DeFi is an abbreviation of the phrase Decentralized Finance, and it encompasses all financial tools and applications built on decentralized cryptocurrency networks. Recently, it’s most frequently used specifically to describe lending, borrowing, and yield farming (also called liquidity mining) on the Ethereum blockchain.
What can I do with DeFi?
While there are a multitude of DeFi protocols and combinations (in fact, they are called ‘DeFi legos’ because of their endless combinability), the varied uses of DeFi can be simplified down to two categories: lending and borrowing.
When you lend crypto, whether by putting it into a savings-account-like smart contract or into a pool to provide liquidity, you can earn interest on your crypto, with the returns often exceeding those provided by traditional finance instruments. You can also gather rewards in the form of the protocol’s governance tokens. These tokens will allow you to vote on proposals about changes to the DeFi protocol, so that you, as an investor, have some control over the project’s direction. Of course, governance tokens can also be sold for profit like any other crypto asset.
When you borrow crypto, you can take advantage of immediate loans without the need for approval from any third parties – BUT, most of the time, you must provide collateral. This means that you would deposit some ETH, for example, and take out a loan of the stablecoin DAI, to be used in any way you see fit.
The loan amount should always be significantly lower than the collateral, but your deposit could also be earning interest and growing in value in the meantime. Therefore, in the best case scenario, you are taking advantage of both the loan and the growing value of the collateral. On the other hand, if market volatility leads to a drop in your collateral’s price and you don’t repay the loan in time, your collateral could be liquidated.
An advanced user might leverage the borrowing and lending capabilities to combine DeFi legos, taking out loans on one platform to provide liquidity on another, earning governance tokens on multiple platforms, and maximizing returns. However, this strategy should only be used by experts who are able to navigate the complexities of the market and have a high risk tolerance.
To summarize, let’s look at the main benefits and risks of DeFi:
Near-instant execution without reliance on third parties
Virtually no geographic limitations
Full control over your funds and information
Unlimited combinability of protocols
Returns on investment that may be unavailable in traditional finance
Market volatility can devalue your collateral, raising the risk of liquidation and making it more difficult to repay a loan
Because of volatility and interest accrual over time, it’s essential to monitor the loan closely to avoid liquidation
Many scams and projects that haven’t had their code properly audited, leading to loss of funds for most participants
Full control over funds also means full responsibility for their security - you alone are responsible for your wallet keys, and for paying back your loans on time