How to demystify DeFi

Although the learning curve for using decentralized finance (DeFi) is steeper than with centralized exchanges, DeFi and its use of immutable smart contracts open up prospects for a more inclusive world. But how can we navigate the core functions of DeFi, use them effectively and profit?

Understand key protocols

Lending and borrowing

Emerging in 2017 with the launch of MakerDAO, decentralized lending and borrowing platforms are the historical first stone of DeFi.

On the lending side, it’s all about putting your assets to work to earn interest from borrowers. On the borrowing side, it’s about depositing collateral to leverage its value, allowing the borrower to remain exposed while unlocking some immediate liquidity.

If the value of the collateral reaches the value of the loan, the collateral is liquidated to repay the debt. By creating loops — sometimes via different protocols — experienced users can make their investments go even further.

Decentralized exchanges (DEXs)

Previously, the only way to exchange one crypto asset for another was through order books on centralized exchanges like Binance or Coinbase. The arrival of Automated Market Makers (AMMs) like Uniswap or xExchange and their liquidity pools set the stage for decentralized trading, where individual users can earn a share of trading fees as income.

The principle is to deposit two crypto assets in equal proportion and receive a liquidity provider (LP) token representing the relative value of the contribution. This method of directly earning trading yields has made AMMs a fundamental part of DeFi.

Derivatives and leverage

Derivatives are financial products where investors can speculate on rising or falling prices. For this purpose, two parties enter into a bet, so to speak, on how a particular underlying asset will perform over a defined period of time.

Likewise, it is possible to bet on falling prices or to use leverage. Leverage means borrowing money for larger investments, opening the door to higher returns but also greater potential losses. This adds an additional layer of strategy and complexity for DeFi.

Know the rules and risks of the game

Arbitration, slippage and impermanent loss

The exchange rate of the tokens on a DEX can, in the event of sudden volatility, decouple from the external exchange rate. Some users will take advantage of the arbitrage opportunity and buy the underpriced token to pocket the difference on the markets.

In order to limit sudden movements, a mechanism called slippage devalues the exchange rate logarithmically in proportion to the imbalance of the liquidity pair.

When a user removes their LP tokens from a pool, it is possible that the value of the two assets they withdraw is less than if the user had just separately held these tokens. Known as impermanent loss, this represents a key risk for DeFi users.

Liquidation

When the collateral for a loan loses its value, investors can face what is known as a margin call. If users are unable to add additional collateral in this scenario, the protocol then begins the liquidation process and sells the investor’s collateral.

Liquidation prices vary for each investment and largely depend on the amount of leverage used. This means investors should carefully consider the intraday volatility of a given asset before trading with leverage in order to avoid being liquidated.

Flash crashes and flash loans

Sometimes, a sale momentarily collapses an asset’s price. This can touch the liquidation limit, allowing predators to recover the liquidity placed in collateral through an event called a flash crash.

Flash loans are uncollateralized loans, where the borrowing and the repayment are done in the same smart contract over the course of a few seconds. This allows traders to take greater advantage of arbitrage opportunities.

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Explore different perspectives

Lego money

Since DeFi contains a range of interlocking protocols, investors should look at the bigger picture. We can see this ecosystem as a huge Lego set, with each protocol representing a different brick. Liquidity providers can then create their own models to take advantage of specific opportunities and construct their own winning combination.

The number of Lego bricks will continue to grow in number, diversity and quality. Over time, this growth allows for increasingly more complexity among DeFi strategies.

Democratization and yield farming

At present, only a small proportion of users have the know-how required to enjoy the full potential of DeFi. However, a truly inclusive ecosystem for a range of experience levels is critical for onboarding more liquidity moving forward.

One possible answer is aggregation solutions that combine the strengths of different protocols. By emphasizing simplicity of use and ergonomics, the complexity of DeFi…