Over the last year or so, Defi, or Decentralized Finance, has really caught the attention of people all over the world. Defi can give unrestricted access to many services you would expect from a bank, but places it in a decentralized environment.
Defi allows you to do cryptocurrency asset exchanges, borrowing, lending, and even derivatives trading. What started as some basic liquidity pools, has now totalled more than $40 billion in TVL, or Total Value Locked in Defi protocols, and that number is growing daily. In this week’s How To Crypto report, we will look at a couple of Defi protocols that allow people to earn within Defi platforms, liquidity pools and yield farming.
First, we will look at what liquidity pools are and how they work. Liquidity pools are part of the yield farming process so it is best to explore liquidity pools first. Liquidity pools are a foundational part of the Defi ecosystem and essential to automated market maker protocols and yield farming, along with many other defi protocols.
The basic concept of understanding what is a liquidity pool is quite simple. It is a big pool of funds created by any number of users, and anyone can participate in a liquidity pool. In essence the pool is allowing the transactions to happen, whether that is on a decentralized exchange or for lending or derivatives trading. On centralized exchanges, most don’t have the ability to participate in benefiting from providing liquidity or being market makers. Defi gives that ability to everyone.
A liquidity pool is a collection of funds that are locked in a smart contract and are used to facilitate decentralized trading, lending, borrowing, and more. In liquidity pools, no direct counterparty is needed to execute trades, therefore, traders are able to get in and out of positions on token pairs that likely would face lack of liquidity issues on centralized exchanges that use order books.
When you execute a trade on a decentralized exchange, or DEX, you do not have the need for a counterparty in the traditional sense. Instead, you execute the trade against the liquidity in the liquidity pool. For the buyer to execute a buy order, there doesn’t need to be a seller at that particular moment, only sufficient liquidity in the pool, and the same goes for a seller not needing a buyer. Someone who provides liquidity for a decentralized exchange, will put up two equal cryptocurrency assets to the liquidity pool.
For instance, if you wanted to provide liquidity for a pair that trades to Eth and you have $500 worth of that crypto to put in a liquidity pool, you would need to provide an equal amount, $500 worth, of Eth to a DEX like Uniswap or similar. The amount of each will vary as trading happens, but those that provide liquidity earn a portion of the gas fees for transactions. You can also provide one sided liquidity to yield farming protocols, similar to Yearn and others, also sometimes called liquidity mining, which we will discuss next.
Yield farming simply is the process of staking assets in DeFi yield protocol ecosystems to earn a passive income. A yield farmer purchases assets and then locks that asset up in a Defi protocol in exchange for a return on their investment.
Yield farmers will typically move assets from platform to platform in search of the highest yield. Some platforms also pay back a percentage in a native, or governance token for that platform on top of the yield of the initial asset. Yield farmers will then sometimes use that gained asset to earn a yield on another platform.
Yield farming can be either viewed by some as a set it and forget it mechanism to earn passively, but others view it as a way to move an asset, sometimes 10-20 times a year in search of the highest yields since the amount of ROI varies depending on the demand of the asset. Some examples of yield farming pools are Aave, Sushiswap, Curve, Yearn, and many more. Make sure you utilize the correct websites and contract addresses if you decide to join the yield farming world. You can go to Coingecko.com to ensure you visit the legitimate website and not a fake scam website designed to look like the original. Even so, also remember, none of these platforms will ask you for your seed or backup phrase, so if you encounter one that does, leave it immediately and run a computer virus scan.
WHAT DEFI OFFERS...
Defi allows anyone to create, launch, and/or participate in financial services. It does not matter where you live or who you are, it gives equal access to all people. The fact that anyone can create a Defi protocol is also a reason to be cautious. Many untested protocols in the past have suffered from exploits in the smart contract or even malicious intent from the creators to do what is called a rug pull, or drain the funds from the protocol.
Also, those protocols that pay high yields like 10-12%+ are usually high for a reason. The higher the yield, the higher the risk associated with that one. Just like any other cryptocurrency holdings, never put in more money than you would be willing to lose if something happened to it so that it wouldn’t burden you financially.
Defi has no regulations, no laws, and no mandatory audits of codes, even though some audited codes have been found to have flaws after the smart contract is audited. Yield farmers must understand the risks associated with yield farming as sometimes established protocols have experienced breeches. Security and safety will continue to evolve as the space matures. There are many upsides to having a system where anyone has access. Those that have been restricted from participating in financial markets can now get the chance to create or participate in Defi.
This can lead to massive innovation within the space as this technology evolves. Whether you embrace Defi, or are skeptical of it, Defi is here to stay and will continue to evolve and innovate. The biggest thing you can do is to do your due diligence when researching how you want to be involved. Also, control your greed when you see 20+% yields available, make sure you understand and limit your risk if you get involved, as in do not put too much in risky, high yield platforms unless you understand the risk. Make sure to utilize the Defi Scan tool on the Newscrypto platform and follow Newscrypto for all of the up and coming tools and info to help you enter the Defi world.