In 2018, DeFi, decentralized finance, was born and in a very short time it had an incredible boom.
Defi is in effect a new financial system that is not based, like the classic one, on brokers and intermediaries such as banks: instead, it uses smart contracts on blockchain. But what is a smart contract? It is a software that autonomously performs operations when certain predefined conditions are met. A software that regulates relationships and transactions between two or more parties. In the classical world it could be a notary who validates a certain transaction. In blockchain a smart contract replaces it, freeing up millions of transactions in real time without anyone having to ask for permission or approval from anyone else: it is all within the terms indicated in the smart contract which, in fact, made possible the birth and the great development of DeFi.
Decentralized finance, therefore, is entirely operational on blockchain where, as a whole, it proposes the main models of classic finance in a decentralized key: loans, options, and futures, insurance, purchase and sale of digital assets, and so on.
With DeFi, finally, the holders of cryptocurrencies have the opportunity to try to earn others during the possession phase, and not only to have an economic return at the time of the sale, if carried out at a higher price than the purchase, of course.
In a few years, DeFi has literally exploded, generating a multitude of solutions to make crypto work, each capable of producing remuneration that is normally interesting and sometimes spectacular, if not incredible. As always happens in the case of a boom in a new market segment, together with technically safe and conceptually sustainable solutions, many speculative ones have arisen, deflated like snow in the sun upon the arrival of the so-called crypto winter that few expected but that has the merit, in fact, of having brought about a significant cleaning and a significant renewal of the market.
During the recent Italian Tech Week Decrypto held a masterclass (you can see it HERE) to tell, among other things, what are the best solutions that DeFi offers today to make crypto work. In my view there are basically three: staking, borrowing & lending pools and the provision of liquidity to DEXs. Let’s see them more specifically.
Staking is the activity that consists in blocking a certain number of digital assets on a validator node of a blockchain in exchange for a remuneration for each validated block. You user believe in my project to the point of blocking a certain number of cryptocurrencies in my blockchain and I blockchain reward you by giving you some other crypto of mine every time you are chosen to validate a block. It is the so-called Proof of stake, the zero energy model to which Ethereum recently passed. There have been blockchains for some time, such as Polkadot and Solana, which allow anyone who owns their tokens to stake them. At the moment the tokens blocked in Ethereum are not yet free but it is reasonable to think that in a few months, starting from the famous “merge” we have also talked about on this blog, the staking activity will be free for anyone.
The borrowing & lendig pools are liquidity pools where cryptocurrencies can be lent and borrowed. They can be borrowed for a few minutes or for days and months, depending on the need, and a fee is paid to those who lend them. Of course, no one knows who he is borrowing from or who he is lending to. The amount of the fee is determined by the … invisible hand of the market, which tends to increase the value of the fee itself when you lend a crypto that everyone wants and to reduce it when the demand decreases.
In the liquidity pools of the so-called classic DeFi, in order to be able to borrow, let’s say, 100 Ethereum, a higher value in high cryoto or stablecoins must be pledged. Lately, various types of pools have arrived on the market, mainly oriented to an institutional audience and therefore in theory more reliable, in which the model with low or even no collateralisation has taken hold. This naturally presents significant risk areas for lenders, at least in theory.
To always attract new lenders, then, many liquidity poools increased their remuneration by giving them certain quantities of their tokens, in fact real marketing campaigns that were highly appreciated until the value of those tokens increased. When, with the arrival of the crypto winter, these pools collapsed, they saw the collapse of operations and with it the attractiveness of remuneration.
Overall, borrowing & lending pools at this time require a high level of understanding on the part of users to be used profitably. It is necessary to know how to untangle various interesting and other less interesting solutions and to be able to identify the potential risks.
Providing liquidity to decentralized exchanges is the third important opportunity for your crypto to work. We will talk about it extensively in the next post.