocols popping up daily, some more memetic (ie named after foods or toys or hip hop songs). The projects we use as examples here are widely considered reputable. None of this is financial advice, please be very careful with your funds and always double check the addresses of the smart contracts!



Once you have deposited your pair of crypto into a liquidity pool (such as e.g. curve.fi’s “Y” pool which consists of DAI, USDC, USDT, TUSD), you receive your LP tokens (in this case inconveniently named “yDAI+yUSDC+yUSDT+yTUSD”, short “yCRV”)


You can then head over to iearn.finance and deposit those tokens to a “Vault”, which is a smart contract that handles all further transactions and is steadily improved to maximize returns.



As always, you will receive tokens that represent your liquidity, here: “yyCRV”.



If you don’t want to go through all this, there’s another Vault that accepts DAI, but in the end, your DAI will end up in the Y pool, as well.



The smart contract (often called “Vault”) will automatically look for the pool with the best returns and most trading, maybe borrow against your capital to create more coins to stake in another liquidity pool and - most important of all - sell the earned Governance tokens on the markets! The returns are used to buy more crypto and re-deposit into your liquidity pool. This can create annual returns anywhere from 30% to 1000% (depending on the crypto you deposit initially and the Governance Token that is “farmed”). As always you will get your “pay out” when you withdraw your funds at the end, in the meantime, you can check your projected daily, weekly and monthly growth in the yearn.finance dashboard or get a more detailed overview at yieldfarming.info.

Risks: Not your keys, not your coins! By handing over the LP token you are basically giving the Vault free reign over your liquidity. It’s not easy to see what permissions the contract has, so DYOR! Also, the more volatile the crypto you are staking is the higher (generally) the return. If some of your stake is very volatile, you might earn 1000%, but if the price of the token or currency crashes to zero, you have exactly that. So to begin with, stick to currencies or tokens that you know will have a future.

Impermanent Loss

“Impermanent Loss” is a risk that Liquidity Providers take when supplying liquidity to the pool of almost any trading pair on a DEX. It describes the scenario in which these currencies trade unfavourable against each other. Ideally, the fees you earn in the pool should cover this risk, but if the pool you stake in has little volume while prices are volatile, the impermanent loss may become “permanent” at the moment you decide to withdraw.


When staking in a pool that consists of ETH and BTC (in whichever form), market prices may lead to your BTC position decreasing and your ETH position increasing. This can happen if users deposit ETH and withdraw BTC from the pool, maybe in an attempt to take advantage of rising ETH prices and selling to BTC. The “impermanent” loss you take is the difference between the value of your stake in the pool vs the value of your stake if you had instead held it in your wallet. The more the price of the two currencies relative to each other diverges, the larger your loss becomes.

In this example, should BTC stay stable and ETH experience a 200% price gain, you will get back fewer ETH and more BTC than you staked. Your overall performance would have been better if you had just HODL’d both currencies instead of staking them in a pool.

This concept is not easy to break down and understand, but it poses a significant source of risk for your stake. To avoid full exposure to this risk, you might want to limit yourself to staking in pools that are at least 50% of stablecoins.

Decentralized Governance

Most conventional companies employ a rather clear hierarchical structure. Although the shareholders may represent a majority of the voting power, the management will devise and implement a strategy that benefits the company (and shareholders). If the management does not fare well, they will get fired and a replacement is hired. In DeFi, some protocols have chosen to hand over most or all voting power to the participants in the network via governance tokens. These tokens can be acquired by e.g. adding liquidity to the protocol’s bliquidity pools or lending crypto that the protocol can then distribute to borrowers. This system creates a quasi feedback-loop of participational incentives and in some cases have led to incredible demand for these tokens.


Lenders or LPs collect interest on their deposits and therefore have a stake in the well-being of the protocol. By adding the ability to also become part of the governance of the protocol, the users are incentivised to propose new features that increase the network effect of the protocol as well as vote on those which they want to see implemented. The governance tokens can be traded, lent and borrowed just like any other token (see also: Yield Farming).

Most protocols require you to “lock up” the Governance Tokens for a length of time to be eligible to vote. Additional incentives to lock your Governance Tokens or vote may consist of a share of the interest that’s collected throughout the whole system.

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