Even people familiar with crypto have been asking, “What is DeFi?”
Short for “decentralized finance,” DeFi is a catch-all term for a digital ecosystem of smart contracts, decentralized exchanges, and special-purpose tokens built on the Ethereum network.
It’s also the latest obsession in the world of crypto investing. DeFi erupted from obscurity to a mania over the summer.
According to the website DeFi Pulse, the amount of money invested in DeFi projects soared from about $950 million in the latter part of May to more than $9.5 billion by the first week of September.
That’s puny by Wall Street standards – or Bitcoin standards, for that matter. The total value of Bitcoin is a bit south of $200 billion these days.
Still, the rise in DeFi represents a 10x increase in just three months. It has huge buzz in the crypto world, at least for now.
And people who are using DeFi are making money – in some cases a lot of money. Investors have earned returns of 20% or more on their money over the past six months.
But it’s wild, unregulated, and extremely risky – even more so than most things crypto.
This is why most investors should avoid putting any money into DeFi projects. But that doesn’t mean investors should ignore DeFi.
As we’ve often seen with cryptocurrency, DeFi is teaching the old dog of finance several new tricks.
“These are experiments in finance,” Preston Byrne of law firm Anderson Kill told Reuters in August. “They’re not necessarily legally compliant in a lot of cases. But that doesn’t mean that they can’t be at some future [time].”
As crazy as it looks now, DeFi has the potential to be the most disruptive development crypto has yet produced.
Here’s a look at what’s going on…
What Is DeFi?
The key part of DeFi is that it’s decentralized. That just means that no person or company is in control. Instead, the system is controlled by digital code.
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You could say Bitcoin was the first instance of DeFi, in that it’s a decentralized digital currency.
But today’s DeFi goes a step further. Rather than just moving money from one wallet to another as Bitcoin does, DeFi covers a range of more complex financial activities. There’s stablecoins, trading on decentralized crypto exchanges, lending and borrowing, and “yield farming” (more on that in a minute).
All of this stuff runs on the network of the No. 2 cryptocurrency, Ethereum. That’s because Ethereum allows for “smart contracts.” These smart contracts are code created and executed on the Ethereum blockchain.
Smart contracts are the magic sauce of DeFi. They allow transactions to happen without a central authority acting as a middleman – the function of a bank or other financial institution in the conventional world.
So the transactions are conducted anonymously between strangers over the Internet. That’s where DeFi becomes a disruptive technology.
“Immature and experimental though it may be, the technology’s implications are staggering,” Coindesk reporter Brady Dale wrote in a July article. “On the normal web, you can’t buy a blender without giving the site owner enough data to learn your whole life history. In DeFi, you can borrow money without anyone even asking for your name.”
How Investors Are Profiting from Decentralized Finance
In addition to being decentralized and anonymous, DeFi offers opportunities to earn outsized returns for such actions providing crypto funds to a borrower. Interest rates are all over the place, but double-digit returns are common.
Stablecoins, which have a value pegged to a fiat currency like the U.S. dollar, are a slice of DeFi I’ve previously written about. Several crypto services allow customers to loan their stablecoins out in return for hefty interest payments in the 8% to 11% range.
The decentralized exchanges (DEXs), also known as Automated Market Makers (AMMs) are what have been drawing the most attention, though. The AMMS started out giving users who provided liquidity (by making their crypto available for trades) a tiny cut of the fees.
But then Compound had the bright idea of rewarding liquidity providers with its own COMP token. This quickly became common practice among the AMMs. And the promise of what essentially is “free money” drew still more people into DeFi.
These tokens, which include SushiSwap’s SUSHI and UniSwap‘s UNI, also trade on numerous crypto exchanges. When their prices rise, those “free tokens” start to represent real gains.
For instance, UniSwap gave 400 free UNI to anyone who had ever used its crypto exchange website. Those tokens trade for about $4 apiece now – a $1,600 windfall available to about 250,000 accounts.
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That brings us to the yield farmers.
These folks scour DeFi looking for the best possible yields. That may be interest from staking crypto on a particular site (typically Compound) or from providing liquidity to an AMM. With no penalties for early withdrawal, yield farmers can and do swap funds rapidly to chase the top yields.
People willing to bear a lot of risk have been able to reap significant profits – we’re talking about tapping into interest rates in the 40% to 50% range.
But as your eyes are bugging out, let me show you why DeFi is such a dangerous place to park money…
Why You Should Stay Away from DeFi – For Now
As tempting as those huge returns may look, DeFi is very much a “Wild West” on investing. Investors need to be aware of multiple risks and pitfalls.
Let me count the ways:
- No protections. DeFi projects by definition have no central authority. So investors have no recourse if something goes wrong. If the project you’re using goes under or gets hacked, you could lose some or all of your money.
- No regulatory oversight. DeFi is so new the U.S. Securities and Exchange Commission (SEC) hasn’t yet weighed in on it. But as with the Initial Coin Offering (ICO) craze of 2017, the SEC may well find that at least one aspect of DeFi – its tokens – are securities and violate U.S. securities laws. SEC actions against DeFi tokens could cause a big drop in value of those tokens and would harm the projects that issued them. Crypto regulation in the United States is inconsistent as well, with different states having different rules.
- Tech complexities. As crypto is tech-based, you need to have at least some tech savvy. The “addresses” used to send crypto are long strings of characters. Getting it wrong – or sending one kind of crypto to the address of a different kind – usually results in the permanent loss of those funds. DeFi adds another layer of complexity. The smart contracts that run most of DeFi can have bugs or security holes. It’s definitely not as straightforward as buying some Bitcoin from Coinbase.
- Tax headaches. Gains from interest on crypto investments are taxable just like any other gains. But few crypto companies send you a year-end statement. A DeFi project certainly won’t. But the IRS considers virtually every crypto transaction a taxable event. So DeFi investors need to keep detailed records for the taxman or use a service like TokenTax.
That’s some pretty daunting stuff.
But make no mistake – DeFi is a pivotal moment in the history of crypto.
ICOs fizzled out because letting people invest in new projects with no disclosure of the merits and flaws of the project made it too easy for scammers to exploit the idea.
DeFi is different. It seeks to replace financial middlemen with the decentralized code of smart contracts. The code only executes when certain mutually agreed-upon conditions are met.
It’s a whole new form of finance – one that gives individuals more control over their money.
And though DeFi is very rough around the edges now, it will mature with time.
“There is an actual value on what is being built on these protocols,” Maya Zehavi, a founding board member of the Israeli Blockchain Industry Forum, told Reuters. “It might end up being an instant financialization ecosystem for any project. That’s the promise.”
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About the Author
David Zeiler, Associate Editor for Money Morning at Money Map Press, has been a journalist for more than 35 years, including 18 spent at The Baltimore Sun. He has worked as a writer, editor, and page designer at different times in his career. He’s interviewed a number of well-known personalities – ranging from punk rock icon Joey Ramone to Apple Inc. co-founder Steve Wozniak.
Over the course of his journalistic career, Dave has covered many diverse subjects. Since arriving at Money Morning in 2011, he has focused primarily on technology. He’s an expert on both Apple and cryptocurrencies. He started writing about Apple for The Sun in the mid-1990s, and had an Apple blog on The Sun‘s web site from 2007-2009. Dave’s been writing about Bitcoin since 2011 – long before most people had even heard of it. He even mined it for a short time.
Dave has a BA in English and Mass Communications from Loyola University Maryland.