Decentralized finance (DeFi) is a term that many have heard, but few have explained simply. If we think of our traditional finance systems, you typically have a bank that will hold your cash for you in checking or savings accounts. That bank then can utilize that money you have deposited to try to earn yield, but ultimately you have very little knowledge or control of how they do so.
The main difference in decentralized finance is that individuals have custody of their own assets and can utilize various applications to try to earn yield. Decentralized finance applications (dApps) are built using crypto, specifically on a blockchain. The most widely used blockchain for smart contracts is Ethereum.
DeFi offers the same suite of applications that you would expect from a bank, including lending, savings, and many others. For instance, there is a protocol called Anchor Protocol which currently offers approximately 20% APY (annual percent yield), meaning if you deposited $1000 and waited for one year, you would have approximately $1200. Annual percent yield takes into account the effect of compounding. This rate of return vastly exceeds what traditional banks offer in savings accounts..
The risks are that any application in decentralized finance relies on smart contracts, which are essentially contracts built on top of blockchain. If these smart contracts have vulnerabilities, hackers or designers can potentially abuse them to wipe out user’s funds. In the traditional finance world, there is FDIC insurance on bank deposits, but in the DeFi world, there are some insurance protocols that haven’t been as tried and tested.
Nonetheless, audits and research can help mitigate this risk, but in general higher return has an associated higher risk.
A fundamental building block for DeFi are stablecoins. Stablecoins are digital tokens that are supposed to hold peg to traditional currencies. Examples include USDT or USDC, which are pegged to the U.S. Dollar. Stablecoins allow users of DeFi protocols to park their assets in relatively stable crypto assets instead of constantly transferring back and forth between traditional and cryptocurrencies. There are risks with any stablecoin, particularly if the stablecoin loses peg to the associated fiat currency. There are many ways to earn yield on stablecoins currently, either through custodial providers such as Celsius or Blockfi, or utilizing decentralized applications yourself.
Another way to earn yield in DeFi is through a method called yield farming. Yield farming is essentially providing liquidity to enable trading on a platform. In the simplest form, you supply equal parts of two crypto assets and earn a yield from trading fees generated or other incentives from the platform. An example is a protocol called Pancakeswap. For example, we can provide liquidity for CAKE and BNB and earn roughly 34.61% APR (annual percentage rate), which doesn’t take into account compounding. This pool has $278 million in liquidity
