Decentralized finance refers to the entire financial ecosystem in which liquidity is not provided by a bank or centrally governed exchange, but, rather, by individuals, and one-on-one transactions governed by smart contracts in a software protocol.
The software governing each exchange is one of the great financial innovations in the last few years: An Automated Market Maker (AMM). The AMM software is responsible for paying out the fees and executing all the smart contracts in the chain that would otherwise be delivered by a financial institution using an order book.
Examples of larger exchanges operated by AMM’s include Uniswap, AAVE and Yearn.finance. These exchanges are two-sided. One side is the Traders and on the other side, the Liquidity Providers (LP’s) who deposit into the pool. Let’s take a closer look:
- Traders are people who are swapping or trading coins. For example, on Uniswap, a trader may swap Ethereum for USD stable coins, or vice versa.
- Liquidity Providers (LP’s) are people who deposit to the pool in return for a yield. Their job is literally to create a pool of coins to swap or lend. Rewards can be a percentage of transaction fees, a floating percentage yield, a set yield, and/or additional tokens awarded (LPT’s).
An AMM can have hundreds of liquidity pools, which can be one, two, or multiple coins. Uniswap, for example, is based on swapping one coin for another, and thus requires depositors must put an equal amount of two coins into the pool.
Yearn.finance, on the other hand, calls its pools “vaults”, each of which has a trading strategy, and can have one or many coins.
So LP’s, or the investors who deposit into the liquidity pools have a variety of ways to earn passive income:
- A percentage of exchange fees (Uniswap model)
- Direct lending for interest (AAVE model)
- Interest earned by the strategy created by the controller of the pool called a “vault” (yearn.finance)
- LP Tokens awarded (mined) for adding liquidity
- Yield farming – A combination of all of the above, which can also include re-investing yields to accumulate growth.
The returns are often stunning, and far exceed anything provided by a bond or a CD. So for people holding cryptocurrency longer-term, pools are an attractive way to leverage up their investment. There are, however, also risks. You must know these risks hands down and start by investing only small losable sums in DeFI projects.
The three biggest risks associated with DeFi are smart contract software glitches or hacks (exploits), impermanent loss, and counter-party threats. Let’s take these one by one.
- Smart contract software glitches or hacks, called “exploits.” New companies can have one simple problem: The software built on Ethereum and communicating with blockchains has a glitch. The result can mean funds disappearing, so keep investments in newer, untested companies small enough to be comfortable with a loss, and check out the background of the technology team. Hacks can take a variety of forms; yes, hackers are trying to get into alt-coin software, but also since they can reach out to you in “fishing” expeditions pretending to be an exchange (complete with a site replica) and convince you to input your secret passwords. Poof. We’ve seen it happen, and it is not pretty.
- Impermanent loss. This is the trickiest issue for most investors since they will typically be investing in two or more coins that are moving against each other’s price within the pool, and thus, entirely capable of varying from the market price outside the pool. If the price of a coin drops below the market due to fluctuations in value within the liquidity pool itself, you will lose money if you withdraw the coin. Until then, the loss is impermanent, as it only becomes permanent when funds are withdrawn.
- Counterparty threat. If any party is unable to deliver its side of the contract, because the funds are not there, there is no bank insurance to prevent this scenario. A smart contract is, after all, a promise to pay. But what if the vault strategy carefully designed to deliver 6% fails and everyone suddenly wants their money back? That is why investing in larger pools with huge liquidity is safer, even if the return is not as great. In fact, staying under 10% and looking for a large pool is a better bet than putting all your eggs in the high-flyers.
While DeFi can deliver higher returns, these risks mean that investors should only deposit into pools they understand, and funds which they are willing to gamble against these risks.
So why do it at all? For the same reason that people put long-term funds into a saving account, instead of a checking account. If you are holding, say, Ethereum, Cardona, or HNT’s long term, why not earn while you are holding them? What’s more, the rates are better than savings accounts or bonds, 6 to 10% is often both feasible and a reasonably safe bet, depending on the Defi protocol, especially if you are going to hold these coins – which are always more volatile than money – long term.
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