Eve Wealth DeFi Guide
Decentralized Finance (DeFi): The guide to earning on digital assets for investors
Part I: The Basics – How DeFi Works & Why it Matters
Part II: Understanding the DeFi Landscape
Part III: DeFi as an Investment Opportunity
Part IV: DeFi in a Portfolio Strategy
Part V: Key Risks & Considerations for Investors
Since the emergence of Bitcoin in 2009, investors have used decentralized finance as a way to borrow, trade, and build wealth without the regulations, limitations and intermediaries required by traditional finance methods.
Decentralized finance, or DeFi, is an ecosystem of open financial applications built with blockchain technology. While traditional finance methods have required individuals to lend, borrow, and accrue money through financial intermediaries, such as bankers and brokers, decentralized finance creates an open system where people can exchange funds, make investments, and raise capital without going through a middle man.
In part because of the unparalleled access to wealth that DeFi provides, cryptocurrencies and other digital assets have exploded in value and use in recent years. This paper aims to inform investors about the background and basics of DeFi and provide practical tips and advice for those wishing to add DeFi as part of a balanced investment portfolio.
BACKGROUND AND HISTORY
In 2008, Bitcoin was released by a person (or several people) utilizing the pseudonym, Satoshi Nakamoto. This was likely the earliest predecessor to decentralized finance. With Bitcoin, an unchangeable record of digital history was developed. Bitcoin laid the foundational infrastructure which would later be leveraged by DeFi protocols for trustless transactions. Bitcoin was the first crypto currency to significantly disrupt traditional finance methods, thereby creating the conditions for DeFi’s later emergence.
Almost ten years later, in December of 2017, MakerDAO’s protocol was launched. In this case, a “protocol” is a distributed database or set of rules for multiple computers to share data. The MakerDAO protocol allowed loans of a stablecoin called Dai pegged to the USD in exchange for deposits of collateral such as Ether or other cryptocurrencies. The MakerDAO protocol and stablecoin enabled users to take out a loan without relying on a centralized entity, thereby providing access to wealth without the need for a financial intermediary. This was a radical change from traditional finance where individuals are required to provide ID, apply, and get approvals for financial services which can take weeks to confirm.
MarkerDAO is regarded by many as the first instance of DeFi. From there, other financial protocols were developed, including Compound Finance (September 2018), Uniswap (November 2018), Synthetix (February 2019), Curve Finance (January 2020), Yearn Finance (February 2020), Balancer (March 2020), and many more – which set the stage for DeFi Summer, a major period of DeFi growth which took place in the summer of 2020. DeFi summer was the beginning of these protocols coming into the public domain from June to September 2020. Below you can see the uptick in Google Search results for DeFi picking up momentum in August.
Just how extreme was the growth of DeFi during DeFi summer? In February 2020, the total value locked, or the total amount of assets invested in decentralized finance applications was a little over $1 billion. By October 2020, that number had hit $12 billion. Now in 2021, the total value locked in DeFi applications exceeds $100 billion.
There are over 236 DeFi projects listed on ecosystem aggregator DeFi prime and 128 applications listed on DeFi Pulse. Most of these are built on Ethereum but there are growing ecosystems emerging on other Layer 1s like Solana and Avalanche, and Layer 2 scaling solutions like Polygon. As decentralized finance matures, we can expect to see both growth and consolidation of the applications as well as use cases.
Today, the definition of DeFi has expanded to include any protocol that enables an open exchange of finance across payments lending & borrowing, trading, insurance, derivatives and synthetics. Open finance is defined as the ability for anyone to use them without approvals or even verification beyond a digital wallet. The use of cryptocurrency and smart contract functionality is empowering a more open system of wealth-building that eliminates intermediaries while increasing consumer access and autonomy.
PART I: THE BASICS – HOW DEFI WORKS AND WHY IT MATTERS
The best way to build a beginner’s understanding of DeFi is to develop a deeper understanding of traditional finance. In traditional finance, financial institutions are licensed by governments, and laws, which are enacted by governments, regulate all operations. Decentralized finance differs in that it relies on unregulated open-source code that anyone can access, called blockchain.
Blockchain is the key infrastructure that has enabled the spark of this defi revolution. The idea of an unchangeable record of history was popularized by the Satoshi whitepaper for bitcoin. The idea that miners could be compensated for verifying transactions, that the use of energy (proof of work) would discourage nefarious players, and that a public record of verified transactions would provide the trustless system to enable a decentralized world – emerged. As a result, financial transactions could more easily be implemented on this system that replaced the traditional financial system’s legacy infrastructure where each financial institution holds their own centralized ledger (or record). When transactions come through, it can take days for them to verify the transaction on their ledger, and mistakes do happen. More importantly, the blockchain provides a cost effective way to onboard million of people without access to financial services, onto a system where the cost to serve is exceptionally low (because it is automated).
Any financial system requires two main components to function: infrastructure and currency. In traditional finance, the infrastructure is provided by banks and other licensed financial institutions which act as mediators. The judicial system and other regulatory bodies empowered by governments, also provide critical infrastructure. Traditional financial systems rely on fiat currency, that is, government-issues currencies unbacked by any commodity.
Traditional financial systems have a demonstrated tendency to become more centralized over time. From 1990 through 2009, 36 different banks have consolidated into four. This accumulates risk in the system with increased chances of single points of failure. Centralized entities are more vulnerable, error prone, and susceptible to attack. Their inefficiencies and discrepancies have resulted in the loss of hundreds of millions of dollars through instances such as wrong share counts, rebalancing errors, and failures to meet deposit requirements. Lack of transparency can also lead to opaque baskets where investors don’t realize what’s in the securitization until it fails as was the case in the 2008 subprime mortgage crisis. Baskets are essentially financial products that combine multiple assets – in the mortgage crisis these were baskets of real estate, primarily single family homes, that were over leveraged or not securitized properly (too much debt, without owners who would be able to meet the payments). There are also popular financial products – like ETFs and Index funds – which are often baskets of stocks. The S&P500 is a basket of the top 500 companies listed on the public markets by market cap.
Banking Consolidation (1990 – 2009)
In contrast, DeFi applications use smart contracts on a blockchain (like Ethereum) to automatically execute transactions if certain conditions are met. Programming languages (like Solidity) are used to create and deploy these smart contracts. Most rely on oracles, which are any device or entity that connects to a blockchain with off-chain data (like Weather temperature), and provide the data that triggers the smart contract to execute the monetary transaction. Decentralized oracles rely on multiple external sources to increase the credibility of the data provided to the smart contract.
Thanks to the use of smart contracts, DeFi 1) prevents single point failure 2) is less susceptible to attack and 3) increases transparency. First, one of the core tenants of blockchain is that it is decentralized, and by definition removes the risk of single points of failure that come from centralized systems. Oracles can still present a single point of failure for protocols that rely on them, but generally, decentralized finance stores data across multiple notes. Given it’s growth, a number of high profile hacks and attacks of DeFi protocols have become apparent. Increased smart contract security audits and testing and bug bounties (encouraging users to find and report problems) have helped reduce the risk. Open source, community-based security support is unconventional for traditional finance where Global cyber security is a $300B+ industry. The transparency of smart contracts and blockchain transactions further improves the identification of security flaws. So long as developers are competent and careful with reviewing any open source code that is copied, clone projects can expedite the speed to market while minimizing replication of errors from the original (if any).
Like traditional finance methods, DeFi allows individuals to complete the financial functions necessary for a thriving economy with several key differences.
Both TradFi and DeFi allows for issuing, transferring, lending/borrowing, exchanging assets, and investing money. However, with traditional finance models, only the state has the power to issue money, while DeFi issues money through Proof of Work and Proof of State rewards. Instead of transferring money through cash, DeFi allows individuals to transfer money through cryptocurrency and token transactions.In traditional finance, banks control lending and borrowing. In decentralized finance, individuals borrow and lend money direct between peers through tokenized debt. Similarly, where TradFi allows for the exchange of assets only through exchanges and brokers, like Nasdaq, DeFi allows for decentralized exchanges, thereby improving access to wealth.
Because of this, DeFi has significantly changed the way the world thinks about investments. In the past, individuals invested in stocks and bonds, which were only accessible through banks. With the rising popularity of DeFi, individuals can now invest in tokenized financial products, such as ICOs, STOs, and token baskets.
So why is DeFi important or needed? Especially in the United States and much of the developed world, it has become expected that a centralized entity be available to take responsibility, provide customer service, and even have a physical location to access for increased consumer comfort and trust. However, these benefits come at a cost, and DeFi has provided a needed solution, especially for vulnerable popualations.
There are a few use cases which stand out:
- The unbanked
Geographical barriers, lack of funds, and other systemic barriers have left 31% of the global population unbanked. In the US, 6% of households and 25% of adults are unbanked or underbanked, meaning they do not have sufficient access to traditional financial services. Decentralized finance, with digital ledger technologies and lower cost (without the middle men or rent seekers), mean anyone can access banking services, generate wealth, and take out loans without going through a lender or banker.
Companies like Valora, and many others, are specifically dedicated to this mission of increasing access through mobile banking technologies. Built on Celo, a carbon-negative blockchain, Valora is a crypto wallet that makes sending and spending crypto as easy as sending a text, anywhere in the world. This is made possible through low gas fee transactions on the celo blockchain. This makes transacting and exchanging value both easy and affordable to millions of users around the world who have historically not had access to financial services but do have access to internet and a smart phone. Other companies, like Bankless, have dedicated their entire business model to education and a movement around a bankless world.
Other models like play-to-earn (P2E), popularized through the game Axie Infinity, have started to address the income barriers – by allowing rural Filipino communities to survive unemployment during the COVID pandemic. Earnings in P2E games may in the future be used to underwrite loans and open up new models of credit for this population that previously has been ignored by or out of reach for traditional financial institutions.
- Trustless Entities
In countries that have struggled with hyperinflation or oppressive governments, a history of bans, currency manipulation, and poor emergency response have lowered public trust in traditional financial institutions. In times of emergency, bank runs can quickly lead to zero cash balances as seen in places like Argentina, Venezuela and Zimbabwe. When the flow of currency is restricted, people are unable to withdraw savings or control their funds. In these parts of the world, the promise of a system that allows people to circumvent bans, currency manipulation or other restrictions is promising. In some emerging markets, even gaining access to a stable USD-backed currency is revolutionary. For example, in 2021 El Salvador adopted bitcoin as legal tender making the cryptocurrency an accepted means of exchange for goods.
Furthermore, tracking transactions on the blockchain is much more difficult and privacy is more protected. Unlike traditional finance, a government-issued ID, social security number, credit score or proof of address, and even in some instances – collateral – are not necessary to use DeFi. Uncensored access to global financial services is a significant use case for decentralized financial technologies and applications.
- Access to Capital
The most developed product of DeFi is credit. At its most basic level lending is “getting money for interest.” A lender gives a loan to someone with the agreement that it will be repaid with a certain amount of pre-defined interest. This is an ancient concept, which dates back over 3000 years to when farmers began to borrow seeds issued against a later payment of grain on harvest day. Individuals can often borrow money from a DeFi platform at lower interest rates than at traditional banks. In some countries, bank loans can be as high as 20% and in some DeFi applications borrowing costs can be as low as 3-4%. Other forms of borrowing have emerged that allow users and platforms to acquire quick capital or liquidity, sometimes even without collateral. These loans are typically higher return for the investor, and therefore a higher borrowing cost for the borrower but with a willingness to pay to access liquidity on the blockchain. On some protocols, borrowing is also rewarded with tokens that can outweigh the interest expense.
In addition to these benefits, DeFi enables peer-to-peer lending and borrowing that removes centralized approval or oversight. Peer-to-peer loans run entirely online and borrows receive near instantaneous approval, so there is little to no downtime between application and approval. Once approved, most peer-to-peer loans are fulfilled within two weeks. The borrow enjoys much lower interest rates, while the lender typically sees a higher return. Even individuals with a low credit score may be approved for peer-to-peer loans, promoting more equitable access to capital.
PART II: UNDERSTANDING THE DEFI LANDSCAPE
DeFi is new and evolving rapidly. It has the potential to disrupt many, if not all of the sub-sectors of financial services.
To get a sense of scale, global traditional financial services markets are valued in the trillions:
- Exchanges Public Markets ~$95T
- Banking ~$9T
- Borrowing / Lending ~$7T
- Insurance ~$6T
- Payments ~$2T
- Alternative Assets ~$10T
Today, there is ~$100B locked in DeFi, up from ~$20B in January 2021. As equities, bonds and real assets are tokenized in the next 10+ years, DeFi could end up with a market cap of more than $100 trillion dollars.
So what does the landscape look like today?
The DeFi landscape is rapidly growing in popularity, and with a strong understanding of the DeFi landscape, investors can capitalize on DeFi applications. The most popular DeFi applications are Digital Asset Trading (DEXs, AMMs, Aggregators), Lending & Borrowing Platforms, Stablecoins, Staking & Yield Farming, and Asset Management and Investing. In addition, an emerging set of Prediction Markets, Insurance, Derivatives and other opportunities remain on the horizon.
Digital Asset Trading
Decentralized Exchanges (DEXs), Automated Market Makers (AMMs), and Token Swapping Aggregators let users conduct peer-to-peer financial transactions while maintaining control over their funds.
DEXs, like Uniswap, Sushiswap, 0x, ParaSwap allow users to access and trade crypto assets from anywhere there is an internet connection and digital wallet (like MetaMask). Additionally, an increasing number of these platforms also offer swapping, staking, farming, and other standardized DeFi trading action. This means that individuals can lend, borrow, and trade digital assets without the help of an intermediary, such as a bank or a broker.
Lending & Borrowing Platforms
The most established DeFi use cases are non-custodial, decentralized peer-to-peer lending platforms which allow users to borrow funds using crypto assets as collateral and lend crypto assets for interest rates for returns that are much higher (for investors) and access that is much easier (for borrowers) than in traditional finance. Borrowers are currently willing to pay these higher interest rates for a number of reasons, including capital gains. Many defi users will use leverage (debt or borrowing) against assets for transactions rather than remove assets from the blockchain.
Maker, Compound, Aave are examples of non-custodial lending & borrowing platforms. Aave is known for popularizing flash loans, which allow users to borrow instantly without collateral as long as the loan is repaid in full in one transaction. This is considered a type of decentralized arbitrage where the borrower conducts a transaction and instantly repays the loan. Funds are automatically returned if the transaction cannot be completed or would result in a loss. The profit then excludes any interest or fees deducted. These types of flash loans are executed by bots and are typically not available to the average retail investor.
Stablecoins give more stability to activities like loans and borrowing, which are common in the DeFi market. Because stablecoins are anchored to a fiat currency, such as the US dollar or the euro, they have a lower level of volatility compared to cryptocurrencies which makes them more suitable for trade.
Stablecoins have become one of the most fundamental building blocks of DeFi. Thanks to stablecoin, DeFi applications can facilitate financial services such as lending and trading without the risk of quoting services in BTC, ETH or other cryptocurrencies that have inherent volatility.
Today USDT (Tether) and USDC (USD Coin – by Coinbase x Circle) are in the top 10 cryptocurrencies by market cap. The main use cases for stablecoins are trading, settlement (delivery of assets or interest), cross-border payments and transfers.
Staking & Yield Farming
Yield farming is an investing technique that allows users to stake (deposit) their crypto assets to earn high interest rates and rewards. Without yield farming platforms, users would need to manually search for protocols offering the highest returns and move their assets onto those platforms to earn rewards. Example yield farming platforms include Yearn, Enzyme and Vesper.
Yield farming exists as a reward system for early adopters. At the early, and high risk, stage of a protocol incentives are required to attract users. Incentives are provided as protocol tokens that are issues when a user locks up their tokens in a process called staking. Platforms then use these staked deposits to secure the protocol or lend them out to other users seeking credit. Interest is paid out and depositors receive a portion of that interest and the rewards.
Asset Management & Investing
Other staking solutions, managed strategies and index baskets have emerged to provide investing solutions for users looking for a more passive strategy in exchange for a fee.
Projects like PoolTogether, Dharma and Argent are examples of staking solutions. BlockFi and Nexo offer crypto interest accounts but are considered centralized finance or CeFi /CdeFi since assets are custodied by a single entity.
Digital asset managers or managed strategies have evolved to reduce the active management, strategy and effort of users. Examples of managed strategies include vaults with Yearn and other emerging platforms like StakeDAO and Haru. Vaults allow users to deposit different cryptocurrencies to earn interest. That interest comes from a variety of strategies beyond lending.
Unregulated index baskets of crypto projects are being launched by companies like Bitwise, Index Coop, and Amun.
In addition to Digital Asset Trading (DEXs, AMMs, Aggregators), Lending & Borrowing Platforms, Stablecoins, Staking & Yield Farming, and Asset Management and Investing, there is an ever evolving and emerging landscape of new solutions. These include, among others, Prediction Markets, Derivatives and Synthetic Assets, and Insurance.
Prediction Markets allow users to place bets on events (like sports, economics, election results, etc.) using [stable coin?]. One example of a prediction market is Augur. Established in [year] by [who?], Augar is a prediction market that is most notable for [detail.]
Derivatives and Synthetic Assets
Derivatives and Synthetic Assets set the value of a contract based on an underlying asset or set of assets (like bonds, indexes, commodities, stock prices, etc.) Practically speaking, [example of how derivatives and synthetic assets work.]
In DeFi, insurance is created by individuals pooling crypto as collateral to protect against losses from other smart contracts and charge a premium to those who are insured (example platforms like Nexus Mutual, Opyn, and VouchForMe.)
PART III: THE RISE OF DECENTRALIZED FINANCE
The explosive growth of DeFi over the last few years has drawn the attention of the world’s leading financial institutions, funds, and family offices. Investors have been drawn to the space by the promise of higher returns. In 2021 US 10-year treasuries were just over 1% per annum but yields on US stable coins were between 2 – 12%. Other, more speculative protocols have offered yields and rewards at hundreds and sometimes thousands annual percentage yields (APYs).
Some equate investing in digital assets today to technology investment allocation in internet stocks in the late 90s. Where it took seven years for the internet to go from 100M to 1B users (1997 – 2004), digital assets are growing more quickly with 1B users projected by 2024 based on crypto.com growth estimates since 2016. In the same vein, prospective investors will note the risk of speculative bubbles like the dotcom bubble and be prepared for volatility in this new and emerging technology.
Despite the risks, many see increased transaction volumes coming from large institutions and other indicators of significant investment from mainstream entities. A recent report from Chainalysis, noted the share of total DeFi transaction volume coming from large institutions rose from around 10% in Q3 2020 to over 60% in Q2 2021. A PWC report stated that 47% of traditional hedge fund managers plan to invest in crypto (representing $180B of AUM). Other sources, including a survey by Intertrust indicate hedge funds are expected to hold 7% of their assets, equating to $312B, in cryptocurrency in 5 years. Investment firms including HSBC, JP Morgan, Citigroup, Barclays, UBS, Goldman Sachs, BNY Mellon, and many more are pursuing blockchain initiatives including payments, custody, trading and more.
Early entrants in the DeFi space are now reaping rewards. The overall crypto market cap has grown from $17.5B in 2017 to $2.6 Trillion today, a compound annual growth rate (CAGR) of 330% in the last 5 years. Bitcoin has achieved a 175% CAGR for the last 11 years and Ethereum (ETH) has averaged a 291% CAGR since inception (2015 – 2021). ETH has surpassed every global bank’s market cap at over $500B compared to JP Morgan Chase at $481B, Bank of America at $353B and ICBC at $241B. This growth is only expected to continue, making DeFi an important addition to a balanced portfolio strategy.
PART IV: DEFI IN A PORTFOLIO STRATEGY
So how much exposure should a portfolio have to digital assets as an asset class?
The Black-Litterman model, illustrates a neutral portfolio based on the global market portfolio of all asset classes. This model would indicate a 0.5% allocation, given the Global market for stocks totaled $95 trillion, Global bonds at $105 trillion and digital asset market around $1 trillion in early 2021. For an investor with no view on which investments would perform better or worse and at what level of confidence, 0.5% is a recommended starting allocation.
More passive or conservative investors might place 1 – 2% of their portfolio in digital assets, according to Forbes Magazine, with crypto-enthusiasts investing closer to 5 – 10%. Anything more should be reserved for those who are tracking the space closely. According to Morgan Stanley’s 2021 report, “The Case for Cryptocurrency as an Investable Asset Class,” adding 2.5% exposure to Bitcoin (BTC) the last seven years would have increased average portfolio annual returns without additional volatility or drawdown. Other studies, including the CFA Guide to Bitcoin from the CFA Institute Research Foundation found that for the period (1 January 2014–30 September 2020), a quarterly rebalanced 2.5% allocation to bitcoin would have improved the traditional portfolio’s returns by 23.9 percentage points. Importantly, volatility would have remained almost constant (10.5% versus 10.3%). As a result, the Sharpe ratio expanded from 0.54 to 0.75.
No matter the percent allocation, all investors need to be willing to hold through inevitable 60 – 90% pullbacks. In 2018, many investors wrote of digital assets that declined 80%. This level of volatility can be difficult for investors to stomach and handle. As a result, it is important that each individual or fund clearly define their goals, strategy, risk tolerance, max downside and target exposure before diving in.
How to Get Involved with Decentralized Finance
Thinking of dipping your toes into the DeFi world? Here are the things you might want to consider.
Consider strategically how much capital you or your fund is willing to allocate to DeFi exploration.
Getting a Crypto Wallet
Start learning through experimentation by using MetaMask.
Self-custody wallets are your ticket to the world of DeFi, but make sure to save your public and private keys. Lose these, and you won’t be able to get back into your wallet.
Trade Digital Assets
Experiment by trading a small amount of two assets on a decentralized exchange such as Uniswap. Trying this exercise will help a crypto enthusiast understand the current landscape, but be prepared to lose everything while you’re learning which assets and platforms are best and how to manage risks.
An exciting way to enter into the DeFi world without exposure to the price swings of an underlying asset is to try staking stablecoins on platforms like AAVE or Curve to earn competitive yields.
The key to any foray into a new financial space is to start slow, stay humble, and don’t get ahead of yourself. Keep in mind that digital assets traded in the cryptocurrency and DeFi worlds are fast-moving and there’s significant potential for loss.
Research “Blue Chip” Digital Assets
Start following projects and doing research on platforms like Defi Pulse, Nansen, Staking Rewards, Coinmarket Cap, Delphi Digital, ForeFront, Bankless, Rarity Tools and many others.
Learn about projects like:
- Smart contract platforms: Ethereum, Solana, Avalanche, Fantom, Terra, Polkadot, Celo
- DeFi Leaders: Uniswap, Sushi, Compound, Aave, Maker, Curve, Yearn
- Web3 Infrastructure Platforms: Chainlink, Theta, Filecoin
- Exchange Tokens: Binance Token, FTX token
- NFT & Gaming Platforms: Axie
Invest in Index Tokens
Get broad market exposure by exploring index tokens for digital assets.
DeFi Unregulated Index Products:
- DeFi Pulse Index – DPI
- Metaverse Index – MVI
- Bitcoin Ethereum & DeFi – BED
- Total Crypto Market Cap Coin – TCAP
Regulated Index Products on Traditional Finance Exchanges:
- Nasdaq Crypto Index (NCI)
- New York Stock Exchange Bitcoin Index (NYXBT)
- S&P Bitcoin Index (SPBTC)
- S&P Ethereum Index (SPETH)
- S&P Cryptocurrency MegaCap (SPCMC)
- Bloomberg Galaxy Crypto Index (BGCI).
- And many more…
Lend digital assets on Compound or AAVE
Yield Farm on Yearn, Enzyme or Vesper
Set up infrastructure and processes to manage digital assets
- Research and analysis
- Taxes and reporting
- Performance tracking & monitoring
If you are looking for resources and a step by step guide for how to enter DeFi consider looking into a course like Eve Wealth’s Future Finance Orientation. Learn using step by step videos across the major platforms and use cases outlined here.
PART V: KEY RISKS & CONSIDERATIONS FOR INVESTORS
In the same way that newcomers have gravitated to DeFi (80% of institutional investors have expressed interest in digital assets and cryptocurrencies), it can be difficult for these new entrants to separate the good projects from the bad. Many DeFi applications, including meme coin YAM have crashed and burned sending the market cap to zero in minutes. These “rug pull” scams are designed to extract value from everyone but the issuer. Then there are instances of security breaches, including the recent security breach on crypto trading platform BitMart which caused $200 million in losses when hot wallets were compromised. Needless to say, this is a new financial technology that is experimental and not without its problems. Do your own research. Confirm that the issuers and their platforms are sound and solvent. All of the data you need to understand pricing, volume and other market fundamentals are public and on the blockchain for all to see.
Since DeFi is a new trend, it is only to be expected that it also comes with many risks. As a recent innovation, decentralized finance has not been stress-tested by long or widespread use. In addition, national authorities are taking a harder look at the systems it’s putting in place, with an eye toward regulation. Some of the key risks associated with DeFi include:
Decentralized finance uses digital assets or crypto assets, which as we are all aware of, are highly volatile. Although they may use stablecoins to back it up, controlling their value completely isn’t possible as of this moment. So, the whole network of applications that deals with these assets become a volatile ecosystem, which is a great hindrance to economic growth.
There are too many applications suites for a single task in the DeFi ecosystem. Therefore, finding the best one that goes with your needs is a daunting task that requires thorough research on the part of the user. To improve the DeFi ecosystem, developers would do well to consider to a strategy that can directly guide all users to the applications they need, rather than forcing a broad range of applications on every user.
No Consumer Protection
DeFi has thrived in the absence of rules and regulations. But this also means users may have little recourse should a transaction go foul. In centralized finance, for instance, the Federal Deposit Insurance Corp. (FDIC) reimburses deposit account holders up to $250,000 per account, per institution if a bank fails. Moreover, banks are required by law to hold a certain amount of their capital as reserves, to maintain stability and cash you out of your account any time you need. No similar protections exist in DeFi. DeFi platforms generally don’t provide any means by which to recover lost money. If a traditional financial transaction goes awry, a consumer can file a complaint with the Consumer Financial Protection Bureau (CFPB), but no such recourse exists if you become a victim of a fraudulent DeFi transaction.
Vulnerability to Hackers
While a blockchain is extremely hard to change, other components of DeFi are vulnerable to hacking, which might result in money theft or loss. All possible use cases for decentralized finance rely on software systems that are vulnerable to hackers.
Collateral is a thing of value used to secure a loan. In the case of a mortgage loan, for instance, the loan is collateralized by the home. Nearly all DeFi lending transactions require collateral equal to at least 100% of the value of the loan, if not more. These requirements vastly restrict who is eligible for many types of DeFi loans.
Private Key Requirements
With DeFi and cryptocurrency, you must secure the wallets used to store your cryptocurrency assets. Wallets are secured with private keys, which are long, unique codes known only to the owner of the wallet. If you lose a private key, you lose access to your funds—there is no way to recover a lost private key.
DeFi is still dependent on oracles to fetch information from outside the network. An oracle is any device or entity that connects to a blockchain with off-chain data (like Weather temperature), and provides the data that triggers the smart contract to execute the monetary transaction. Oracles are heavily centralized and, therefore, quite vulnerable to attacks. The oracles are massive security flaws of the applications that use them – If decentralized finance technology wants to offer 100% security, it needs to stop using centralized oracles for fetching information.
Moves to Improve
The following trends have emerged to address these risks and considerations.
DeFi platforms are moving toward improved user experience. In the first generation, dapps were created by blockchain enthusiasts for other blockchain enthusiasts. Although these dapps performed an excellent job of presenting fascinating new DeFi possibilities, their usability was lacking. In order to provide open finance to a larger audience, the most recent versions of DeFi applications prioritize design and flexibility of use.
In the future, analysts anticipate that crypto wallets will serve as a hub for all digital asset activities and identity. Platforms are already emerging to display not just what assets you possess, but also how much you’ve invested in various open finance protocols such as loans, pools, and insurance contracts.
The DeFi ecosystem is trending toward decentralized governance and decision-making. Despite the phrase “decentralized” in DeFi, many projects now include master keys that allow developers to stop or shut down dapps. This was done to make updates easier and to offer an emergency shutdown valve in the event of faulty code. We anticipate developers to abandon these backdoor options as the code gets more battle-tested. The DeFi group is experimenting with several approaches to give stakeholders a say in decisions, such as using blockchain-based Decentralized Autonomous Organizations (DAOs).
A number of states and countries have made efforts to provide guidance for digital asset management and governance. Wyoming was the first US state to legally recognize DAOs and grant them the same rights as limited liability companies (LLCs) as of July 1, 2021. The State of Colorado has a flexible cooperative law framework and is often referred to as the “Delaware for cooperatives.” Singapore is enabling a crypto boom by offering an enabling environment for users including clear guidance from the Monetary Authority of Singapore (MAS). Crypto regulations and laws cover initial coin offerings (ICOs), tax, AML/CFT (combating the finance of terrorism) and the methods of buying and trading in virtual assets. At times, lack of guidance has led to a loss of investment opportunity or projects from the US to offshore options.
In summary, there are a number of known and yet to emerge risks and considerations for investors to assess. With high returns, comes high risk and high volatility. Difficulty tracking the true ROI inclusive of fees, rewards, token depreciation/appreciation and other moving targets make performance monitoring and rebalancing particularly difficult. The question is whether these characteristics will remain in the future as the ecosystem evolves and matures.
Despite all of the growth and excitement related to Defi, significant challenges remain for investors approaching the market as it increases in efficiency. Price manipulations, unaudited code, and overhyped DeFi tokens are some of the lessons learnt from early players. Looking into the future, regulatory risks, requirements around on-chain identity, and scalability will affect the evolution.
At a more macro level, investors may struggle to understand how and why yields can remain so high. Is it a sustainable system? Is there real value in digital assets? Or is this all a scam?
The goal of this guide is to provide an introduction to decentralized finance: what it is, how it is evolving and where it may go in the future. DeFi has several potential advantages and disadvantages. It’s important to remember that this is still a new technology, and dismissing it based on centuries-old design and standards would be a mistake.
Since the start of human civilization, money and finance have existed in some form or another. Cryptocurrency is only the most recent digital incarnation. Every financial service we use in today’s fiat system might be redesigned for the crypto ecosystem in the coming years. Asset issuance and exchange, borrowing, lending, custody, and derivatives have all been established through DeFi. We are witnessing a quantum jump in the functioning of money – a once-in-a-lifetime opportunity to witness a new industry emerge from the ground up with all of its strengths and weaknesses.
The sector has the potential to tackle the issues that centralized finance has failed to address, but rather than completely redesigning the system, DeFi is doing so by building upon the traditional finance model through increased collaboration. Ultimately, the success or failure will be determined by the ability for decentralized finance to deliver on its promise of open, trust-free, and non-custodial financial services while remaining trustworthy. However, it’s difficult to predict what innovations may emerge over time when the ability to construct financial services is democratized to anybody who can write code.
As we move into the next decade of finance, the question becomes, what should we anticipate on the horizon?
Will we look back on this time as another crypto bubble? With defi as an idealistic and utopian ideal – or worse – a casino like expulsion of slot machine style get rich quick schemes focused on evading securities regulations?
Or, will digital-asset powered block chains and decentralized financial applications continue to develop unique use cases across financial services to broaden access, transparency, efficiency or more?
Maybe most important to investors, will the high yields persist? And for how long?
These are the questions investors and followers of this early technology will continue to deliberate and observe in the years to come. We hope that this guide serves as a useful a foundational reference the current state of DeFi as well as future considerations for those interested in understanding how idle crypto assets could be made productive.
One thing feels clear, the emergence of a paradigm shift in core human technology – money – is rare and exciting. We continue to watch and explore…
Disclaimer: Information based on factsheets and company websites. Investors should consider the above information not as a de facto recommendation, but as an idea for further consideration. The report has been carefully prepared, and any exclusions or errors in it are totally unintentional.
Coinbase. (2021, February 3). A beginner’s Guide to Decentralized Finance (DEFI). Medium. Retrieved November 1, 2021, from https://blog.coinbase.com/a-beginners-guide-to-decentralized-finance-defi-574c68ff43c4.
Notion. 2021. Notion – The all-in-one workspace for your notes, tasks, wikis, and databases.. [online] Available at: <https://www.notion.so/DeFi-Onboarding-Guide-a0713cfe5d844ff28bc829006625b118> [Accessed 1 November 2021].
Crowdcast, I., 2021. DeFi Discussions – Crowdcast. [online] Crowdcast. Available at: <https://www.crowdcast.io/e/defi-discussions> [Accessed 1 November 2021].
Anwar, H., 2021. How Does Decentralized Finance Work?. [online] 101 Blockchains. Available at: <https://101blockchains.com/decentralized-finance-work/> [Accessed 1 November 2021].
Napoletano, E., 2021. Decentralized Finance Is Building A New Financial System. [online] Forbes Advisor. Available at: <https://www.forbes.com/advisor/investing/defi-decentralized-finance/> [Accessed 1 November 2021].
The Defiant. 2021. All the Ways to Generate Passive Income With DeFi – The Defiant. [online] Available at: <https://thedefiant.io/all-the-ways-to-generate-passive-income-with-defi/> [Accessed 1 November 2021].
Information provided in this report is general in nature and does not constitute financial advice. Before making any financial or investment decisions, we recommend you consult a financial planner to take into account your personal investment objectives, financial situation and individual needs. No content should be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.
Eve Wealth Corp is not a Registered Investment Advisor, Financial Analyst, or Financial Planner.