Discovery Path - DeFi Investing Series: Part III
Since the beginning of 2020, the global value locked up in DeFi contracts has grown from $650 million to $66 billion. DeFi yield contracts have opened the door to a higher level of sophistication and a more diverse set of investment opportunities for crypto investors to add new dimensions to their investment and trading strategy.
DeFi refers to a set of smart contracts used to perform transactions and services in cryptofinance. Lending and trading are currently the main functions served by DeFi, but services continue to expand with the range and types of asset classes, instruments and derivatives for more complex financial use cases including insurance and re-insurance. Nevertheless, most new crypto-currency investors are still simply looking to "buy the dip", failing to make use of DeFi instruments to optimise their cryptocurrency assets and manage market risks in both bull and bear markets.
Essential knowledge of DeFi
Define DeFi - As we know, decentralised financial services (DeFi) rely heavily on cryptography, open-source blockchain and smart contracts, which are the main building blocks. Both Ethereum and Bitcoin operate on decentralised open-source blockchains, but Ethereum has a comparative advantage in its smart contract capabilities to handle complex transactions. While the Bitcoin blockchain can only send and receive data about how much bitcoin one has, Ethereum can store code on its blockchain, known as smart contracts. The main reason for this is the fairly robust programming language called Solidity, which allows advanced smart contracts to be written that can contain all the logic necessary to create investable projects (protocols). The Ethereum platform also contains its cryptocurrency Ether which can be used to transact on the platform.
DeFi Applications - One of the first projects in the decentralised finance movement was MarkerDAO, founded in 2015. It allows users to lock in collateral and generate "DAI", the popular USD-anchored stablecoin. "DAI" can also be used to save on the MarkerOASIS platform. These types of decentralised applications (D'apps) are among the original pillars of the DeFi framework. They are some of the most disruptive DeFi service applications available to manage and enhance crypto investments:
Crypto Loans
Crypto Yield Farming
Crypto Lending
Crypto Savings Accounts
Crypto Staking Platforms
Decentralized exchanges or DEX - use smart contracts (blockchain-based apps) that coordinate large-scale trading of crypto assets between many users, entirely through automated algorithms. Using a DEX allows each party to retain full control of their respective cryptocurrency holdings rather than depositing them in a wallet held by a centralized exchange that may be vulnerable to hacking. DEX users who create liquidity by supplying cryptocurrency can, in certain markets, earn income by being awarded portions of the transaction fees. The most popular DEXs are Uniswap, SushiSwap, Kyber, dYdX, 0x, IDEX, Balancer, DEX.ag, Airswap, Totle.
How to Use DeFi - The easiest way to get started is to create and connect some Ether tokens to an Ethereum wallet that can also connect to various DeFi protocols. For example, MetaMask, the most commonly used interface, makes it easy to connect an Ethereum wallet to various DeFi protocols via a browser. Once this is done, users can access all DeFi applications to start building strategies and managing their crypto assets directly from the program's interface.
Key DeFi Investment Strategies
Best Defi strategy - For beginners, a simple crypto optimization strategy would be to earn interest or reward on cryptocurrency deposits with a DeFi protocol platform. Depositing funds for a longer-term can earn higher interest rates, fixed or variable depending on the market. Ultimately, the "best" is always different for each person depending on risk tolerance and investment goals. The most popular DeFi protocols for earning interest or rewards include:
Uniswap, a decentralized exchange.
dydx, a perpetual contract trading platform.
Yearn, is a gateway to other DeFi applications, featuring community‐driven investment strategies.
Aave, is an open‐source protocol for earning interest and borrowing digital assets.
Metamask and Argent: Ethereum‐based crypto wallets that also enable investing, borrowing, and saving.
Anchor, a Terra‐based savings and yield protocol.
RabbitHole, is a gateway to new DeFi projects that offers rewards for exploring the space.
DeFi platforms apps also give access to a full spectrum of asset management services and much more. There are many ways to build investment strategies with DeFi for both smaller and larger portfolios or to integrate crypto assets in traditional portfolios. The four most popular and easy-to-implement investment strategies are:
Buy and Hold Strategy or "Hodl"
At first glance, HODL appears the simplest passive strategy for any new cryptocurrency investor to go about building your portfolio, but it may not be the smartest. After all, it solely relies on the value of crypto holdings rising over time, and in so doing ignores the opportunities DeFi offer in generating passive income from these crypto holdings.
Lending and Borrowing Strategy
Collateralized Borrowing and lending platforms enable users to either borrow against their crypto assets or earn interest rates as a liquidity provider. The smart contract serves as an automated digital “intermediary” that sets rates based on the coins or tokens available in a collection of funds also known as a liquidity pool.
Loans issued in a DeFi protocol are usually “over-collateralized” as borrowers have to provide a guarantee in the form of crypto worth more than the actual loan.
The borrowing protocol also enables to access fiat currency credit to take loans at lower rates than DEX. Unlike traditional borrowing mechanisms, DeFi loans often do not have a set repayment schedule. As long as the borrower leaves their collateral deposited, the loan can remain open. Defi lending offers extremely beneficial margin trading options for both lenders and borrowers. On some protocols, lenders can earn between 1% and 6% and accrue interest every minute (or even every 15 seconds) on their DeFi deposits.
DeFi Staking Strategy
Staking is another option to achieve additional income by putting crypto holdings at work. It is the process of supporting a blockchain network and participating in transaction validation by committing crypto assets to that network. Users lock or hold their funds in a crypto wallet to participate in maintaining the operations of a proof-of-stake (PoS) based blockchain network, and in return get a pre-defined interest rate. Most DeFi projects offer staking rewards in the form of governance tokens which can either be kept as voting power or traded. Just like traditional saving, the longer an investor "stakes" its DeFi assets, the greater the gains.
As an example, a borrower takes out a loan and swap the borrowed funds for another high-performing token; then uses that token to provide collateral for another loan and stake the borrowed assets. Thus, these crypto-assets can be folded multiple times to maximise the interest and earned taking rewards.
Compared to yield farming, staking is, therefore, a safer passive investment strategy as it does not necessarily involve borrowing at high-risk interest rates or collateral ratios.
Yield Farming or Liquidity Mining Strategy
Yield Farming is the process of generating rewards by contributing to liquidity pools or locking assets into new protocols in exchange for rewards. Yield farmers can earn passive income by providing liquidity in the form of crypto assets to a decentralised exchange (DEX). The DEX uses this liquidity to execute orders created by token swappers who pay a fee. Depending on their contribution, the Yield Farmers earn a portion of these fees. This can be done automatically through an automated market maker (AMM) protocol that executes the transactions.
Like a traditional dividend-paying stock or bond, the yield on DeFi tokens fluctuates depending on how these projects and exchanges roll them out.
DeFi projects involved in Yield Farming, including Aave, a project that allows users to lend and borrow some cryptocurrencies, or Yearn Finance, enables users’ funds to move between different lending and liquidity protocols to get the best interest rate. Finally, Compound is a platform that allows people to earn dividends on their crypto savings.
Yield farming can be a more complex investment strategy that combines lending, borrowing, and staking to maximize profits through interest earned and staking rewards. It offers some of the highest gains in DeFi, it also carries the highest risk.
Risk vs. Reward with DeFi
The diversity of investment opportunities, as well as the continued growth of the market, makes DeFi an attractive and potentially very lucrative investment. However, as with any niche investment, there are different levels of risk such as market risk, tracking risk, counterparty risk, programming risk, security risk and future regulatory risk that each investor must consider, before jumping in. Specifically, beyond the risk related to the impact of crypto-currency volatility, there are also specific security and fraud risks related to DeFi protocols, which rely on trusted smart contracts, some of which may have vulnerabilities that can be misused Until some form of regulation or standardisation of market processes is put in place, to avoid the risks of fraud and hacking, in particular, investors should focus on the most established and important protocols in terms of volume, be patient and invest with caution.
However, the cryptofinance market is still in its infancy and its future is so promising that the decentralised finance (DeFi) niche is now being taken seriously by traditional finance. In a survey of institutional investors in the insurance, banking and trading sectors conducted by Euromoney, 86% are implementing or evaluating services based on a DeFi framework, and 58% are concerned about losing their competitive edge by ignoring the DeFi revolution.
Disclaimer: This article is provided for information purposes only and does not constitute an invitation to invest. Please seek advice from your investment advisor before investing.
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