DeFi: Making Money From Decentralized Finance

9 mins

DeFi: Making Money From Decentralized Finance
  • DeFi, or decentralized finance, is a new way of transacting that doesn’t rely on central intermediaries like brokerages, exchanges, or banks for financial products and services.

  • DeFi achieves decentralization by using blockchain – basically a digital database of transactions that’s duplicated and distributed across an entire network of connected computers.

  • Mining involves allocating computing power to blockchains based on proof-of-work. The reward for doing so is earning newly created cryptocurrency coins.

  • Staking is a less resource-intensive alternative to mining, and it involves allocating existing cryptocurrency to blockchains based on proof-of-stake. The reward for doing so is earning additional crypto.

  • Yield farming is a more advanced strategy involving the provision of cryptocurrency liquidity to DeFi platforms in return for a share of the proceeds.

DeFi, or decentralized finance, is a new way of transacting that doesn’t rely on central intermediaries like brokerages, exchanges, or banks for financial products and services.

DeFi achieves decentralization by using blockchain – basically a digital database of transactions that’s duplicated and distributed across an entire network of connected computers.

Mining involves allocating computing power to blockchains based on proof-of-work. The reward for doing so is earning newly created cryptocurrency coins.

Staking is a less resource-intensive alternative to mining, and it involves allocating existing cryptocurrency to blockchains based on proof-of-stake. The reward for doing so is earning additional crypto.

Yield farming is a more advanced strategy involving the provision of cryptocurrency liquidity to DeFi platforms in return for a share of the proceeds.

Introduction

One of the financial industry’s fastest-growing trends is decentralized finance, or DeFi for short. DeFi is a new way of transacting that doesn’t rely on intermediaries such as brokerages, exchanges, or banks for financial products and services.

Take a simple transfer of money. If you want to send $100 to a friend, you first send the instruction to your bank, which then deducts $100 from your account and increases your friend’s balance by $100. The bank is in total control: only it can maintain and alter the database of everyone’s account balances and historical transactions.

DeFi, by contrast, aims to revolutionize finance by doing away with such central intermediaries. Key to this is the technology known as blockchain: basically a digital database of transactions – or ledger – that’s duplicated and distributed across an entire network of connected computers. That’s why a blockchain is often called a decentralized database – one independently stored on thousands of computers rather than being controlled by a single authority.

One of the largest and most popular blockchain networks is Ethereum. And for good reason: it’s fast, open-source, and offers plenty of functionality. As a result, many of the biggest DeFi platforms out there right now are being built using Ethereum as their underlying blockchain.

Some of the DeFi platforms using Ethereum (Source: The Block)
Some of the DeFi platforms using Ethereum (Source: The Block)

How blockchain works

Before we dig into how you can make money from DeFi, it’s important to be clear about how blockchain works. As mentioned above, a blockchain is essentially a digital ledger of transactions that’s duplicated and distributed across a connected network of computers. Each “block” in the chain records a specific set of transactions, like a page in a physical ledger.

Every time a transaction takes place on the network, it’s first verified and then grouped with other transactions into a single block. That block is then added to the end of the chain (hence “blockchain”), and everyone’s version of the blockchain is updated. This collaborative system of recording transactions makes it very difficult to change or cheat the system.

And who verifies those transactions, groups them into blocks, and adds these to the blockchain? The thousands of people who’ve hooked their computers up to the relevant blockchain network.

But they don’t keep everything running smoothly for nothing: they’re encouraged to do so by the promise of financial rewards in the form of blockchain-native cryptocurrency. These incentives were originally distributed through a process called “mining” – but many blockchains are now moving towards something called “staking” instead.

Mining vs. staking

Both mining and staking aim to keep a blockchain network working as planned by incentivizing people to process transactions and update everyone’s blockchain accordingly. But the way mining and staking go about doing this is different.

Mining is essentially a competition among users’ computers to solve a complex mathematical puzzle. Whoever gets there first gets the right to add the next block to the blockchain. In return, they're compensated by earning newly created cryptocurrency coins. That last bit is important: mining is also the process by which new coins enter the cryptocurrency money supply.

Mining is based on a concept called proof-of-work (PoW) – because by presenting the correct solution to the complex mathematical puzzle, miners prove that they put in a lot of work. The only way to solve the problem is to throw a significant amount of computing power at it. And that makes blockchains using PoW pretty secure: any would-be hacker looking to falsely alter transactions in their favor would have to control more than 50% of the network’s total connected computing power.

One major downside of the PoW system, however, is that it also involves thousands of miners wasting large amounts of computing power, failing to guess the answer to a puzzle that serves no real purpose other than keeping the network secure. Bitcoin’s PoW-based blockchain alone consumes more electricity than most countries.

Luckily, there’s a less energy-intensive way of keeping blockchains decentralized and secure. Enter staking, which is based on a concept called proof-of-stake (PoS). Here, users lock up (or “stake”) their existing cryptocurrency coins for a period – and at certain intervals, the network randomly assigns one lucky staker the right to add (a.k.a. “forge”) the next block to the blockchain. The winner also gets a share of the network’s transaction fees in the form of some cryptocurrency – often, but not always, the same sort as that staked.

PoS systems are obviously secure because any would-be hacker would have to control more than 50% of the staked cryptocurrency. That raises an interesting difference between PoS and PoW: staking requires an investment not in computer hardware, but in the blockchain’s relevant cryptocurrency.

PoS-based blockchains often begin life by selling a prefabricated batch of cryptocurrency coins, or else they launch with mining and a PoW setup before switching over to PoS later. Ethereum is the highest-profile example of a blockchain that’s currently in the process of doing exactly that: its developers argue that the new system will be more environmentally sustainable while also allowing the blockchain to expand.

How to stake

As mentioned, people who want to participate in a network’s staking process are required to lock in a certain amount of cryptocurrency. Generally speaking, the greater your stake, the greater your chances of being chosen to forge the next block in the chain – although other factors, such as token age, may be taken into account to ensure that the same big stack bullies aren’t selected every time.

You can therefore use staking as a passive investment strategy, putting your existing cryptocurrency holdings to work in order to earn even more crypto. And doing so may well make sense: after all, why keep your assets idle when you could be both supporting a blockchain network and generating an income?

While you can stake directly yourself, the barriers to entry are pretty high. To stake on Ethereum once it moves to a PoS system, for instance, you’ll need to put up a minimum of 32 ether tokens, worth some $70,000 at the time of writing. You’ll also need to run special software – and run it continually, or else face penalties.

A much simpler way to stake involves going via cryptocurrency exchanges. Many popular exchanges such as Binance and Coinbase allow you to stake a wide selection of cryptocurrencies with a much lower entry threshold. That’s because when you stake on an exchange, you’re basically contributing your coins to a wider pot called a staking pool. That pool stands a much better chance of raking in token rewards, which are then proportionally distributed among the pool’s contributors.

Yield farming

Staking lets you put your crypto holdings to work. But another relatively recent development, known as “yield farming”, takes the concept to an entirely new level. Yield farming is riskier and a lot more complicated, so bear with us while we explain what’s been dubbed “DeFi’s Wild West”.

Similar to staking pools, yield farming involves you contributing cryptocurrency to a liquidity pool which can then earn you additional crypto. That’s why yield farming is also sometimes called “liquidity mining”.

Remember, DeFi is a form of finance that doesn’t rely on intermediaries offering products and services. Two of its most popular applications today are crypto-based lending/borrowing platforms and decentralized (i.e. non-centrally controlled) cryptocurrency exchanges. In both cases, yield farmers provide liquidity: the crypto funds necessary for these platforms to function.

Consider a decentralized cryptocurrency exchange. Like your local foreign exchange store, it has to be ready to buy and sell a bunch of different currencies whenever a customer comes along – and in order to do so, it has to have all of these stocked in its drawers. That same sort of liquidity (only digital) is what allows a decentralized crypto exchange to act as an instant, automated market maker.

In the crypto exchange’s case, this liquidity is provided by yield farmers, who basically deposit their various cryptocurrencies with it. As a reward for doing so, the yield farmers get a cut of the exchange’s transaction fees in the form of additional crypto. Uniswap is one large DeFi cryptocurrency exchange adopting this approach.

And what about DeFi lending platforms? Well, they’re just like your everyday Main Street bank, which takes in money in the form of customer deposits and then lends that money out to customers who want loans. Depositors provide the bank with the necessary liquidity – and in return, they earn interest.

At a DeFi lending platform, the only thing missing is the bank itself. Yield farmers essentially act as depositors by providing the lending platform with crypto-based liquidity – and in return, they get a cut of the interest the platform charges borrowers when they take out crypto-based loans, often via “smart contracts”. Compound is one example of a large DeFi lending platform.

Yield farming is currently the biggest growth driver behind the burgeoning DeFi sector, helping it balloon from a sub-$1 billion business at the start of 2020 to a $50 billion-plus industry at the time of writing, according to index provider DeFi Pulse. Incidentally, this website also shows the total value locked (TVL) of each of the top 100 DeFi platforms, or the aggregate liquidity supplied to them by yield farmers. By comparing TVL across platforms, you can also compare their market shares of the wider DeFi sector.

Yield farming, it should be stressed, isn’t nearly as simple as staking. Yield farmers employ complicated strategies, constantly moving their crypto between different DeFi platforms in order to maximize returns. It’s the sort of game that’s only for very experienced blockchain users with a lot of money to deploy: yield farmers generally have to put down a large initial sum to generate any meaningful profit.

For those reasons, precisely how to go about yield farming is beyond the scope of this Pack. Still, if you are interested, this article provides a good step-by-step guide to getting started.

Conclusion

Staking and yield farming represent two different ways to employ your existing cryptocurrency in the pursuit of earning even more. Staking can be done relatively easily using big crypto exchanges – while yield farming is considerably more complex.

Whether you’re heading out to go about either, both, or none of the above, you should now have a much better idea of what these groundbreaking DeFi-based investment approaches involve. And if nothing else, at least you’ll be able to take control of the dinner conversation next time cryptocurrency comes up!

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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