What is decentralized finance or DeFi?
DeFi, or decentralized finance, refers to a range of financial applications that can make citizens independent of banks, insurance companies and other institutions, and also, to some extent, of states.
Historically, finance is a domain managed by banks and some institutional actors. Individuals can deposit their money in order to generate returns through various mechanisms. In the last few decades, however, individuals have started to be more and more involved, a clear sign that a paradigm shift is underway.
At the root of DeFi applications is a feature of the Ethereum cryptocurrency: smart contracts. These allow a computer program to be associated with a given currency.
However, the key point of DeFi applications is that they are not linked to a given company; they rely solely on smart contracts. Once the application has been programmed, it works by itself. This results in minimal costs for the user since there is no structure to maintain, no offices to rent, no intermediaries to pay.
In addition, registration procedures are reduced to a strict minimum. As a result, a DeFi-based insurance will cost very little and will be of a flexibility unknown in the real world.
Of course, one may want to use DeFi for different reasons, but clearly, what attracts the most is the possibility to earn money.
Decentralized finance has created new “jobs” just as classical finance has created traders. The arrival of the blockchain in 2009 with Bitcoin raises the hope of an imminent change. However, it will take until mid-2019 for decentralized finance to really emerge and attract users in a big way.
There are whole new skills and activities being created on DeFi. Users from all over the world are increasingly using decentralized services with annual returns (APY) that make traditional banks blush.
We could say that DeFi is the bank without borders, open to everyone, no matter what their budget is, everyone will find their interest.
The 4 methods to make money on DeFi
The period from 2019 to 2022 was extremely prolific for the decentralized finance ecosystem. The total value locked (TVL) on the various protocols went from $0 to nearly $100 billion in August 2022. In other words, there is almost $90 billion deposited in protocols and apps offering decentralized financial services. In December 2021, this figure has even reached $250 billion, and that’s in less than 3 years of existence.
Method 1: Lending and borrowing
This is certainly the best known and oldest DeFi activity. In fact, the first DeFi platforms at the beginning mainly offered this type of service: lending and borrowing cryptos.
We can think for example of the pioneers in these fields that are Coumpound Finance and MakerDAO. It is a relatively simple protocol to understand. There are two types of users on these platforms: the lender and the borrower.
MakerDAO, the most valued protocol on the market at the time of writing, offers all the classic financial services that a bank offers. You can borrow or lend funds through its Oasis application. MakerDAO’s flagship product is DAI, the decentralized stablecoin with the largest capitalization.
Method 2: Staking
This is certainly the activity on DeFi that is the most popular and is also the simplest. There, the user will deposit in a smart contact a certain amount of a given token. To take images of the classic bank, it’s like having an “A” account, except that here the interest is much higher than the usual rates announced by the banks.
Your deposit will generate by itself additional income, usually from the same token you deposited.
In general, the greater the amount deposited and the longer the locking time, the greater the reward.
The hardest part of staking is actually choosing the right platform and the right token! One can very well decide to stack on a token that does not have a great durability although it has an interesting rate.
Method 3: Become a liquidity provider
Becoming a liquidity provider is also called Liquidity Mining.
DEXs like Uniswap and especially SushiSwap have popularized this activity on the DeFi. Decentralized exchange platforms are the equivalent of trading platforms on the DeFi. They are what we call automated market maker protocols (the famous AMM) or market Maker.
There is no order book but instead liquidity pools. Liquidity pools are composed of pairs of tokens (with the same value). So, in a liquidity pool of $1000 ETH/USDT for example, there will be $500 ETH and $500 USDT. It is thanks to these pools that users can exchange tokens between them, without the need for an intermediary.
Naturally, the more exchanges there are on the pool, the more money the LPs earn.
Method 4: Become a farmer who practices yield farming
This is actually a (logical) continuation of liquidity mining. This is why many people confuse the two types of processes. When you do liquidity mining, you receive liquidity tokens in exchange for your deposit.
So, while those who do liquidity mining are mainly interested in recovering the commission fees, farmers are more interested in the LP tokens they receive. LP tokens are specific to pools and they represent the share that one has deposited in the pool. They were originally created to give us a kind of “receipt” for our deposit. Thus, it is by giving back the LP tokens that the smart contact of the liquidity pool returns our deposited funds + the earned fees.
Thus, there are now “farms” in which one can lock in LP tokens ( to earn other similar tokens or even other tokens. When you farm, in fact, and quite clearly, you are staking. To be clear, farmers are liquidity providers who are staking LP tokens, that’s all.
It is also in farming, that we see the highest APY rates with 4 digit sums sometimes.
DeFi is a very young concept which evolves every day, to improve its functionalities, but also to solve current problems. There are already important areas of improvement under development. We call it DeFi 2.0.