Just like the classic lasagna, DeFi comes in many delicious layers. From conservative to speculative, there are many ways to enjoy the different flavors of investment available.
Decentralized Finance (known as DeFi) is a collection of apps, website, and products that do things similar to what banks and financial institutions do in the regular world, but on a blockchain. In this article, we will walk through what some of these projects are, and how they compare with each other in terms of risk and safety.
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So first, a very short glossary. Most things in DeFi are very similar to their regular world counterparts, but just with a different name:
- A stock exchange in DeFi is known as a DEX, or Decentralized Exchange. One example is Uniswap.
- And a savings account, just like in a bank, is known as a savings protocol in DeFi. One such example is AAVE.
- And companies, that run and direct businesses, are called DAO's in DeFi. One such example is Maker DAO.
There are also some things which only exist in DeFi such as Yield Farming, tokenized yield, and flash loans. We'll explain more in a bit.
Disclaimer: DeFi Desk is an entertainment platform, and not a source of financial advice. You must remember that you are wholly responsible for any and all investment decisions that you make, whether they lead to life-changing profit or loss. You are the sole driver of your caravan, which may include your family (if you are providing for one), so do consult a professional and make sufficient research before investing in any products mentioned.
1st Layer - Savings
Just like in the regular world, savings are usually the safest place to park your money and earn a passive interest (in regular banks, around 0.1-0.3% per year, if you're lucky).
In DeFi though, this passive interest can start from anywhere around 0.16%, to up to 2.8% per year (on AAVE), which is a much better deal! It can even be higher on some stablecoin-only savings protocols (like Anchor Protocol). If you haven't heard the term stablecoin, it's a kind of crypto whose value is fixed to $1. Now for many reasons, some stablecoins are more reliable than others, but this is something to be discussed in a later article.
How do Savings protocols make money?
Savings protocols lend deposited funds to borrowers, who promise to pay back the loan + a yearly interest that is lower than the bank's. These loans are not based on credit score (since crypto accounts are anonymous), but on collateral. It works like a pawn shop: you leave something of value with the lender, and you can borrow up to half of the cash value of the item.
Can a lender run away with the money?
As a security for the loan, to prevent the borrower from taking the funds and leaving, the collateral they have to deposit is usually 2x or 1.5x the value of the loan. E.g. Borrowers borrows $500, they would need to deposit $1000 of collateral, either in ETH or BTC. Some other well-known tokens are also accepted as collateral. That way, if the borrower defaults (runs away), the collateral can be sold to repay the loan.
Why would someone take a crypto-loan?
The incentive for borrowers to make crypto-loans in this way is because they can continue to hold their BTC or ETH assets without selling them, while also getting some cash for spending (or to invest in more assets. This is like taking a second mortgage loan against the value of your house, except ETH or BTC can rise in value a lot faster than the average house! Unlike banks, savings protocols don't charge late payment fees, or compounding interest, so it's a lot more peace of mind for the borrower. And since the loan is overcollateralized, it is also safer for lenders. Also, instant and unconditional approval! As long as you can deposit enough collateral.
What's in it for the savings protocol?
Savings protocols also take a % of the interest earned, which is how they earn, and this is usually paid to their token holders, similar to how dividends for companies with shares.
2nd Layer - Strategies
Strategies, also called vaults in DeFi, work very similarly to mutual funds in the regular world, where a group of investors put their money together and hire someone to make investment decisions on their behalf. In the regular world, this would be a fund manager, who would research and evaluate companies, stocks, bonds, commodities, and futures etc. in order to make the best return. The most famous example is Yearn, or Alchemix.
In DeFi, this job is actually done with the help of an algorithm called a strategy, that picks the best path towards higher returns. This can be accomplished using data from the blockchain itself, because there are no barriers to information on the blockchain, all if it is accessible and considered by the algorithm before picking an optimal method of investment. For example, the transactional data, price movement, total value of any protocol can be found on the blockchain.
Alchemix does this with user-deposited DAI, placing it into vaults to earn via a strategy. But they have a slightly different approach in that they provide a way for you to earn your profit upfront (this is called tokenized yield), and in the meantime, they keep your deposit until it has earned back the amount that you've withdrawn.
What are the risks of using Strategies?
Algorithms do what they're programmed to do, and sometimes bad programming can be blamed for their mistakes. A badly written algorithm might not only be unprofitable, it could also be too profitable, or in other words, it can overpay investors and thus make the protocol lose money. One example is Alchemix's alETH vault mistake, which unwittingly allowed investors to deposit and withdraw future profit, as well as withdraw their deposit, giving them instant profit at the expense of the protocol.
Strategies are also susceptible to being tricked, by having their price sensors obscured or confused. Hackers can do this via flash-loan attacks, which use a large amount of capital (such as $1M in ETH) to upset the price of a token (like DAI) and make the algorithm think that it is worth much more or less than what it really is. This strategy was used to successfully steal $2.8M USD in DAI from a Yearn vault back in February 2021.
What are the benefits of using Strategies over savings?
Savings protocols are generally dead simple, and so hackers have little leeway to do any kind of exploit. And so far, AAVE has been safe from such incidents. However, with the same capital, a depositor can earn much more by investing through a Strategy rather than simply depositing in AAVE.
In Yearn, annual returns can be as high as 42%!
What are tokenized yields?
Earlier we mentioned that Alchemix provides tokenized yield by allowing you to withdraw your profits upfront as an interest-free advance. Basically, it's giving you a loan that will be repaid by the interest generated on your deposit. In the process, Alchemix also creates the byproduct of alUSD, which is their synthetic stablecoin that is overcollateralized by DAI and (mostly) pegged to $1.
Another protocol that does this is Flashstake. In return for committing your tokens to them, they will provide a calculated "future yield" amount that will be paid to you as an upfront, interest-free advance, based on your time commitment of staking. You can stake up to 364 days (almost a year) maximum, and your tokens will unlock and be fully withdrawable at the end of that time period.
You don't have to understand all this by the way. All you need to know is tokenized yields = future profits NOW.
Why do protocols do this?
You might be saying, that sounds too good to be true! Now here's the catch... Protocols can only pay you future yields in their own token: alUSD for Alchemix, and FLASH for Flashstake.
Why protocols do this? It is because they want your tokens (ETH, DAI, SUSHI etc.), so that they can use it to earn yields in other ways (liqudity mining, lending, etc.). Protocols use deposited funds to earn profits, so giving you a token like alUSD (which has no intrinsic value, except that it can be used to withdraw DAI from Alchemix) is no problem for them.
But why do you as a depositor want to use Alchemix instead of finding those strategies yourself?
- It saves on time, you don't have to go looking for those strategies yourself.
- It saves on transaction costs as well, since your funds are now in the protocol along with other investors' funds, the protocol will pay for the transaction fees every time it needs to deposit, claim rewards, or move funds.
- It's easier.
That last one is probably the most important for those who are not experienced in the space. The DeFi space is filled with people who just arrived at the party, so don't feel alone. With tokenized yields, you don't have to understand what DAI is or how it can be used to earn profits, or what the overall ecosystem of DeFi is like. You can simply deposit it in Alchemix (or Flashstake), take your advance, and move along.
You also have peace of mind from knowing that no matter what, the protocol will find a way to earn the maximum amount it can from the deposited funds (due to aligned economic incentives).
Alright, that's part 1 and 2 of our introduction series on DeFi protocols. Follow us on publish0x, or on Twitter @DeskDeFi for updates on part 3 and 4!
Stay safe crypto-cowboys!