Decentralized Finance: The Best Way to Engage and Operate

Decentralized finance (DeFi) has been a concept in the spotlight since DeFi Summer 2020, as its usage, often measured in total value locked (TVL), has risen dramatically since then. According to data from DefiLlama, last year alone, TVL has increased by 240%, and the current "locked value" of DeFi projects has reached 209 billion US dollars. Investors can not only enter promising DeFi projects through tokens (hoping for capital gains), but also use these platforms to generate regular and stable income through various activities. And, it's even more attractive in a bear market.

It's the allure of reliable risk-free returns independent of crypto market movements that draws many investors into this risky space. Remember: there is no such thing as a free lunch. In this article, we will unpack the concept of DeFi and dive into its ecosystem, analyzing the strategies and risks of private and professional investors allocating capital to the decentralized space.

From TradFi to DeFi

First, let’s understand the transition (or disruption) from traditional finance (i.e. TradFi) to decentralized finance (DeFi). Simply put, DeFi disintermediates processes traditionally run by banks and financial institutions such as lending and market making by cutting out the middlemen. It allows investors to interact directly on a peer-to-peer (P2P) basis, provide loans or liquidity for transactions, and assume these roles/functions in order to earn fees, although at the same time assuming risk. Serial technology entrepreneur and co-founder of AltAlpha digital encryption hedge fund Marc Bernegger said: "The disruption of the banking industry that we have seen in recent years driven by financial technology players has now been upgraded to the next level. DeFi has laid the foundation for the p2p ecosystem. Basics." We will discuss the business model and participation methods of DeFi.

Common factors used to classify the TradFi space include that it is trust based, you need to trust your bank as the only counterparty, and that there are significant barriers to entry for banking services, still 50-70% of the population in many emerging countries No bank account. Banking services are often slow, expensive and not very customer friendly. What can you expect if they are only open Mon-Fri, 9-11am and 2-4pm? This is in stark contrast to the DeFi world, which is built on code that does not require a trusted intermediary; agreed terms are recorded on and enforced through blockchain mechanisms.

With the advent of the internet and the ubiquity of cheap smartphones, accessibility has increased dramatically. Digital assets can be accessed 365 days, 7 days, and 24 hours a day, and the global network coverage continues to expand.

As good as it sounds, DeFi still has a long way to go. For many, the topic remains complex and difficult to understand. There is still a lot of room for improvement and simplification in the user interface and process, fees may vary, resulting in unreasonably high fees for smaller transaction amounts, DeFi hacks are increasing all the time, becoming your "own bank" will also Facing a series of operational challenges and risks.

Related elements in DeFi

Looking at DeFi as a whole, it is like building a house, where different layers are superimposed to form a new digital service product.

Taking a house as an example, the first layer, the underlying blockchain technology, can be Ethereum or Solana (layer-1 protocol), just like our basement or cellar. Depending on the blockchain you are using, there are certain trade-offs you need to make. This is known as the blockchain trilemma, a phrase coined by Ethereum co-founder Vitalik Buterin.

Consider a triangle where each corner represents security, scalability, and decentralization. You can only optimize two corners and compromise on the third. Putting this into context, Hubble Protocol founder Marius Ciubotariu said:

“Neither Solana nor Ethereum compromise on security, but Solana nodes are more demanding than Ethereum, where almost everyone can run a node with a laptop. However, in a world governed by Moore’s Law, It doesn’t seem like a trade-off anymore.”

He continued: "As a blockchain, Solana is designed for high-frequency (financial) activities. Solana's design is performance-oriented, putting speed over cost." The system provides a more subtle perspective. To address these challenges, developers are creating new "base layer" blockchains to address these constraints, such as Polkadot and its layer-0 solutions, or by introducing layer-2 scaling solutions on top of layer-1 blockchains , such as Ethereum using zk-Rollup smart contracts to reduce costs.

Then, in our basement, we have our Walls, which are the respective protocols, also known as Decentralized Applications, or DApps, offering their services as Decentralized Exchanges (DEX) such as Curve Or Uniswap, or as a loan agreement, Aave or Maker, or as a derivatives liquidity agreement, such as Synthetix, etc. This is a space that is constantly growing and developing.

You have to put a roof over the walls, and for that, we have "pools". When using a DApp service like a loan protocol, you can choose which tokens you want to offer. For example, when using Aave’s services, you can decide to only lend against the USD Coin (USDC) stablecoin. Alternatively, on UniSwap, you can only be a liquidity provider for Ether (ETH) and USDC trading pools. Imagine when you go to the bank and say you want to borrow money or trade stocks, you also have to state which currency you want to borrow, or which reference currency you want to buy stocks in. We describe these activities in more detail in the next section.

Finally, you want to plant a flag on your roof, and you can also use wallet aggregators like MetaMask, Trezor, and Ledger, DEXs like Thorchain and 1inch, or centralized exchanges like Kraken and Binance. They simplify access by combining services from different platforms into a single entry point/UI. Die-hard fans of cryptocurrencies will refuse to use centralized exchanges because it goes against the whole principle of decentralization and self-custody of your private keys (passwords for crypto assets).

When making the analogy between DeFi and the structure of a house, we are not just trying to simplify the structure, of course, we also omitted some nuances and details, but to show that if the foundation or layer-1 blockchain has cracks, the whole house will be broken. risky. So when doing your risk assessment, consider the stability of the entire house, not just the floor you're standing on.

How to make money with DeFi?

Simply put, you can invest in DeFi projects/protocols by purchasing corresponding tokens such as SushiSwap (SUSHI), Aave (Aave) or Maker (MKR), while expecting to gain through price increases based on quality platform products, user and asset growth capital gains. Alternatively, you can use these platforms as "operators" and earn income from various offers.

You can also have your cake and eat it too, buying high-convincing items and earning some extra income by:

pledge. By staking, you can earn rewards by participating in the consensus mechanism process, or by using your staking tokens such as Tezos (XTZ), Polkadot (DOT) or ETH, effectively becoming a validator for the network. This is called Proof of Stake and is used by blockchains such as Tezos, Polkadot, and soon Ethereum 2.0 to ensure the security of transactions and the network. With the increase in staked tokens, that is, locked tokens, new concepts such as "liquid staking" (liquid staking) have emerged, basically creating derivatives of the pledged token, which is then "liquid" again and can be Redeploy while earning staking rewards.

to borrow. Instead of taking a loan from a bank, having other investors fund it, or essentially peer-to-peer lending, you can get a loan through a DeFi protocol. In return, investors will receive a portion of the interest on the loan as their return. Note that when you hold shares in a bank for example, the bank will most likely lend those shares to some financial institution such as a hedge fund for which you pay a deposit fee which in turn can be used for short selling and other leveraged transactions. Obviously, you didn't see a penny.

Provide liquidity. When you buy or sell shares on a traditional exchange, financial institutions act as intermediaries in coordinating the trade and providing liquidity in shares or cash. In the digital asset space, these activities have been disrupted by automated market makers (AMMs), which operate like automated code-based decentralized exchanges. Lost liquidity is again provided by other investors who will receive income in the form of fees generated by these liquidity pools. These pools are made up of various trading pairs such as cryptocurrencies vs. cryptocurrencies like BTC/ETH, cryptocurrencies vs. stablecoins like DOT/Tether (USDT), or stablecoins vs. stablecoins like USDC/Terra ( UST).

Yield farming. Imagine you lend money to a liquidity pool, say SushiSwap, and start earning your first SUSHI rewards. You don't want these assets sitting idle. You can make them work again through various opportunities and accumulate more rewards. In a nutshell, Yield Farming is constantly putting your tokens to work (money doesn’t go dormant), chasing higher compounding yields through protocols, pools, and otherwise.

All of these activities offer their respective annual yield (APY) or fee share split, which will depend on the platform such as Curve or Compound, the service such as equity or liquidity provision, and the underlying token used such as BTC or USDC. These earnings can come in the form of storage tokens, called “supply APY,” or in the platform’s native token, called “reward APY.” For example, the SushiSwap protocol will give you SUSHI tokens, while the Aave protocol will give you Aave tokens. Some of these platforms distribute governance tokens that give owners the right to vote on the direction of the platform, such as gaining the option to become an activist investor.

what should i pay attention to

This part could write a whole article, here we will list some key points. First, use the analogy of a house to consciously understand risk assessment across layers and interdependencies. Focusing on the protocol or your counterparty risk, you'll want to review some specific levels and ask key questions:

• team. Is this team known or anonymous? What is their technical and practical background? Are there large/well-known crypto community supporters involved?

• technology. Were there any hacks, were there 3rd party smart contract audits, did they issue security bounties?

• Token economics. Are governance tokens rewarded? What is the total value currently locked? What are the growth figures for assets and active users? Does the project run through a decentralized autonomous organization (DAO) and community-supported model?

• Insurance. In the event of a hack, is there a vault that makes investors "whole" again? Is there any insurance policy?

• pool. What is APY? Is it ridiculously high? Are APYs stable? How much trading liquidity is there in the pool? Impermanent loss, lockup period or transaction fees?

When you are actively "using" your tokens to generate income, you are usually "hot" on these protocols/exchanges, and therefore, more vulnerable to hacks or counterparty risk. Some institutional providers, like Copper, offer safe custody not only for buy-and-hold investors, but also for staking tokens at a cost. These security and custody concerns are the key differentiators of investing in DeFi through the purchase of tokens that can be stored cold, while operating strategies that generate ongoing, active revenue.

All in all, this is incredible territory: We have and will continue to witness a new trillion-dollar industry being built before our eyes. However, I'm also here to warn everyone: beware of deals/APYs that are too good to be true, they may only be attractive at first, and fees can suddenly explode and yields suddenly plummet. Be careful with your assets as there is always the possibility of loss.

If you are new to this field, you can try it out, test it out, and learn it at the beginning. Or, if you want to get involved, but don't want the hassle, you can hire professional managers to design, execute and monitor these strategies in an institutional setting. However, you also have to do your due diligence as carefully as the steps mentioned earlier when selecting a manager.

Cointelegraph Chinese is a blockchain news information platform, and the information provided only represents the author's personal opinion, has nothing to do with the position of the Cointelegraph Chinese platform, and does not constitute any investment and financial advice. Readers are requested to establish correct currency concepts and investment concepts, and earnestly raise risk awareness.