Defi is a means of managing and growing your money. Virtually anything you can do with a digital bank or credit card can be done in Defi. Instead of fiat currency (i.e. the money that’s stored in your bank), Defi uses stablecoins, usually pegged to the US dollar or to a national currency such as EUR or GBP. Instead of using assets such as property, gold, or savings as collateral, Defi uses crypto assets such as ETH or BTC.
If you’d like to take out a loan in Defi, for example, you don’t need to declare your income, submit your tax documents, or prove your creditworthiness: you simply need to lock your crypto assets into a smart contract to be used as collateral.
Defi allows you to take advantage of the following services:
Saving/Staking
Defi wallets combine tools for money management into a mobile or desktop app, allowing you to earn interest on your crypto usually by staking crypto assets into a smart contract and to receive an agreed return paid in that same cryptocurrency.
Borrowing
Using the same platforms, you can borrow Stablecoins and crypto assets, in return for paying interest. Given DEFI is permissionless you can only borrow against existing crypto as collateral, that way credit checks and application forms aren’t necessary.
Yield Farming
Similar to staking, yield farming enables you to earn interest and secondary tokens by locking tokens such as ETH into a smart contracts. Whereas staking is passive – funds are locked up on a one time basis – yield farming is the active pursuit of the best yield so might involve multiple a complex set of steps e.g staking ETH to mint a synthetic ETH, yETH which is then staked elsewhere for a Stablecoin, which in turn is farmed elsewhere.
Liquidity Provision
Defi users can ‘pool’ tokens into automated market makers (AMMs) such as Uniswap. Every time someone swaps between the two tokens that are in the pool (e.g. ETH and USDT), you’ll earn a portion of the fee.
All of these services – plus many more, pertaining to things like credit, insurance, and derivatives – are provided by smart contracts. These are pieces of code that have been programmed to perform a particular task.
In traditional finance, these are processes that are performed by people, such as bank managers and accountants. Smart contracts automate this, creating a system that is more efficient and inclusive.
A smart contract can’t discriminate against you based on your income, gender, or nationality: it simply checks whether a transaction is valid (e.g. do you have enough collateral to receive the stablecoin loan you are seeking?) and then processes it.
For example, when you lend money using a Defi lending platform, you don’t have to worry about the borrower running off with it and never returning it. The smart contract ensures that you retain a claim to your original stake (i.e. the capital you loaned), and are able to withdraw it at any time.
Similarly, if you’re borrowing money using Defi, the collateral you must lock into the smart contract will prevent you from defaulting on the debt along with an agreed process for increasing collateral if its value falls below a certain level.
This results in a more transparent financial system in which anyone can participate.
Where do the high yields come from?
Hopefully you can now understand why DEFI is such a big deal. New technology is reinventing and disrupting banking. What was previously only possible on Wallstreet can now be achieved on a smart phone. New technology doesn’t on its own enable high returns on assets, so how exactly does DEFI generate such dramatically higher returns?
- Demand: The excitement around crypto, and the dramatic returns it is providing mean there is a huge speculative demand. People want to access to crypto – and those high returns – and are prepared to pay high rates to borrow it. Leverage is a huge driver of demand, where traders risk multiples of their capital to chase higher returns.
- Perceived Value: DEFI protocols create mini-economies by minting their own tokens which are earned as reward for staking crypto or providing liquidity. In a bull market perception is skewed to the point where every new DEFI token is perceived to have the potential for huge increase in value, without any specific justification other than being new and having a funny food-based name.
- Altcoin Trading: As the crypto economy grows, and without the ecosystem of new tokens and cryptocurrencies, so does the demand to exchange these new assets. Centralised exchanges have to follow clear processes for adding new trading pairs, whereas a DEX (decentralised exchange) can do this almost on the fly with AMM logic. This means there is a circular economy of token creation, farming and trading, with fees earned on the back of all of that.
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