In a broad sense, DeFi refers to Decentralized Finance – the ecosystem of blockchain-based, digital financial tools which include everything from digital securities and cryptocurrency to NFTs (Non-Fungible Tokens) and CBDCs (Central Bank Digital Currency). However, DeFi also refers to a variety of peer-to-peer financial services that permit crypto trading, loans, interest accounts, algorithm-driven cross platform trading and other services. It is reliant on public blockchains like Ethereum and cryptocurrencies. The growth of the DeFi industry accelerated in 2020, growing from $700 million to $13 billion. It reportedly hit $40 billion this year, based on industry data across a host of sources.
As the global financial system continues to digitally transform, DeFi (in both its broader and more narrow definitions) has incredible growth potential – catching the eye of the world’s largest banks and investors. Yet, as with any asset class, it’s imperative to understand the asset, the market and the ways to invest.
One of the ways to invest in DeFi is to trade DeFi assets – tokens representing DeFi networks, applications or protocols, which typically involves buying low and selling high. It’s not for the faint of heart since there is also high volatility and risk involved. However, the opportunities abound. Some examples include Uniswap (UNI), Terra (LUNA), Wrapped Bitcoin (WBTC), and Chainlink (LINK).
Don’t feel intimidated by these new financial terms. Staking is just one more option to achieve passive income based on DeFi. Users lock or hold their funds in a crypto wallet to participate in maintaining the operations of a proof-of-stake (PoS) based blockchain system, and in return get a pre-defined interest rate. In a world of negative interest rates, getting a decent interest rate on your holding (especially if you were planning to hold these digital assets anyway) is not something to sneeze at. The total amount of cryptocurrency assets staked on DeFi platforms is worth around $21 to $23 billion, as of January 2021.
DeFi Yield Farming
Yield Farming provides another way to gain additional passive income for your Crypto holdings. Yield farmers make a living by providing liquidity in the form of crypto assets to a decentralized exchange (DEX). The DEX uses this liquidity to execute orders created by token swappers who pay fees. Based on their contribution, yield farmers earn a portion of these fees. This can be done automatically through an automated market maker (AMM) protocol that executes the transactions. There are a number of DeFi projects currently involved in Yield Farming, including Aave – a project that allows users to lend and borrow a number of cryptocurrencies. Another, Yearn Finance, enables users’ funds to move between difference lending and liquidity protocols to get the best interest rate. Finally, Compound is a platform that allows people to earn money on their crypto savings.
DeFi Lending & Lending Protocol
DeFi Lending platforms enable users to lend their crypto to someone else and earn interest on the loan. Defi lending can benefit both lenders and borrowers. It offers margin trading options, as well as allows long-term investors to lend assets and earn higher interest rates. It also enables users to access fiat currency credit to borrow loans at lower rates than DEX. Moreover, the users can sell it on a centralized exchange for a cryptocurrency and then lend it to a DEX.
Another way to invest in the DeFi ecosystem is through funds and trusts. This is the most, passive, “novice friendly” way to get exposure to DeFi. Some examples are Bitwise’s DeFi Index Fund, Grayscale’s Diversified DeFi fund, and Galaxy Digital’s DeFi index tracker fund.
Risk vs. Reward with DeFi
The diversity of investment opportunities, along with the continued growth of the market, makes DeFi an attractive and potentially very lucrative investment. However, as with any investment, there are risks and market participants should be informed before jumping in. Specifically, beyond the risk of the crypto volatility impact, there is also a security and fraud risk with DeFi that stems from the DeFi protocols that rely on smart contracts, which may have vulnerabilities that can be exploited.
The DeFi market, the technology that drives it, along with the needed regulations that will inevitably come, will only lower vulnerabilities and risk and increase the attractiveness of this digital finance tool. Be patient, be smart and never miss a good opportunity.