What Is DeFi and Is It a Sound Investment?

Despite a small correction in early September, crypto has entered a boom phase again and it is largely due to an explosion in Decentralized Finance (DeFi) projects. These projects aim to bring financial derivatives to the crypto market and could mark the start of a new era in cryptocurrency.

However, there are significant challenges on the horizon and concerns about the legitimacy of DeFi are on the rise. Long-term, this could make crypto investing less reasonable and call the whole market into question.

How Does DeFi Work?

While Bitcoin makes a great store of value, it is difficult to actually do anything with it beyond long-term holding or riding short-term price trends to profit from volatility. The big problem with most existing blockchains is usability and transaction speeds. DeFi is designed to solve a number of these problems by mimicking the real-world financial derivatives and instruments.

Rather than relying on a bank or financial institution to let you borrow money in crypto, or make an instant trade, DeFi uses code to control how transactions are conducted. There are a number of different kinds of DeFi projects, including:

• Decentralized Exchanges (DEXs): These allow users to exchange fiat currencies for Bitcoin, Ether, or other cryptocurrencies. There are also exchanges that use a combination of a central governing body, with coded contracts to allow users to exchange directly. This combines the privacy of P2P exchanges with the ease of use of a centralized exchange like Coinbase.
• Lending Platforms: These platforms use smart contracts to set up loans using cryptocurrency, often with high interest rates designed to encourage lenders to provide liquidity.
• “Wrapped” Bitcoins: A unique way to utilize Bitcoin directly in Ethereum’s DeFi ecosystem. It enables users to lend out Bitcoin on Ethereum-based platforms without the need to actually convert their currency, giving the cryptocurrency more utility.
• Stablecoins: These tokens peg their price to a specific currency. For example, Tether is pegged to the US dollar. This is done to maintain a stable price in comparison to other assets.
• Financial Derivatives: DeFi also makes it possible to bet on the future value of crypto and other assets without having to go through a centralized intermediary.

These advances are significant because they form the second layer that crypto is currently missing. By opening up lending platforms, arbitrage opportunities, and financial derivatives it brings significantly more dynamism to the cryptocurrency sector, which in turn brings more liquidity to the market.

The two most significant aspects of DeFi are lending platforms and decentralized exchanges. The former have helped to drive the price of Ethereum through the roof and have provided a way for investors to “stake” their cryptocurrency in exchange for interest. However as yield farming returns drop it is likely that the big advance will be decentralized exchanges.

In September, one of the largest DEXs, Uniswap, surpassed coinbase when it processed more than $15 billion in transactions. Even as yield farming operations slowed down and the DeFi sector took a hit, volume on Uniswap appears to have been broadly unaffected. It is likely that DEX will become increasingly popular in the future. Even the CEO of Binance expects decentralized exchanges to cannibalize his business.

The Potential Is Huge, but So Are the Risks

It’s undoubtedly true that DeFi is a big step forward for cryptocurrency but it hasn’t come without its problems. The unregulated nature of the market, combined with its high technical barrier, has created the perfect environment for poorly constructed projects and outright scams to thrive.

Poorly constructed projects arise from the way smart contracts are created. As they are designed to be automated, even a small coding error can have huge long-term implications. In fact, smart contract vulnerabilities were the cause of DeFi platform Bzx losing $8.1 million in their third hack of 2020. It was also discovered that a bug in Bancor’s code enabled any user to withdraw an unlimited amount of funds. This vulnerability was discovered to be common in a number of DeFi apps.

Additionally, after a number of high profile exit scams in recent weeks, people have been reminded of the ICO scandal of 2017-2018. Exit scams involve the project leaders withdrawing assets from the project and essentially stealing investor’s money.

Examples include LVfinance and Emerald Mine and many others. While these scams cost investors dearly, the bigger problem is that they are damaging the reputation of the crypto market.

Despite the fact that the finCEN files revealed that banks have processed over $2 trillion in illicit transactions, there remains an outsized concern about crypto money laundering.

There are concerns that the lack of Know Your Customer (KYC) checks on decentralized exchanges have opened the door to money laundering. Given the established financial sector’s poor practices in this area it seems a little hypocritical. But cryptocurrency will always be placed under a microscope, and even small scandals could risk a minor crash.

However these crashes or corrections might not be such a huge problem, in fact I would argue that they are inevitable. Crypto is an unstable asset, DeFi doubly so, and while the sector finds its feet there will be a lot of ups and downs. In the long term any major corrections, or even minor crashes, should help clear out unviable DeFi projects and allow high quality projects room to breathe.

Specifically a reduction in the number of projects focused solely on offering inflated interest rates to attract yield farmers needs to happen. As these greed focused lending platforms begin to die off we will see a handful of high-quality DeFi lending platforms survive, or grow to take their place.

This process is already happening and the fact is that the DeFi market still has strong fundamentals. According to DeFi Pulse, there is currently more than $10 billion locked in DeFi contracts, and despite a slight contraction this number doesn’t appear to be crashing, more levelling off. This means that viable projects, like UniSwap, will be able to continue, but cash-grab projects might struggle in this tougher environment.

Is DeFi a Good Investment?

The short answer: With the right due diligence, yes DeFi is a promising albeit high risk investment. By its very nature DeFi is unregulated and this bring with it the key risks described above:

• No Governing Body: Means that it is difficult to prosecute project owners if they commit fraud, if you make a bad call, you will be left holding the bag with little to no recourse
• High Price Volatility: Brings opportunity but also means that you could find your asset worthless overnight, the history of crypto is littered with promising projects that flopped.
• Vulnerability To The Media Cycle: Any asset can experience sudden dips from the news but the crypto market is very strongly driven by fear and greed. This means that the media can have a large impact on price fluctuations, increasing risk overall.
• Risk of hacks: Any DeFi investor needs to be aware of the risk of hacks and will need to take best practice steps to protect their asset.

Those risks aside, promising DeFi projects should be able to weather any major crash, no matter how big the bubble becomes, so any crypto investor looking for a long-term hold, or a short-term bet, will likely be okay. The key is to avoid chasing high interest rates, or high-risk projects promising absurd returns, but to focus on projects with the right fundamentals. This requires a lot more research, but in the long term, will bring stronger returns.

The takeaway:

The key is to follow investment best practices: Do your research, diversify your portfolio, don’t act with haste, and don’t invest money you can’t afford to lose. If you do that, you’ll be just fine with DeFi.