The Beginner’s Guide
If you’re diving deep into the cryptocurrency world, you’ve probably heard of the term “DeFi” used to describe a variety of new protocols and assets.
First, it’s important to acknowledge that DeFi is a newer term and is now in wider use. This means that DeFi, short for decentralized finance, does not have a strict definition. Instead, it tries to define what a particular class of cryptocurrency is currently trying to achieve.
However, it can be said that DeFi cryptocurrencies have common points that emerge.
Most DeFi projects are software protocols that run on top of another cryptocurrency (usually Ethereum or Cosmos) and use a combination of that protocol’s crypto asset (as well as their own and maybe others) to automate a financial service.
In practice this is a great example cryptocurrency DAI .
Simply put, DAI allows users to “lock” the cryptocurrency in a smart contract running on the Ethereum blockchain, where funds are used as collateral to create new assets that power the lending service.
DeFi projects like DAI allow users to influence project direction. Or it could include what’s called a “management token”, a crypto asset that could allow it to earn profits from the service.
Proponents of Defi cryptocurrencies argue that these tools serve as “capital assets” similar to stocks and bonds. Therefore, while Bitcoin can serve as a pure money or store of value, these new crypto assets are aimed at exposure to the value of the service provided.
Note: The above is our best effort to summarize the latest state of the industry.
As always, you should be careful when analyzing projects and protocols. And this may be doubly true for projects operating on the emerging edge of technology.
What do DeFi protocols do?
As the number of DeFi protocols grows, it is helpful to understand the different classes of problems these projects are trying to solve.
The purpose of this section is when building your crypto portfolio. And what can help when diversifying is categorizing the various categories that popular projects fall under.
Lending and Borrowing
Focusing on lending, DeFi cryptocurrencies could allow users to take out loans with software, eliminating the need for a trusted third party.
These projects backed by code rather than paper contracts. It can automate the maintenance margins and interest rates required for lending. Among other things, this allows automatic liquidation if balances fall below the specified margin rate.
While each lending protocol has different nuances, they all act similarly. For example, there are typically two types of users. Those who lend their tokens to the protocol and provide liquidity to the protocol and borrowers.
Someone who wants to lend cryptocurrencies sends these tokens to an address controlled by the protocol, earning interest based on the amount lent.
Borrowers, on the other hand, provide collateral in the form of a cryptocurrency. They are then allowed to borrow cryptocurrencies as a percentage of the posted value.
If the protocols work as intended, users can easily borrow cryptocurrencies and owners can earn a return on their holdings.
Examples of lending protocols are Aave , Compound , yEarn .
Decentralized exchanges (DEXs) can allow true peer-to-peer trading of cryptocurrencies by allowing users to exchange crypto assets without the need for a middleman.
Users of the protocol can often instantly convert cryptocurrencies without needing to access an order book. Instead, the conversion rate can be included in the network.
The idea is that DEXs can provide access to trading pairs even if the volume of the underlying asset is too small for larger exchanges.
Another important benefit of DEX is that user funds are not held by central parties. Instead, the privacy of those using DEX is increased by being kept in personal wallets.
Examples of decentralized exchanges are Uniswap, 0x and Kyber Network.
Derivatives markets are where buyers and sellers exchange contracts based on the expected future value of an asset. These assets can be anything from cryptocurrencies to future event results to real-world stocks and bonds.
In protocols like Synthetix, users can buy and sell real-world assets such as stocks, currencies, and precious metals in the form of tokens on Ethereum.
In other protocols, such as Augur or Gnosis, users bet on the outcome of events. With Augur, users can create and exchange “shares” that represent some of the value of the results, such as election results or sports results.
Finally, protocols like dYdX offer users the ability to trade margin tokens, allowing them to leverage short or long positions in a variety of markets.
How does DeFi work?
As explained above, DeFi protocols use a combination of crypto assets to provide a service.
In doing so, advocates argue that these services may benefit over the offerings of banks and other central financial institutions.
Such services can be defined as:
Automatic: Users can access DeFi services 24/7 without the lengthy approval processes imposed by traditional financial institutions.
Open : Users can participate in decisions necessary for the service. (This may include the ability to vote on changes in rates, for example.)
Permissionless: Users cannot be denied arbitrary or recent access to Defi services to unfair regulation. Or you may be able to fork a project if needed or desired.
Trustless: Users may not have to rely on a central institution to access the service. It can only trust that the software will work as the code describes it.
Note: You should always check the code for such protocols to make sure it works as advertised.
Evaluating DeFi Protocols
Finally, the rise of DeFi has also spawned new metrics that claim to give insight into their performance. Note: These metrics are as new as the crypto assets themselves.
An emerging standard in DeFi is the “Total Locked Value” metric put forward by data aggregator DeFi Pulse. As of August 2020, more than $4.5 billion has been locked into DeFi protocols.
The metric attempts to show how much value is locked in cryptocurrency in the contracts of a protocol. However, this metric can rise and fall based on the par value of the assets stored. Therefore, it is possible that it will rise significantly without any change in base protocol usage.
Another emerging metric is “on-chain cash flow,” which aims to show the daily amount of money issued to users holding tokens that support DeFi protocols.
Note: The information, comments and evaluations contained here are NOT in the Scope of Investment Consultancy. Keep following the SinceCoin.