DeFi—the 'Wild West' of Crypto
Introducing the Good, the Bad and the Ugly of Decentralized Finance
What is this DeFi thing?
My introductory book “What Is This Bitcoin Thing?” provided readers with a brief taster of other areas of the crypto world, beyond bitcoin. With this post, I’m going to start to introduce Decentralized Finance (or DeFi) in a little more detail.
You will have heard about the crypto exchange FTX and its founder and former CEO, Sam Bankman-Fried. The collapse of FTX shook the crypto market—investors lost billions of dollars, the exchange went bankrupt and Bankman-Fried was arrested and faces criminal and civil charges.
Such financial shenanigans are what crypto was specifically invented to avoid. Following the ethos of the bitcoin whitepaper, cryptocurrency technology provides the opportunity to create ‘trustless’ financial systems, where we no longer have to rely on ‘trusted’ third parties to meddle with our money. The goal is to create so-called Decentralized Finance services, where you will have complete control and ownership of your own financial assets.
You would logically look to some of the largest crypto firms to find familiar banking-type services like deposits and withdrawals, savings, lending and borrowing, and investing in a wider range of instruments and markets. But, for the most part, these products and services may be blockchain-based, but controls are NOT fully decentralized, and nor are they part of the current regulated banking system.
Despite firms like Nexo and Coinbase replicating many financial services on the blockchain, these only mimic those provided by banks. They lack the full range of services and integrations, and the safety, security, and protection regulated banks offer their customers. Choosing to deposit your crypto with these firms in exchange for attractive rates, requires that you give over custody of your crypto assets—with no guarantee that you will be able to withdraw those assets should the firm run into troubles. But I guess that’s no different from your average high street bank these days!
There are better places to look to see the promise of DeFi.
Yield farming and liquidity pools
In a yield farm you lend, or ‘stake,’ your crypto in exchange for interest or other cryptocurrency rewards.
Various yield farming platforms will take your staked crypto and lend this out to innovators who need crypto, or ‘liquidity,’ to launch and grow their projects. Compound Finance is an example of one of the big players in this market, and a visit to their website will show you the various rates on offer to lenders and borrowers.
You can also contribute your ‘liquidity’ to decentralized exchanges like UniSwap and PancakeSwap. They will use your money to facilitate the process of swapping between pairs of cryptocurrencies. For example, you can buy BUSD-BNB LP tokens, and you will currently earn 6.24% per annum on PancakeSwap.
This will no doubt sound like gobbledygook to you! I’ll give you a quick example, so you get the idea. Let’s say you have $100 that you are holding in the BUSD US dollar stablecoin. You convert half of this to the BNB cryptocurrency, and then you buy some BUSD-BNB ‘liquidity pair’ or LP tokens on the PancakeSwap platform using your $50 of BNB and your $50 of BUSD. These tokens are then deposited, or ‘staked,’ on the PancakeSwap platform. The platform uses this ‘liquidity pool’ to enable trading to take place efficiently between the BNB and BUSD tokens. Whenever a trade takes place on the platform, you, as a liquidity provider, will receive a small proportion of the fees received from the trade.
This is actually quite a complex area of DeFi, so don’t worry if this still sounds like gobbledygook. Something for later, perhaps. Like crypto ‘banks,’ yield farming platforms are not risk-free—but the rewards can be pretty exceptional when staking some of the more esoteric cryptocurrencies.
Other passive income protocols
Many crypto products have been created with blockchain smart contracts to offer passive income. One of the most well-known was the Anchor Protocol, which provided lending and borrowing based on TerraUSD’s UST stablecoin. The platform was regarded by investors as super-safe and offered a return to lenders of almost 20% per annum. Over $14 billion had been invested in the Anchor Protocol, but users fled the platform as the UST stablecoin started to collapse on May 7, 2022.
The consequences for investors in this ‘safe’ protocol have been dramatic. The collapse of UST and the Anchor Protocol has given rise to all sorts of discussions about the risk and sustainability of this and other similar protocols.
Yet passive income products continue to evolve—some die without a trace after a few months, and others continue to perform well. Critics shout “Ponzi!” while faithful supporters laud the talented developers that have made them rich. Passive income products, or ‘protocols’ in the DeFi space are controversial, risky, and also somewhat irresistible. This is where we see the full spectrum of the good, the bad, and the ugly of DeFi.
Bankroll Flow was a DeFi protocol launched in October 2019. It was the first example of an ROI DApp—return on investment decentralized application. Broadly speaking, an ROI DApp works like this:
You deposit money into the protocol. This is ‘locked’ and you can never withdraw it.
You earn daily interest on the money that you have deposited. You can either withdraw this money or add it to your initial deposit to grow your ‘investment’.
Every deposit and withdrawal is subject to a ‘tax’. These taxes are used to fund the daily interest that is paid out to participants.
There will be protocol-specific rules about interest rates, tax rates, and limits on deposits and withdrawals.
There will be incentive structures for participants to promote the growth of the protocol.
Each protocol will have its own ‘token’ that you buy when you put money in, and sell when you want to remove money. The price of that token can vary depending on levels of supply and demand.
Essentially, an ROI DApp is a micro-economy with its own rules where that participants hope to make profits as the protocol grows.
Bankroll Flow design wasn’t refined enough to stand the test of time. There were various issues with the mechanics and incentives of the protocol that prevented sustainability. Yet that early design has been successfully copied and improved upon. The DRIP Network protocol is one such example that today celebrates its 2-year anniversary—quite an achievement in this fast-moving space. Another successful-looking protocol is Ark Finance, which has many controls to ensure sustainability.
Doing your own research in this space is critical as not all protocols have been successful by a long way. Some have been launched by bad actors, some have experienced malicious attacks and theft, and others have simply been launched with poor designs that are destined to implode.
One example of a ‘bad actor’ was the creator of the Wonderland Defi protocol, 0xSifu. The protocol was plunged into chaos after a Twitter user unmasked 0xSifu as Michael Patryn. He had previously pleaded guilty to charges of credit card fraud, burglary, grand larceny, and computer fraud—spending 18 months in U.S. federal prison.
One example of a protocol that is currently struggling is Furio. The price of its token has continued to plummet over recent months and it’s quite unclear whether the promises of developers to make improvements to the protocol will be successful.
This is the Wild West of crypto. The potential rewards are high—1% per day, 2% per day, 2.5% per day—start compounding these levels of interest and the results are eye-watering. But it’s risky out there and lessons are frequently hard learned. Right now, very little in Defi is fully decentralized and ‘trustless’.
In a future post, I’ll share my own personal experience of participating in DeFi for almost two years. Some of it is good, some is bad and some is just plain ugly!
Suggested actions for beginners…
Firstly, make sure you’ve downloaded and reviewed my ESSENTIAL Crypto Survival Quick Start Guide. You’ll find plenty of helpful advice to keep you safe as you take your first steps into the world of crypto—along with some suggested first steps you might take.
In the area of DeFi, consider:
Trying out yield farming on a platform like PancakeSwap or Curve Finance. Learn about liquidity pools, LP tokens, and how returns are made. Try adding liquidity to one of the ‘pools’.
Experiment with a simple ROI DApp like DRIP Network. Learn how to buy a small amount of the DRIP token and deposit it in the ‘Faucet’. See how returns are made and try compounding and withdrawing the interest.
WARNING: Because it is so new and unregulated, the Defi landscape is full of risk. If you choose to participate, do so with great care and take those familiar words to heart: You shouldn’t invest more money than you can afford to lose.
My suggestion would be to ‘play’ with small amounts initially. Figure out how to do things and how things work. In future posts, I will provide some explanations of specific DeFi protocols that you might like to try out—things that have worked well for me.
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Marco Hødd is a crypto enthusiast and global nomad. He is the author of the book “What Is This Bitcoin Thing?” and the “Crypto Matters” newsletter on Substack.
Please note that the information contained within this newsletter is for educational and entertainment purposes only. All efforts have been made to present accurate, up-to-date, reliable, and complete information. No warranties of any kind are declared or implied. Readers acknowledge that the author is not rendering legal, financial, or professional advice.