There are banks and there is code. Which one do you trust? The magical world of decentralized finance (DeFi) opens up opportunities for us to utilize a decentralized economy without ever having to sacrifice assets (depending on the type of investment you’re making) or going off-chain. If you’re still wondering what DeFi is, you’ll find the answer to your question down below.
The hard part about DeFi is the public’s perception of it as a risky, scammy investment type. While some DeFi platforms are indeed fraudulent, as long as you stick with the legitimate ones and play your cards right, you can potentially make life-changing trades. If you learn how to invest in DeFi properly, you’ll never have to give up your holdings to use your money elsewhere.
This article explains everything about DeFi from its definition to its use cases.
What is DeFi?
DeFi, or decentralized finance, is an alternative to conventional centralized finance where banks are in control. With DeFi, instead of banks, you’ll have code to run functions or smart contracts for you, which are transparent and verifiable on the blockchain.
In order to understand DeFi, you’ll first have to understand how centralized finance works.
How do banks make money? If you’ve been thinking that the bank is this magical place where money grows in hidden greenhouses, you’re wrong. Banks make money through lending and collecting a fee.
As a standard, banks ask borrowers to deposit 20-30% as downpayment and/or provide collateral equal to or more than the loan they are taking. There are also debt collectors in place that are responsible for collecting payments in the event that a loan goes sour.
Problems with centralized finance
- Applications take time
- Not every loan is granted
- Interest rates can be extremely high
- Transactions can be inconvenient
- Long waiting times
Unlike centralized finance with banks as governing bodies, decentralized finance relies on code to keep transactions in place and carry out smart contracts (contracts that automatically carry out if conditions are met). The concept is the same wherein the lender still needs collateral in order to lend out money/crypto and you may be thinking, why borrow crypto by collateralizing the crypto you already have?
Let’s explain it this way, say you’re holding $1000 worth of Ethereum, and under no circumstances would you give it up. Instead of selling the Ether you have, you can collateralize it to borrow $800 worth of another crypto, or say, a stablecoin like USDT.
The $800 worth of USDT can then be used to trade, invest, buy non-fungible tokens (NFTs), stake, yield farm, or put to use anywhere else you might have planned. When the time comes to pay your debt, you’ll have to pay the crypto lending platform $800 plus the fees and interest that you agreed to claim back your $1000 worth of Ethereum.
With DeFi, not only will you be able to hold your ETH, but also borrow against it and put the borrowed crypto to good use. The risk is that if you aren’t able to pay back the loan, you would lose your collateralized funds by default.
Solutions of DeFi
- Open to anyone
- No credit score is needed (collateral only)
- Fixed interest rates on different assets
- Instant transactions
How Does DeFi Work?
Everyone knows banks usually have that Scrooge McDuck money vault in the back but not a lot of people realize that the money in the bank is from people depositing their money. Banks actually pay you interest on your savings that usually amount to a fraction of a percentage up to maybe 2-3% depending on the bank (be cautious when choosing a bank with high interest).
The best DeFi earnings can be accessed through the same method but with a twist; investors place their money in a crypto lending platform and earn a fixed percentage through staking, lending peer-to-peer with the help of smart contracts, or other methods but we’ll talk about that later.
Now, there are two entities in DeFi that you’ll have to learn about, DEXs and lending platforms:
A DEX is a decentralized exchange that exists on the blockchain where you can lend money out by providing liquidity or farming.
Lending Platforms (DeFi Platform)
These types of platforms specialize in allowing lenders to place their money on the platform and borrowers to borrow that money as long as they place down collateral.
How to Make Money with DeFi (In Theory)
Now that you understand the basics of DeFi, let’s dive deeper into the exciting complexities of how to make money with DeFi (in theory). Of course, making a profit completely depends on what type of investments you make.
There are many types of investments you can conduct in DeFi, which makes it hard for beginner investors to keep track. It’s important to note that each type of investment comes with its own set of risks so invest wisely and DYOR (do your own research).
We’re here to help you understand the different types of investments within DeFi. Here are the best DeFi passive income techniques:
Staking provides you with interest by holding a particular type of crypto. Some cryptocurrencies like Tezos or Cardano offer native staking within their blockchain network so you won’t have to place your crypto elsewhere. Basically, cryptocurrencies offer staking rewards to incentivize people to hold their coin or token. Not every cryptocurrency provides staking but they can still be staked on DEXs.
Some cryptocurrencies use proof-of-work (PoW) in order to validate transactions, where instead of allocating the rewards to the stakers, they are sent out to miners. With proof-of-stake, however, since validation happens within the cryptocurrency itself, the rewards are sent out to holders and stakers.
The cons of staking, however, is that you’ll have to lock your assets in a blockchain network for them to become a validator. Since your assets are locked, you might miss out on some other lucrative trades that might come your way.
Warning! A lot of people lose money in scam yield farm projects so don’t fall for that 10,000 % APY. There are certain crypto projects out there that promise over a thousand percent in APY by providing lending certain crypto on the platform.
What is Yield Farming
The term yield farming refers to maximizing returns using DeFi. Say you are bullish on Bitcoin and want to hold it while getting the best DeFi earnings possible; why hold it and just rely on appreciation when you can lend or provide liquidity and earn interest through yield farming.
How Some Yield Farms Work
In some DeFi platforms like PancakeSwap, yield farming is divided into two, the liquidity Pool and the Farm. The pool allows you to lend your crypto to the platform and earn rewards with APYs depending on what crypto you stake. The Farm, however, requires you to lend two cryptos and earn rewards in certain crypto. Some platforms offer rewards in the native token of the platform or offer a multiplier if lenders choose to take rewards in their native token.
Example of Yield Farming Risk
Let’s use the imaginary crypto called $IMAGI for example. Say there’s a yield farm that promises 10,000% APY if you lend the $IMAGI token and your interest will be paid in $IMAGI. That sounds like a good idea since if you place $100 of $IMAGI, you’ll be able to hypothetically earn $10,000 a year in $IMAGI! Except, this isn’t the case.
Some yield farm tokens don’t have actual use-cases except for yield farming and as more people catch onto it, early investors start cashing out resulting in the price tanking.
Let’s say the value of $IMAGI was $1 each when you bought it and a month later, it tanked down to $0.00001, you would have earned $0.1 after a year but the amount of IMAGINARY you bought in at $100 dropped down to $0.001. In total, your $100 investment would have resulted in less than a dollar after a year counting fluctuations and this is where a lot of people lose money.
Liquidity Pool Provider
Being a liquidity pool provider means lending two cryptos to a DeFi swap to allow trades to be made between the cryptos. There are a few concepts to understand when it comes to becoming a liquidity pool provider and although some people would say this is the best DeFi passive income vehicle, you should still understand the risk or how you might lose or earn money by understanding the concepts below.
Automatic Market Makers
Swaps use a method called automatic market makers for trades to push through. This means buyers place a bid (the price they want to buy the crypto) and sellers place an ask (the price they want to sell the crypto). When transactions match, this is where the exchange is made.
Since there are many different prices for different sellers, some swaps ask buyers to input a slippage which is the amount they are willing to go under to make the purchase.
Constant Product Automated Market Maker
Since we mentioned that being a liquidity pool provider requires that you lend two types of crypto to a swap, the constant product automated market maker is what guarantees that your crypto investment doesn’t fall off too much in value.
Let’s say you place $100 in a 50:50 Ethereum-Basic Attention Token (ETH-BAT) liquidity pool, whenever buyers want to purchase BAT with ETH, the pool will have more ETH and less BAT. The pool will then charge higher for BAT due to its declining supply and less for ETH since there is more ETH in the pool while charging a small fee. This is how the pair manages to stay constant in value despite trades being made.
Routing is the process of a swap trading in crypto in one pool for crypto to another. Let’s say there are two pools, ETH-BAT and ETH-BNT (Ethereum-Bancor), and you want to make a trade by exchanging BAT for BNT. The pool will first use your BAT to buy ETH in one pool and exchange ETH to buy BNT in another while charging a small fee for each pool.
Making Money by Being a Liquidity Pool Provider
Whenever a trade is made between the pairs you provide, a percentage of the fees goes directly to the participants of that pool. Naturally, the fee is split evenly between the members of the pool meaning smaller pools could give bigger rewards while larger (and more popular) pools usually give smaller rewards.
Risk of Impermanent Loss
Impermanent loss is somewhat similar to opportunity cost. Let’s say you provide 10 ETH at a fictional $100 price ($1000 in total) and 100 BAT at a fictional $10 price ($1000 in total) in a pool and when you decide to stop the pool, you are left with 5 ETH and 200 BAT. If the price of Ethereum went from $100 since you bought it to $150 and the price of BAT dropped to $1, you would have taken out $750 in ETH and $200 from BAT, you would be taking home $950 from a $2000 investment.
This is a worst-case scenario but it demonstrates the risk of impermanent loss compared to buying 20 ETH at $100 for a total of $2000 and just holding it which would have given you $3000 (profit of $1000) if you would have just held the crypto.
How to Do Research
Like everything crypto, there is always risk and reward in order to make DeFi passive income possible. You’ll have to do research on determining which staking, yield farm, or liquidity pools are profitable. First, you can find the top DeFi projects on DeFi Llama.
Technical analysis involves looking at charts and data to ensure your investment is profitable. There are different ways to do technical analysis depending on the type of DeFi investment you want to get in.
Staking Technical Analysis
When it comes to staking, you should look at the chart and use indicators to see if the crypto is going up. A basic technical analysis would be to use indicators like the following:
- MACD – the Moving Average Convergence Divergence to help you know if an asset is trending up or trending down by comparing price action based on different intervals.
- RSI – the Relative Strength Index helps indicate whether an asset is being overvalued or undervalued based on the speed and magnitude of its price action.
- Bollinger Bands – Bollinger Bands are good for indicating when a large price action might occur, the bands are thin when not a lot of price action happens and expand during a huge uptrend or downtrend. This could be a good indicator of when to enter or exit a position.
It’s important to note that there are hundreds of different indicators out there and to find the most effective indicator, you’ll have to first assess which ones you trust the most or which ones give you the most success. Social buzz is also a good indicator of hype and can be used to determine whether more people are talking about the crypto which could potentially impact its price.
Yield Farming Technical Analysis
When doing technical analysis on yield farming, you’ll have to apply your staking analysis to the cryptos involved. Let’s say you want to stake ETH to earn CRV, if you are bullish on Ethereum and believe its price will go up, you’ll then want to do technical analysis on the CRV (the reward token).
Let’s say for example CRV is declining while Ethereum is rising, you can compute your APY on CRV if it is worth it. Let’s say the price of CRV has declined by 50% over the last year and promises you a 10% APY, if the price of CRV was $2 but declined to $1 when you bought it, assuming it will drop another 50% to $0.50, you will be earning 10% of CRV tokens based on the $0.50 depending on how much ETH you put in.
It’s important, however, to do your technical analysis and see if CRV (reward token) is at a reversal and is on a bullish trend since if it does, you will earn 10% of CRV plus its appreciation.
You’ll also have to compare pools with one another for either different types of cryptocurrencies or the APYs offered on different platforms. Another thing to watch out for is whether the rewards seem too good to be true. Like with LUNA’s UST, although the concept was simple, the network did not have enough money to back up its returns and thus resulting in a crash. We’ll cover more of this in our fundamental analysis down below.
Liquidity Pool Technical Analysis
As explained earlier, users are at risk of impermanent loss when providing a pool if one crypto in the pair goes up and one goes down or both go down. One of the safest ways to earn from a liquidity pool is through stablecoins. The rewards, however, might not be as substantial.
Liquidity pools work best when both assets stay consent in price. When doing technical analysis, you can look at the price action and use MACD and Bollinger Bands to see if the price is expected to remain the same. There are also other indicators like the Average True Range that help you understand the volatility of an asset or the crypto pair in the pool.
Fundamental analysis aims to understand the real value of an asset. In terms of DeFi, it means finding the real value of either the crypto to be staked, the yield farm, or the liquidity pool. In order to do proper fundamental analysis, there are a few steps you can follow:
STEP 1: Read the whitepaper of the platform or crypto you are planning to use in DeFi. Some tokens disclose that their literal use-case is to be used for yield farming and this could be a red flag.
STEP 2: Understand the cryptos involved. Aside from the asset or assets you plan to invest or lend out, you should also understand the reward token and its true use case.
Some platforms allow you to auto-stake reward tokens to earn more rewards in that crypto. This will only be effective if the price will go up. If your technical analysis tells you otherwise, sell your rewards and don’t wait for them to tank.
STEP 3: Look for red flags within the platform or blockchain you plan to invest in. LUNA’s UST caught people by surprise. How could a stablecoin lose value when it should have been backed up by the same amount in US Dollars? Apparently, it was pegged to the US Dollar via LUNA and not directly to the US Dollar.
This means that instead of spending US Dollars to keep the currency consistent, LUNA used its LUNA crypto to back its price. When there are different shady tokens or even tokens that you don’t understand within the blockchain network or platform, this should be a red flag for you.
STEP 4: Look for investor traces. One important aspect of fundamental analysis is finding out the real value of an investment and one way to discover this is by finding out who thinks the investment is profitable.
If you don’t mind doing some digging, everything is available on the blockchain. You can search for an investor or hedge fund’s crypto wallet and find out which cryptocurrency projects they invest in. The bigger the confidence of investors, the more likelihood that the project becomes profitable.
Investing in DeFi can be risky which is why both fundamental and technical analysis is recommended. Although they aren’t absolute indicators of profit, they can help you make better decisions regarding what pool to invest in, whether to stake, or if it would be safer to just hold a particular crypto.
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