ABCs of DeF(i)
The summer of 2020 is notable for a host of reasons. A pandemic. #BLM protests. USPS shenanigans. But within the blockchain/crypto space, the summer of 2020 will be remembered as "DeFi Summer." Short for "decentralized finance," DeFi refers to a system of automated financial arrangements stored and executed on a distributed ledger such as blockchain. One of my business faves, Mark Cuban, recently touted the potential for DeFi to explode in the next 10 years. I may be biased but I agree; DeFi has the potential to revolutionize finance.
Automation is Key
We know that blockchain can facilitate peer-to-peer transactions in a trustless environment, that transactions happen without the need for a third party intermediary, and that an immutable record of the transaction is stored on the ledger. In other words, transactions happen automatically and records of transactions are incapable of being changed. This is why bitcoin was created. This is blockchain 1.0. We also know that blockchain can be programmed to execute transactions automatically when predetermined conditions are met. This is the basis for smart contracts and what many consider to be blockchain 2.0.
Well, DeFi operates no differently than your basic smart contract--transactions execute automatically when predetermined conditions are met. With no need for middlemen to verify that conditions have been met, transactions occur more efficiently in terms of both cost and time. Instead of creating a smart contract to send eth to your niece every year on her birthday, you are creating smart contracts with more complicated if-then scenarios (think loans, investments, exchanges, betting, insurance). These complex financial transactions require a more complex or sophisticated code but the mechanics are the same. And they can occur without the red tape and roadblocks that tend to accompany traditional financial institutions. But then again, who needs a credit check when you have a collateralization ratio of 150%?
DeFi Summer came to be because of a rise in popularity of the practice known as "yield farming." Without nerding out too much, yield farming essentially involves a user lending a particular crypto asset to a decentralized application (or dapp) and receiving interest, returns or other incentives in return. A popular incentive that helped drive the yield farming buzz last summer was governance tokens. These tokens give their owners certain rights with respect to the dapp, and these governance tokens have their own value that can increase or decrease. DeFi Summer was driven, in part, by the massive rises in increase of some of the more popular governance tokens. But what goes up can also go down (quickly), hence the warning. In the digital currency ecosystem, speculation knows no bounds, bad actors run rampant, coding mistakes happen and, well, people can lose a lot of hard-earned/hard-mined crypto. And the law cannot always (or even oftentimes) make people anywhere close to whole. If a DeFi project is offering returns that are too good to be true, they probably are and you will be lucky if you don't lose your entire investment. Always #DYODD (do your own due diligence).
Read about the rise and fall of DeFi project, Yam Finance, here.
Competition is Real
DeFi projects are coming online (usually on the Ethereum network) at a rapid clip and the growth is certainly fueled by an increase in market cap across all DeFi projects in the past few months. There are projects that involve lending and exchanges and derivatives and assets and payments. There are (and will be) plenty of opportunities to dip your toe into the DeFi space. Take the following into consideration when evaluating a project (taken from Reddit):
Total Value Locked/Fully-Diluted Market Cap
Market Cap / Revenue
% of Token Supply on Exchanges
Unique Address Growth
Token Balance Change on Exchanges
Liquid Inflation Rate
Virality (i.e., clear narrative, meme-ability)
Attractiveness of liquidity mining program
Audits/Management of technical risk
So now that you know a little more about DeFi, what are your thoughts? Do you believe in the promise? Or does it sound even less desirable than the costly fees and wait times we have with current traditional financial institutions?