Beginner’s Guide to DeFi
What is DeFi?
“I want my bank to have even more control of my life!”
Said no one. Ever.
DeFi stands for “Decentralised Finance”, as opposed to the centralised, regulated kind of finance that rules your life with an iron fist.
The promise is this: you can be your own bank! You can lend! You can borrow! You can trade! No credit rating can stop you!
It’s a big idea that you might find either exciting or scary, depending on your personality. Don’t worry though: there are ways to profit from DeFi that are suitable for beginners, or people just dipping their toe in the Ether.
How does DeFi differ from traditional finance?
DeFi is exclusively digital numbers in a database. The “tokens” that run it don’t exist physically. However, most of the dollars in circulation in the world don’t exist physically either. The big difference is where the numbers are stored. Centralised Finance stores its numbers in its own servers, which it shares with trusted third parties (including Governments).
Decentralised Finance records are stored in public, on a network of privately owned computers, and while the transactions are traceable, the people generally aren’t (there’s no visible database connecting identities to blockchain addresses). The people owning the computers have no control over how the blockchain works.
This probably sounds scary: but blockchain technology was built to operate in the open without having to trust the people doing it (“trustless”), and to let anyone join in (“permissionless”). This makes the technology impossible for Governments to control or exclude people from.
Another big difference is that DeFi doesn’t deal in actual currency! It deals in “digital assets”. In this context, a digital asset is a “token” you can own that lives in a digital ecosystem called a “blockchain”. The tokens act suspiciously like money but are treated by the legal systems of most countries as property. This has some unexpected tax implications!
A “blockchain” is a shared global database on many privately owned computers worldwide. Its primary job is to record transfers of assets between “addresses”. An address is like a mini-wallet that can “hold” tokens, and a blockchain can have an infinity of them.
Then they borrow (for example) 72% of that value as something else that they think might go up in value. The borrower hopes to make a profit on that Crypto so they can pay back the loan and any fees. If the loan isn’t paid back, then the lender keeps the underlying USD Stablecoins.
You can certainly make a profit off this activity, but it sounds stressful at both ends!
P2P isn’t the only option available to borrowers: some Crypto apps and exchanges also offer the chance to use your Crypto/Stablecoins to borrow other Crypto.
Why on earth would anyone do this?
In a phrase: “Yield Farming”. The idea is that you make a profit in one place, and re-invest it in another to make more profit, and then continue doing that.
Sounds good? Well, in theory, it’s a sound idea if your research and maths are good enough to find the opportunities.
There are some drawbacks though.
First of all, we’ve mentioned transmission fees. Moving your tokens from one opportunity to another can wipe out any profit you make until fees become much lower.
Secondly, when you’re farming it makes sense to wait until the crop is “ready” before harvesting it, otherwise you’re just micromanaging tiny sums that don’t generate any meaningful return. This means that for some of the time, the yield is doing nothing.
It can be argued that the best kind of Yield Farming is the kind that happens automatically: i.e. your yield is re-invested automatically. That way, it is never just sitting there.
The Future of DeFi?
That’s still in the hands of regulators and politicians. They might not be able to police the ecosystem, but they can certainly police the companies and individuals that interact with it.