The cryptocurrency industry is constantly evolving. One of the new promising applications of blockchain tokens is decentralized finance (DeFi).
DeFi (decentralized finance) is a set of services and applications developed using blockchain, cryptocurrencies/tokens and smart contracts. The services are integrated into a single network, offering users services that are usually provided by banks and other financial institutions.
In simple words, it is an alternative banking sector, which can be used by people who do not want/need to deal with traditional financial institutions.
We could compare the current state of the DeFi crypto industry to the Internet boom of the 90s, when the Internet, on one hand, already promised amazing opportunities, a huge amount of innovation and explosive growth potential for investors, and on the other hand, many bubbles waiting to pop and burst in the late 90s. In much the same way, DeFi protocols promise to radically change the financial world, just as the early Internet transformed a huge number of industries, from travel to retail and everything in between.
Today’s world runs on money: whether it is fiat money like the euro or dollars, or cryptocurrency, the basic use case is the same. It is at the core of our daily existence. Any revolution here is something that will affect everyone sooner or later. DeFi is still in its infancy at the moment, but judging by the way things are going, DeFi could very well penetrate the realm of traditional finance very quickly.
In this article, we look at the differences between investing in decentralized finance (DeFi) tokens such as UNI (the management token of the UNISWAP decentralized exchange) or AAVE (the token of the platform of the same name that powers the decentralized protocol), or through DeFi products such as UNISWAP (a non-custodial crypto exchange that uses the decentralized protocol of the same name) or AAVE (a decentralized financial platform where customers can borrow digital assets or lend coins and without intermediaries). We will also look at how to actively invest in DeFi or use DeFi to generate passive income. Different approaches have advantages and disadvantages depending on the desired outcome and personal risk appetite.
Decentralized finance is a new way of looking at how we bank, borrow, lend, speculate financially, and even buy insurance. Usually when we provide these financial services, we have to look to banks or financial institutions to offer the opportunities, but by decentralizing (removing intermediaries) them, we leave it up to blockchain and open-source smart contracts available for inspection. You don’t really know how your bank works, but you can be pretty sure that the smart contract will do what the code says.
Aside from the fact that these traditional financial services are simply decentralized and therefore more reliable and efficient, there is also potential for new ways to make your money work for you.
The two main ways to invest in DeFi are.
- Investing directly in DeFi tokens, such as UNI or AAVE.
- Investing through DeFi products, which means earning through contributing your crypto assets to UNISWAP or AAVE liquidity pools.
Investing in DeFi assets, such as UNI or AAVE, means that you buy the token itself, which is a traded digital asset, and make or lose money depending on its rate fluctuations. This is different from investing through the DeFi protocol, where you use the DeFi platform to make money by earning interest or other types of rewards. Roughly speaking, investing in tokens is buying stock in your bank. And investing through the DeFi protocol is making a lucrative deposit into your bank.
Direct investing.
Let’s start by looking at how to invest in popular DeFi projects by buying UNI or AAVE tokens. Of course, there are many others, but we will use UNI and AAVE as examples.
AAVE is a decentralized loan pool system in which, on the one hand, interest-bearing deposits can be made and, on the other hand, borrowers can use pools of liquidity in exchange for a fixed or variable interest rate. AAVE launched in 2017 as ETHLend after raising $16.2 million in an initial coin offering (ICO), which allowed it to create the AAVE DeFi protocol lending platform.
UNISWAP is a decentralized exchange platform without intermediaries. In other words, it is a DeFi crypto exchange, analogous to traditional stock exchanges – the only difference being that there is no physical intermediary.
UNI token holders have the opportunity to help shape the direction of UNISWAP by being able to make proposals and vote on them. As a UNI holder, you get to vote on things like network updates and policies, with each vote proportional to the number of UNI tokens. It should be noted that to be able to submit proposals to UNISWAP, you must own at least 1% of the total UNI proposal. This is a pretty powerful idea for UNISWAP members, investors really have the ability to influence the direction of UNISWAP, rather than just hoping for the best and holding on as best they can!
Buying UNI or AAVE tokens actually means betting on the technology itself and the ecosystem. In the world of traditional finance (TRADIFI), buying UNI or AAVE can be akin to buying shares of a publicly traded company such as Barclays bank or HSBC bank. As bank stocks rise in value, investors make money. Similarly, if you have UNI or AAVE tokens and their price goes up, you profit from the increase. However, unlike stocks, you don’t automatically receive dividends, but you can vote on a proposal to distribute some or all of the profits to the token holders.
Investing through DeFi projects.
If we invest through DeFi by depositing cryptocurrency into UNISWAP or AAVE, the purpose of using their liquidity pools is to make money by earning commissions or interest.
UNISWAP’s automated market maker is designed to make it easier for investors to trade crypto assets similar to a traditional exchange, except that there is no middleman like traditional centralized exchanges. The platform connects the two parties in exchange for low commissions using smart contracts, which are a set of rules and conditions written into the software. Commissions resulting from financial transactions are distributed to all liquidity providers proportionally based on their exact contribution to the liquidity pool.
It is important to know what goals you are aiming to achieve, as investing your funds in UNISWAP/AAVE or their tokens are two very different offerings with very different risk/reward profiles.
Expanding your DeFi portfolio with tokens is really like buying traditional stocks, where stock price – and potential dividends – are the main concern, whereas when using a DeFi product to make money, it’s about the level of return (passive income) you can earn by providing liquidity to the protocol.
When providing liquidity on DeFi, you are mostly exposed to the risks of smart contracts. When buying DeFi management tokens (UNI/AAVE) you are mostly exposed to the risk that their price will drop to 0.
Yield Farming.
The process of providing liquidity to a pool to generate passive income from your crypto assets is known as yield farming, or literally “money growing.
If you look at it using a banking analogy, depositing cryptocurrency into an AAVE pool resembles making a yield deposit. The bank will use your funds within the larger pool to lend in exchange for paying you interest. Since interest rates at conventional banks are negligible these days, and no bank is willing to lend to people offering cryptocurrencies as collateral, this has created an opportunity for innovative DeFi startups to offer those with available capital in the form of digital assets a chance to get a reasonable return on them. Not surprisingly, investors are taking advantage of these high interest rates through DeFi rates/deFi lending to increase the overall value of their assets. This is the main thing that makes investing in Defi so attractive.
Income farming (farming) has become a very popular DeFi practice that works similarly to bank loans, but this time you are a bank and earn interest on the money (cryptocurrency) that you invest in DeFi. When you grow a crop, the investor puts the crypto into a lending protocol or automated market maker to earn interest or commissions from trading or borrowing.
Risks of DeFi-Farming.
As with the cryptocurrency space in general, there are risks associated with it. There is a heavy reliance on smart contracts to ensure the decentralized nature of DeFi, but these pieces of blockchain technology can still have exploits in the code that can lead to problems and loss of funds.
The use of stablocoins is another factor to consider when assessing the overall risk of DeFi. Stablecoins are not fully – or at all – regulated, and there has previously been controversy about dollar reserves being unaudited and tampered with. Moreover, Stablecoins can lose their anchor to the underlying asset and have volatility in price. Of course, with anything in crypto, protecting your funds and the integrity of your wallet is important. If you give away your private key, you are giving away your money.
Finally, network congestion and even the fees associated with a congested network can be detrimental to your farming plans, as it can slow down your progress and force you to incur additional costs. Important and characteristic of DeFi: If you borrow funds, be sure to keep an eye on collateral ratios, or you risk being liquidated.