By Hanniz Lam

Blockchains, NFTs, DeFi, Cryptocurrency. Just insert these words in sentences at a networking meeting and people will either flock to you with excitement to share their knowledge or look at you as you were from another planet. Here are some thoughts about DeFi being the future of finance:

I believe DeFi be the future of distributing finance. The tech is a catalyst for a global dual economy future. People drive the demand and governments will have to governs the supply.- Neil Liew

And one more:

I believe that most of what the field of finance has established (regulation, risk management, inflation management mechanisms) will continue to be necessary, whether the context is TradFi or DeFi.

Having said that, DeFi as it stands today is attractive for reasons that are not likely to be universal.

For example (non exhaustive)-
1) high ROI -> risk profile is also higher, which is par for the course for all things crypto today.
2) lack of gatekeeping and AMLA/CFT regulation -> while there have been notable cases of scammers / hackers returning stolen money due to the traceability on blockchain, I think that in general a blockchain scammer will be harder to pin down & charge vs a tradfi scammer. To some people, this is not a bug but a feature.

I do think web3 is rapidly providing a superior overall customer experience to tradfi in some domains. In a few years, it might indeed be ready for general adoption, beyond those demographics that are already open to crypto today, but it will definitely not look the same as it does today.- Johann Oh

Not all think so:

Companies will undoubtedly try to get to mass adoption which then requires regulation. Once regulation starts, whether its a KYC thing or whatever, governments will have them in their watch and you know what happens when more people start losing money because they don’t actually know whats going on and more importantly, when the company starts making money. More regulation. Which then completely removes the entire point of DeFi.

The tech however, is exciting.-Nicholas Chong

So today, let’s try to understand a little bit more about DeFi and how it’s used for lending so you can boast about how knowledgeable you are at your next coffee session and perhaps make passive income when you start lending.

Decentralised Finance (DeFi) is a system that allows financial products to appear on a public blockchain network which is not regulated by a central bank or intermediary. Most applications that categorise themselves as “DeFi” are built on the foundation of Ethereum – which is the world’s second largest crypto blockchain and currency.

DeFi systems aim to provide an autonomous and decentralised option for financial services that are otherwise regulated by banks and national or international administration.

Unlike a bank or brokerage account, a government-issued ID, Social Security number, or proof of address are not necessary to use DeFi.

More specifically, It uses a Peer-to-Peer network to establish decentralized applications that would enable everyone to connect and manage their assets regardless of their status and location. It aims to provide an open-source, transparent and permissionless financial service environment.

KEY TAKEAWAYS

• Decentralized finance, or DeFi, aims to use technology to remove intermediaries between parties in a financial transaction.
• The components of DeFi are stablecoins, use cases, and a software stack that enables the development of applications.
• The infrastructure and use cases for DeFi are still in development.

DeFi applications provide users with more control over their money through personal wallets and trading services that explicitly cater to individual users instead of institutions.

Smart contracts are the foundation layer for decentralized finance as they are self-executing and do not require intermediary oversight.

Better yield rates, innovative products and accessibility to funds at any time from anywhere. What’s not to like about DeFi?- Adrian C.

What is Defi lending?

Defi lending offers complete transparency with easier access to assets for every money transfer process without involving any third-party. It provides the most straightforward borrowing process; the borrower needs to create an account on the Defi platform, have a crypto wallet and open Smart contracts.

Defi ensures there is no preferential treatment.

Defi lending benefits both lenders and borrowers. It offers margin trading options, allows long-term investors to lend assets and earn higher interest rates.

It will also enable users to access fiat currency credit to borrow loans at lower rates than decentralized exchanges. Fiat money is government-issued currency that is not backed by a physical commodity, such as gold or silver, but rather by the government that issued it. Eg Malaysian Ringgit is fiat currency.

Users can sell it on a centralized exchange for a cryptocurrency and then finally lend it to decentralized exchanges.

The underlying value of crypto assets may increase or decrease, but sitting idle in wallets doesn’t accrue any interest. And you know by now that we need to make our money work for us, right?

Defi loans enable users to lend their crypto to someone else and earn interest on the loan just like the banks are doing.

A lender can loan their assets to others and will be able to generate interests on that loan. This process can be done through lending pools, the loan offices of traditional banks.

While taking a loan from a bank, collateral is required that is associated with that loan. For example, for a house loan, the house itself is collateral.

When the user stops paying the loan, the bank will seize the house and auction it off.

The same goes with the decentralized system; the only the difference is that the system is anonymous and doesn’t involve any physical property used as collateral.

To get a loan, the borrower needs to offer something more valuable than the loan amount. Smart contracts are used to deposit this amount of currency of at least equal value to the loan amount.

Collaterals are available in wide varieties; any crypto token can be used to exchange borrowed cryptocurrency. For example, if a user needs to borrow one bitcoin, he’d need to deposit the price of one bitcoin in DAI.

Dai (DAI) is a stablecoin linked to the value of the U.S. dollar. To maintain its price stability, DAI’s value is regulated by MakerDAO, its decentralized governance community.

While actual DAI stablecoins are produced via its Maker Protocol platform that accepts various cryptocurrencies as collateral, DAI can also be bought directly using fiat money (like the U.S. dollar or Malaysian Ringgit) on most regulated crypto exchanges, such as:

• Coinbase
• Kraken

What’s a stablecoin?

Stablecoins are a distinct subset of cryptocurrencies that strive to minimize the volatility usually associated with cryptos. Stablecoins also provide the expected crypto benefits of:

• Secure transactions
• Instant transfers anywhere in the world
• Lower fees
• Speedy settlements

Stablecoins such as DAI can do this because they are backed by a reserve currency or other underlying asset.

What’s the Maker Protocol?

Maker Protocol is the foundational system developed by DAI creator Rune Christensen. It allows anyone in the world to produce the DAI stablecoin using a variety of cryptocurrencies as collateral. 

The prices of Bitcoins keep swinging wildly. A case may arise when the cost of collateral drops below the price of the loan. How do you deal with this situation?

An example could explain it better. Let’s say a user wants to borrow 100 DAI. MakerDAO requires borrowers to collateralize their loans at a minimum of 150% of the loan value. This means that the borrower needs to collateralize the loan with $150 in ETH. And when the value of collateral reduces below $150 ETH, it becomes subject to liquidation penalty.

This means that you need to put up a guarantee of (more or less volatile, more or less liquid) crypto-assets, the total value of which is more than 115-150% of what you’re borrowing for them (e.g., in some cases, you can borrow 80% of what you’re putting up).

This may not make sense immediately, but it very much depends on the kinds of assets you’re lending, borrowing, or putting up as collateral.

For example, the value of Ether may appreciate, and you do not want to sell it. Still, you do need actual money off it, so you can lock it up for some stable Dai as fixed to the US dollar and, upon repayment, get your Ether back (which can appreciate, but you still need to pay only that much Dai back).

Here are four ways of generating a passive income in DeFi and examine practical examples of how this works.

Method 1: Staking
Staking is the process by which you lock (or “stake”) tokens into a smart contract and earn more of the same token in return. The token in question is usually the native asset of the blockchain, such as ETH in the case of Ethereum.

Why would anyone give you free tokens simply for locking up your existing tokens?

Well, there’s the rationale behind token incentives besides rewarding network users. Blockchains that are secured by Proof-of-Stake rely on users locking their assets into special smart contracts.

These are controlled by network validators, who are tasked with upholding the blockchain’s consensus rules and ensuring that no one has tried to cheat the system. Validators who act dishonestly can be penalized by losing part of their stake.

Because cheating makes no sense from an economic perspective, stakers are incentivized to lock up their assets for an extended period of time and earn rewards for contributing to the network’s security and decentralization.

With Ethereum, users who lock their ETH into the Ethereum 2.0 smart contract will earn additional ETH for playing their part in enforcing its consensus rules.

Because this process is automated, it doesn’t require manual oversight. After depositing funds into the smart contract, you can leave the Proof-of-Stake mechanism to take care of the rest, while periodically claiming your rewards.

In the case of Ethereum 2.0, you are required to stake your funds for an extended period, so this approach is suited to users who have a low-time preference.

Although the minimum requirement to stake in Ethereum 2.0 is set at 32 ETH, some platforms use a pooling mechanism that allows you to deposit a lesser amount.

Method #2: Become a liquidity provider
Decentralized exchanges such as Uniswap and SushiSwap support swaps between token pairs, like ETH and USDT. This liquidity comes from pooled tokens belonging to Liquidity Providers (LPs), i.e. ordinary defi users who place their tokens into the smart-contract controlling the pool in question.

In doing so, you will earn a 0.3% fee from all swaps, proportionally to your pool share, on Uniswap’s DEX. The more trades that are conducted via that pool, the more you’ll earn.

LPing doesn’t always guarantee profit. When the price of one of the pooled tokens fluctuates significantly, you can actually lose money through a process known as impermanent loss (IL). There are ways to mitigate this, though, by choosing highly liquid pools that contain less volatile assets, such as WBTC/ETH.

To maximize your profits, you can analyze data from LP aggregators that pull real-time data and help you project potential returns from various pools.

Method #3: Yield farming
When you LP in a DEX like Uniswap, you will receive tokens denoting your pool share. These tokens can then be locked into yield farms, which are essentially DeFi protocols that reward you with more of the same token or with a different token.

This means that while your pooled assets are earning a share of all fees in Uniswap, your LP tokens can also be earned.

It’s important when yield farming to conduct due diligence on the platform in question, to ensure that it is scrupulous and that its developers have no intention of “rug pulling” by stealing LP tokens and using them to withdraw liquidity from DEX pools. Select established platforms that have a positive reputation and whose smart contracts have been externally audited.

Method #4: Lending
Lending platforms pay users an APY for locking their assets into a smart contract. These tokens are then utilized by borrowers, who pay interest, a portion of which is returned to the lender.

Compound Finance, for example, currently offers an APY of 8.19% for lending DAI. Because the entire lending and borrowing process is governed by smart contracts, there is no risk of the borrower failing to repay their debt. Thus, you should always be able to withdraw your staked assets at any time.

DeFi provides a way to grow wealth for small businesses while playing a part in increasing the liquidity and value of the entire ecosystem. It’s never been easier to generate a steady income, whichever way the market moves.

References:

https://www.leewayhertz.com/how-defi-lending-works/

https://www.entrepreneur.com/article/366908

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