Intro to DeFi — Part 2
Your opportunity to achieve FIRE — Financial Independence and Retire Early. Don’t miss this chance because you’re still early!
Welcome back to part 2 of the What is DeFi series where we teach you how to go from DeFi to FIRE!
We left off talking about decentralized exchanges, where providing liquidity to the exchanges can earn you a great source of income. This is also popularly known as liquidity mining, or yield farming, so whenever you hear those terms, it usually means providing liquidity to a protocol.
In this article, we’ll briefly explore derivatives, oracles, insurance, governance, as well as some DeFi related risks. Each of these topics are very heavy on its own, we are rebuilding the financial system after all, but I may go through each category in more detail in future videos.
Derivatives as its name suggests, derives its value from an underlying asset. The most common type of derivatives are perpetuals, futures, options, as well as synthetics. I will just briefly go through them as each of them are a topic on its own.
Perps, or perpetuals, are a way for investors to buy and sell the value of an asset without owning it by using stablecoins as collateral to bet on the price. Your position can last forever, hence the name perpetual swaps. However, you usually need to pay a funding rate to the shorts if you are going long or going bullish on your perpetual contract. This is to ensure that the price of the perpetual swap remains soft pegged to the underlying price by incentivizing others to short your contract to balance the price close to the real price. DYDX and PERP.FI are popular decentralized platforms for perpetual contracts.
Futures are basically derivative contracts that obligate the parties to transact an asset at a predetermined future date and price. For crypto, futures typically carry a premium, also known as Contango, where futures price is worth more than the current spot price, and this may be because of the belief that crypto generally trends up over time. A popular strategy for futures because of the premium is known as cash and carry, where you short the futures, and hold the spot, effectively being delta neutral, and you pocket the premium. This is how most crypto lending companies like Celsius and Hodlnaut can afford to pay you interest on your crypto, because they lend to entities that perform this risk-free strategy. Bybit is a popular futures platform and is unavailable in certain countries, but I think DEMEX is the only decentralized derivatives exchange that has futures, and they are based in Singapore too so that’s cool.
One interesting benefit about using perpetuals and futures is that they offer a way to leverage, sometimes up to 100x, but leverage is a dangerous tool, I won’t be going into details but I won’t recommend it for beginners. I mean the name itself tells you how dangerous it is, leverage is just levering up your age.
But no joke, leverage has destroyed a lot of lives and finances so try to avoid it as much as possible.
As Warren Buffet once said, there’s only three ways a smart person can go broke: liquor, ladies, and leverage.
But a life without liquor, ladies, and leverage may not break your bank, but it might break your soul, not spiritual advice, I’m not a spiritual advisor.
Options give buyers the right, but not the obligation, to buy or sell an underlying asset at an agreed-upon price and date. There are 2 types of options, a put option and a call option. Put options are bearish where you bet the price goes down, and call options are bullish where you bet the price goes up. A simple way to remember is that when you call your broker you pick up the phone, and when you are done, you put down the phone. I like to explain options as insurance and lottery tickets. If you think the price is going to crash, you buy puts which are insurance, and if you think the price is going to go up, you buy call options which are lottery tickets. Opyn and Hegic are popular decentralized options platforms at the moment, but Deribit has the lion share of the volume and I trade options on Deribit as well.
Finally, synthetics are crypto tokens that mimic the price of an asset but are not actually backed by it. It is often soft-pegged with the help of an oracles, a liquidation engine, and arbitrageurs to ensure that the price does not deviate too far from the underlying price. If that sounds complicated, Mirror is a great protocol to check out and I will be giving a full tutorial on mirror soon.
Speaking about oracles, let’s move on to them.
An oracle is basically a third-party service that provides smart contracts with information from the outside world. Protocols such as Mirror requires the real life stock price to help soft-peg the synthetic price, and this is achieved using oracle services where they pull or relay data from the outside world into the blockchain world. It is the bridge in allowing blockchain protocols to interact with data and networks from non-blockchain systems.
The most popular oracle is Chainlink $LINK, followed by Band protocol $BAND (which happens to power mirror protocol as well).
As DeFi continues to grow rapidly with the total valued locked growing by more than 20x in a year currently sitting at over 50b, it is attracting new protocols to be created every day. It is important that DeFi investors can safely invest into these protocols, especially the established ones, but no matter how established a protocol is, it may still be exploited from bugs, flashloans, and rug pulls.
In 2020 alone, 120m was stolen from exploits.
https://www.rekt.news is a website that shows you protocols that have been exploited, and the number keeps getting bigger as the DeFi space gets bigger.
This is where DeFi insurance comes in, where they provide you with coverage against smart contract failure. The most popular one is nexus mutual, which is a people-powered, peer-to-peer decentralized insurance protocol. They charge as little as 2.6% annually for protection against a smart contract bug, which pays you out in $ETH or $DAI.
Insurance is a giant industry in the traditional financial markets, and as DeFi becomes mainstream and adopted by the traditional institutions, they will also seek a way to buy insurance in their investments.
Governance tokens are very popular in DeFi projects as it makes it more decentralized by giving holders the voting rights over proposals and changes of the protocol, allowing them to decide on changes to how the protocol operates. This also includes how the treasury of the protocol is spent.
Additionally, governance tokens also capture value from transaction fees. For example, sushiswap takes a small fee from each transaction which it uses to automatically buy back sushi and give it to users that stake sushi, as a reward for staking sushi. This automatically increases the price of sushi when there are more transactions, and if you stake your sushi, you also receive additional sushi, similar to receiving dividend incomes.
cryptofees.info and tokenterminal.com are great websites that shows you fees generated by protocols and gives you the P/E ratio and P/S ratio of the governance token of certain protocols. These profitable governance tokens are sometimes known as ‘productive assets’ because they actually generate profit.
Another popular governance token is Axis Infinity $AXS. The protocol has generated over 21.6m in the past 7 days, more than all the other protocols combined, making $AXS one of the most profitable and potentially undervalued governance token.
With new innovations, there are inevitably risks involved as well. The most common type of risks are smart contract bugs which can allow it to be exploited either through a rug pull, flash loan attack, minting exploit. The earliest DAO launched in 2016 had $120m worth of $ETH invested into it and half the value was stolen using an exploit less than 3 months later, causing Ethereum to do a contentious fork to roll back the hack and that is a story for another time.
In terms of audits, Certik and Hacken are some of the more popular professional crypto audit firms, but www.rugdoc.io is a fantastic community that reviews protocols by passionate coders and auditors.
One more important risk to know about is impermanent loss.
As liquidity providers, impermanent loss is the temporary loss of funds because of price movements in a trading pair. Due to the pricing curve they use in an AMM DEX (automated market maker decentralize exchange), if you are holding a stable asset such as $UST, and pairing it with a volatile asset such as $TSLA, when the price of $TSLA goes up, essentially someone buys your $TSLA and gives you $UST. So you now own lesser $TSLA and more $UST, but in terms of net gain, you actually lost profit as you own less $TSLA that is now worth more. This topic might be a bit confusing, so I am making a dedicated video on this soon! But just know that impermanent loss is worth it as long as the yield you earn is more than the loss.
You can use baller.netlify.app to calculate your potential impermanent loss on price movements before deciding to pool or not to pool your liquidity.
With that, I’ve come to the end of this article, hope you have found it useful, and do subscribe to our YouTube channel for more information about DeFi!
Hope you catch the freshest gains across the markets!