Decentralized finance, commonly known as DeFi, has been the hottest talking point in the digital asset markets in 2020. Internet-based financial protocols are providing new avenues for tech-savvy investors to earn double and triple-digit yields, attracting more and more investors to this space.
Learn what DeFi is and how to invest in this new, high-risk digital asset class.
What is DeFi?
Decentralized finance (DeFi) refers to open-source financial software that aims to provide financial services to anyone with an internet connection.
Autonomous, internet-native financial protocols provide an array of financial services by replacing traditional financial intermediaries with smart contracts and a hard-coded economic incentive structure.
In today’s DeFi market, you can:
- Deposit digital assets into money market protocols to earn above-average yields
- Borrow digital assets to place leveraged long positions in the market
- Convert one digital asset for another using autonomous trading pools
- Earn fees for providing liquidity to decentralized trading pools
- Invest in tokenized traditional assets (equities, commodities, and FX)
- Hedge your digital asset portfolio using decentralized derivatives
And that’s not all! New decentralized financial solutions are emerging on a monthly basis, suggesting that this growing market is just getting started.
At the time of writing, the total US dollar value “locked up” in DeFi protocol stood at $14.37 billion.
In comparison to Bitcoin’s $347 billion market capitalization, that may seem small. But given that the DeFi industry is only two years old, the size of this nascent market is already quite impressive.
DeFi: The Next Step Into a Bankless Future
DeFi proponents believe that the developments in the decentralized finance market are the next steps towards a bankless future.
The decentralized digital currency, Bitcoin, enables us to store, send, and receive monetary value over the internet. The next iteration of this decentralized, bankless future are the autonomous financial products and services built on top of blockchain networks, such as Ethereum.
Mythos Capital founder and outspoken DeFi advocate, Ryan Sean Adams, wrote in his daily newsletter, Bankless:
“We’re getting closer to the point where people don’t need a bank to bank. Savings accounts, mutual funds, mobile payments—these can be replaced by a bankless alternative….today! Alternatives that are better than incumbents options—alternatives that are accessible to anyone in the world with a smartphone!”
He has a point.
Despite still being in its early stages, the DeFi industry already allows individuals across the globe to download an app, buy digital currency, and deposit it to earn higher interest rates than on traditional savings accounts.
And best of all, this can be done without the need for paperwork, identity verification, or a KYC check. All it takes is a smartphone!
The idea of a bankless future is, therefore, not so far-fetched. If you can download a suite of smartphone apps that can effectively do everything a bank does, why would you ever walk into a bank branch again?
Yield Farming: The Hottest Digital Asset Trend in 2020
When talking about the DeFi market, there is no way around the topic of “yield farming.”
Yield farming, also known as liquidity mining, involves depositing digital assets into yield-generating protocols that reward users with a token that is issued to liquidity providers as an incentive to use the platform.
For example, a yield-hungry investor could lend USD Coin (USDC) on Compound and earn interest that is determined by market forces of the USD Coin borrowing and lending pool. Additionally, as a liquidity provider on Compound, the investor would also receive Compound (COMP) protocol tokens in relation to the amount the user contributes to the pool.
As a result, the “yield farmer” would earn interest for depositing their USDC in the lending pool and earn yield in the form of COMP tokens for providing liquidity to the protocol.
That’s yield farming.
This trend took off as newly launched protocols started offering triple and quadruple-digit APYs, paid in the form of their protocol tokens to lure in yield farmers.
Unfortunately, many investors lost money as unaudited, prematurely launched code led to the exploitation of vulnerabilities in smart contracts that caused a loss of funds for users. That is why yield farming has earned a somewhat negative reputation and many experts warn investors not to engage in this new form of digital asset investing.
Top DeFi Protocols
There are dozens of DeFi protocols that you can use to access investment opportunities in the decentralized finance market.
At Bitcoin Market Journal, we have composed a list of ten promising projects to help get you started in the world of DeFi.
The Risks of Investing in DeFi
Decentralized finance applications enable investors to seamlessly earn interest on their digital asset holdings as well as providing an array of trustless trading, investing, and hedging solutions.
For experienced digital asset investors who are looking for the next high-risk, high-reward market trend, there is plenty to choose from in the DeFi markets.
However, as with all types of investing, the DeFi markets are far from risk-free. If anything, DeFi investing can be classified as highly risky, especially as you move away from the handful of established and thoroughly audited protocols to newer applications and platforms.
Essentially, there are four main DeFi risks:
- Code Risk
- Market Risk
- Centralization Risk
- Regulatory Risk
Arguably, the biggest risk for DeFi investors is potential vulnerabilities in the code of live protocols that could be exploited, thus leading to a loss of user funds and/or a sharp decline in the protocol token’s value.
The market risk faced when holding DeFi tokens is much higher than when holding established digital assets, such as bitcoin (BTC) or ether (ETH), as they are less liquid and typically only have a single use case. In combination with a lack of liquidity, DeFi tokens are thus as risky as investments can come.
Centralization risk is another factor that DeFi investors should be aware of. Ironically, many DeFi applications rely on centralized services – such as Oracles for price information – to provide their services. Should any of these third-party services experience downtime or a hack, this could adversely affect your DeFi investment position.
Finally, there is regulatory risk. For now, decentralized financial applications have not gained much regulator attention. However, as the market went from de facto non-existent a year ago to a $14 billion market today, regulators are starting to take notice. As digital assets become a more regulated industry globally, we can expect DeFi regulations to follow. Strict regulations may affect your DeFi returns.
Is DeFi A Bubble?
The hot DeFi trend in 2020 was without the shadow of a doubt yield farming.
Newly launched, unaudited (and, for some reason, often food-themed) DeFi applications emerged, offering 1,000+ percent yields only to find an error in the code collapsing the price or an anonymous developer leaving with a large share of issued tokens.
For anyone who has followed the SushiSwap saga, the Yearn hack, or the Harvest Finance token theft knows that liquidity mining on insecure protocols and investing in DeFi tokens is more likely than not a fleeting sensation, moved more by greed than the desire to create lasting financial innovation.
However, that does not mean that the technological strides that are being made in the DeFi industry are not poised to make their mark on the future of finance.
While the yield farming hype moved fast into bubble territory, the broader DeFi market is starting to mature with the aim of bringing accessible, next-generation financial services to the world.
The Takeaway
Decentralized finance has the potential to break down the barriers of the legacy financial system and provide internet-native banking services to the world. However, it will take time for the industry to mature to a level where bankless financial services will be secure and frictionless enough for the entire world to benefit.
Until then, the DeFi markets are reserved for tech-savvy digital asset investors who are comfortable interacting with smart contracts and taking on a substantial level of risk to generate above-average returns.
Further Reading:
- Bitcoin Investing 101: What is Bitcoin & How Can You Invest in It?
- Blockchain Investing 101: How to Build Long-Term Digital Asset Wealth
To stay up-to-date with the latest developments in DeFi and the digital asset markets, subscribe to Bitcoin Market Journal.
