Intro to DeFi — Part 1
Your opportunity to achieve FIRE — Financial Independence and Retire Early. Don’t miss this chance because you’re still early!
DeFi stands for Decentralised Finance which is recreating traditional finance using blockchain and smart contracts and is open to everyone and doesn’t require an intermediary (i.e. bank).
It allows you to consistently earn an additional 10% to 40% on your existing assets usually, by replacing the middleman in the traditional financial system. This means you get to be your own bank, your own market maker, your own insurance company, and more, allowing you to earn the attractive fees that they charge which is usually inaccessible to normal folks in the traditional system.
Not sure of the terms I just mentioned? That’s why I’ll be touching on a few key components of the DeFi ecosystem namely:
- Lending & borrowing
- Decentralized Exchanges
Wallets can be centralized and decentralized. Centralized wallets means you do not actually have control over them. Centralized wallets include Coinbase, Binance, or even your Bank or CPF Retirement account. If something happens to them, or they decide to act against you, you may lose access to your funds, however the probability of anything bad happening is low so everything is fine until it’s not.
As the saying in crypto goes, not your keys, not your coins.
Here’s something to remember, every time you go to an ATM to withdraw your money, and they show you your balance, that is not how much you have, that is how much you lent to them or in other words, what they currently owe you. If you need their permission to move your funds, then it’s not your coins.
For decentralized wallets, you hold the keys to them, so they are truly yours, but that also means it is truly your responsibility to take care of them. There is no forget password button if you lost your keys, so be sure to keep your keys properly. I’ll talk about how to store your keys securely in another video.
There are two main types of decentralized wallets, cold wallets such as ledger and trezor which are more secure but less convenient, and hot wallets such as metamask and trust wallet which are more convenient to use but less secure.
Cold wallets are also known as hardware wallets because you require a physical device. They are offline and more secure because someone will need physical access to steal your funds. Ledger or Trezor are the popular choice.
Hot wallets are also known as online wallets exist in your browser or your phone, and if your computer or phone is compromised, your funds can get stolen, making them more dangerous. However they are more convenient as you are not required to interact with a physical device. Metamask is the popular choice as it’s available on both desktop and mobile phone. Metamask can also be used together with a physical wallet on the desktop for additional security, but metamask with hardware wallets on mobile is not yet available.
Realistically it makes sense to have your funds on all 3 types of wallets as they all have their own purposes. Centralized wallets for high liquidity and low fee transactions, hot wallets for constant interactions with a smart contract protocol, and cold wallets for assets you intend to keep and hold for a long time.
Stablecoins are essentially fiat currencies on the blockchain. The most popular stablecoin is USDT, where 1 USDT = 1 USD supposedly.
There are 3 main types of stablecoins, asset-backed, algorithmic, and collateralized.
Asset-backed simply means the stablecoin is backed by an equivalent amount of dollars in real life, for example, 1 BUSD is audited in their monthly attestations that they are backed by 1 USD in FDIC insured banks and they are regulated as well, making them a lot safer. USDC and BUSD are the safer stablecoins to use.
Algorithmic stablecoins such as UST achieve price stability by balancing the circulating supply of the asset, for example if UST is $1.10, the protocol prints UST to devalue UST back down to $1. If UST is $0.90, the protocols burns UST to increase the scarcity of the UST and increase the value back to $1. That’s an oversimplification and I will go into more detail when I deep dive into the $LUNA protocol soon.
Collateralized stablecoins such as DAI requires users to deposit existing crypto assets such as Ethereum, in order to take a loan by borrowing against the asset to receive DAI. It is similar to taking out a mortgage or a loan on your house in order to receive more USD.
Lending & Borrowing
One of the pillars of any financial markets are the credit markets, which is the lending and borrowing market. There are also centralized and decentralized lending and borrowing platforms.
Centralized lending and borrowing platforms include Celsius, BlockFi, Nexus, Hodlnaut, and more. We call them CeFi, which stands for Centralized Finance. They allow you to deposit your assets and they help you to lend it out to other reputable parties so that you can earn interest on them. They also allow you to take a loan by collateralizing your assets with them.
However these centralized platforms requires KYC (know your customers) where you need to submit your information and the loans that you request for requires time to be approved.
Decentralized lending and borrowing platform include AAVE and Compound where you do not need KYC and you can borrow and lend instantly without approval as long as your collateralization ratio remains healthy.
How AAVE’s dashboard looks like, with deposit rates far better than banks:
This is where the fun begins. Traditional exchanges require a centralized market maker to fill the order books with buy and sell orders and they profit from the spread and transaction fees. If you take out the market markers, suddenly the order book becomes thin and transactions creates high price movements (aka slippage) due to low liquidity.
In a decentralized exchange (aka DEX), you get to be the market maker by providing liquidity on assets you already own. If you have an existing asset such as bitcoin, you can provide bitcoin and USDC, also known as BTC-USDC LP.
LP stands for liquidity provider and it’s the token you receive for providing liquidity and the amount of token you receive represents your share of the liquidity pool when you need to withdraw them later.
You usually earn 0.2% — 0.3% multiplied by your % share of the pool of every transaction as fees. This means if you own 10% of a pool, and the pool has a daily volume of 10m with a 0.3% transaction fee, you earn 10% (your pool share) * 0.3% (transaction fee)* 10m (24hr volume) = $3000 a day. But realistically 10% of a pool with 10m daily volume is probably far more than 10m itself.
Additionally, to incentivize liquidity into the pool, the protocol itself will also give out their governance token as a reward for you to provide and stake your liquidity. This can drastically boost the APR you are earning. APR stands for annual percentage rate, you can think of it as ROI but in terms of income as you continue to gain if the assets that you hold grow in value.
An example of providing liquidity on the USDC-DAI pair on DFYN network to earn 40% APR (in their token).
Popular DEXes include uniswap, sushiswap, pancakeswap, and curve.fi, and they all require a decentralized wallet in order to access them.
We have talked about the different types of wallets, stablecoins, lending protocols, and decentralized exchanges.
In the next part, I will talk about derivatives, insurance, governance, oracles, as well as the risks involved in DeFi.
Stay tuned and may you catch the freshest gains in the market!