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DeFi: Should You Buy or Stay Away?

defi coin project

If you have been interested in cryptocurrencies for long, you may have come across the term DeFi. That is, Decentralized Finance, or one of the terms associated with it, such as dapps, stablecoins, or smart contracts. It can be confusing to have to learn a whole new jargon, but once it is explained, you can better decide if DeFi is the right choice for you.

What is DeFi?

Decentralized Finance, at its root, simply means taking finance – savings, loans, insurance – out of conventional financial institutions like banks, and distributing it over a decentralized blockchain. This means that financial services are non-custodial – meaning that there is no third party in control of the funds. They’re also permissionless – meaning that there is no need to apply for, say, a loan through a lending institution’s procedures.

To understand this, first, consider how loans are conventionally made. People deposit their money into a bank. The bank holds that money as capital. Someone applies for a loan at that bank, and if the bank approves the loan, the deposited money is loaned out. The bank charges the borrower interest, and the depositor gets a cut of that interest as payment for allowing their money to be lent.

So as a borrower, you are not actually borrowing from the bank; you are borrowing from someone whose money the bank is managing for them. DeFi eliminates the bank from the equation. With DeFi, you borrow money directly from the person whose money it is.

Peer-to-Peer Lending

Peer-to-Peer (P2P) is a form of network that allows individual users to interact as equals. In its early days in the 1990s, P2P was used a lot in file-sharing platforms, which, unfortunately, led to problems with piracy, as copyrighted materials were copied and shared. However, abuses such as these need not deter you from legitimate use of P2P networks. Blockchains are inherently P2P networks – each node maintains a copy of the blockchain, and all nodes compare their copies. In effect, this forms a public ledger.

p2p network

Malicious activity or inaccuracy shows up as a discrepancy in one node, which is rejected by the other nodes. This system allows individuals to lend and borrow without the need for a financial institution to keep records – the transaction is permanently and publicly recorded in the blockchain. This allows you to find the most favorable terms, not dictated by the profit motive of a bank. This also allows you to obtain a loan without a credit score, and to access the service in low-income places that banks avoid.

The Downside

One disadvantage of P2P lending is that, currently, loans must be over-collateralized. That is, you must lock up assets – typically cryptocurrency – exceeding the amount of the loan. If you had 150-200% of the loan amount, would you need a loan in the first place? There is also little protection if for some reason your smart contract is hacked. DeFi is still an emerging technology, and as it matures, it is likely problems like these will be solved, but until then, it is not the right approach for everyone.

Features of DeFi

Besides the key feature of being built on a blockchain, DeFi has certain other features that make it attractive compared to conventional financial institutions. First, because it is built on a decentralized blockchain with thousands of nodes, it is very difficult for anyone, governments included, to freeze or drain your assets. Anyone who wanted to do this would need to gain control of the majority of nodes – a very difficult and complicated task in a blockchain with thousands of widely scattered nodes. In the same manner, this system prevents third parties from blocking payments.

Another feature of DeFi is the smart contract. Unlike a paper contract, a smart contract is a computer program, with the terms of the contract written into the code. When the specified conditions are met, the contract automatically executes.

Dapps (Decentralized Apps) are the main mode of accessing DeFi. One advantage of dapps is that not only are they open source, but if you have the coding skills, you can build your own, with the features that matter to you.

Transactions Without Borders

From its inception, DeFi was designed to be fully international, equally accessible whether you live in an industrialized nation or a developing nation. Most dapps are accessible to anyone with an internet connection. Also, DeFi was designed to operate based on cryptocurrencies, which are themselves international, since they are not issued by governments.

If you do business across borders – say, your supplier is in another country – you know that international wire transfers take time and often involve fees. In contrast, by borrowing money from a DeFi platform such as MakerDAO or Compound, you can complete an international transaction the same day.

DeFi can also help to protect the assets of people in countries with unstable currencies. Argentina, for instance, has for decades, experienced runaway inflation and devaluation of its currency. Although there is a legal limit to the number of US dollars an Argentine citizen can buy, no such limit applies to the DAI stablecoin, which is pegged to the dollar.

Stablecoins and Tokens

Stablecoins require some explanation. One feature of cryptocurrencies is that they are so frequently traded and speculated, their value can be volatile. For this reason, there are now alternative cryptocurrencies known as stablecoins. One of the best known is called the US Dollar Coin (USDC), whose value is the same as a US dollar.

Stablecoins can also be pegged to commodities such as gold. This captures something of the best of both worlds: the greater stability of fiat currencies, with the speed and low transaction cost of cryptocurrency.

A similar concept used in DeFi is known as tokenization: the owner of some tangible asset – a parcel of real estate, say – will create digital tokens valued at some fraction of the value of the asset.

This allows shares of the asset to be sold to multiple investors without the need for brokers and their fees. The tokens then appreciate or depreciate as the asset itself does.

Flash Loans

One DeFi platform, Aave, offers a unique feature known as flash loans. Unlike most DeFi loans, which must be over-collateralized, flash loans require no collateral. This is because if the borrower fails to repay, the transaction simply reverts as if there never was a loan. This means that they are a zero-risk loan, something unheard-of in conventional finance.

Flash loans are primarily a tool for arbitrage, which is, buying cryptocurrencies on one exchange at a lower price, and selling them on another for a higher price. It can also be for refinancing, that is selling a loan with one interest rate for one with a different interest rate.

In a flash loan, the initial loan, the trades, and the repayment all take place in a single transaction, within a single block of the blockchain. Flash loans have become controversial in that some users took out very large flash loans and make huge profits on their trades.

There are now debates as to whether such actions are legitimate, or are to be considered “attacks” or “hacks.” Nevertheless, zero-risk loans can be attractive to someone without collateral.

The defi world is introduced with more and more terms and keeping up with some of these terms is essential to understand more of the developing industry. Total value locked is a term used in defi research and defi tracking tools to understand how much presumed value a coin has.

What is the total value locked in Defi

Total value locked is a defi indicator that is popular in the defi space and is used by investors to determine the total value of a defi asset. Total value locked is a measure of all crypto assets deposited and locked in a decentralized finance protocol.

Since the rise of defi in 2020, there has been massive adoption and new innovations and upgrades in the world of decentralized finance. According to a report by DefiLlama, in 2022 the total value locked in defi protocols increased to over $200 billion globally, an increase from an initial $400 million in the past 2 years.

This exponential increment in the total value locked globally could be due to the growing popularity and adoption of decentralized finance protocols globally by the cryptocurrency community.

The total value locked includes all the coins and tokens deposited in all defi protocols, including

  • Lending
  • Staking
  • Liquidity pools

It is important to note that the total value locked in these Defi protocols is not constant as it fluctuates. These fluctuations are not caused by investors withdrawing or depositing funds, rather, they fluctuate according to the dollar price movements.

The value of the TVL is affected by a number of other factors apart from deposits and withdrawals in the Defi Protocol. Some Defi projects have their own native tokens, and so deposits to the Tvl are made in the native token. When there’s an increment in the value of these native tokens, the value of the TVL also increases, and if there’s a decrease in the value of the native token, the TVL value also decreases.

Importance of total value locked in defi

Total value locked has grown to become one of the most important defi indicators used by investors to determine whether a defi project is undervalued or overvalued. Investors utilize this to know if a project is worth investing in in the long term or not.

The total value locked ratio is what is used to determine the ratio value score of a defi project. Theoretically, one of the ways to determine if a Defi project is undervalued or overvalued to help guide investors’ decisions is if the Defi project’s total value locked ratio is less than 1, it indicates the Defi project is undervalued in most cases.

However, Defi protocols require capital to function in staking pools or as liquidity in trading pools. Capital is required to effect funding of borrowing and lending activities. When there is an increment in the total value locked in a defi protocol, it indicates that there is an inflow of capital and increased liquidity on the platform. A high TVL value is seen as a good signal as it implies more capital locked in the Defi protocol and investors enjoying benefits from yields. However, when there is a low TVL value, it implies the liquidity within the protocol is low and capital is low also.

How to Calculate the Total Value Locked

In order to successfully calculate the TVL, a number of metrics are used in place, such as

  • Market cap
  • Circulating supply
  • The current price

To get the total value locked in, it is essential to first get the market cap. The value of the market cap is calculated by multiplying the circulating supply with the current price of the coin or token. After the market cap has been deduced, divide the market cap by the circulating supply to get the TVL.

In the defi space, the TVL is an important indicator used to measure the condition of a defi protocol. Like other indicators in the crypto space, the TVL is not a 100 percent guarantee of a project’s quality or sustainability.

A Growing Trend

As of this writing, there are US$2.13 billion locked in DeFi, of which the three largest platforms are Compound at US$641.2 million, Maker at US$629.3 million, and Synthetix at US$388.1 million, all using the Ethereum blockchain. Although this is as yet a small fraction of the amount of money still circulating in conventional finance, DeFi shows an overall growth trend since 2017, and the steepest growth so far since April 2020.

At present, there are some obstacles to the growth of DeFi, one of which is that the user experience is not very intuitive to those without technical know-how. Another is that bugs in the code of the smart contract could create irreversible erroneous transactions.

As the technology matures, however, we should expect solutions to these problems, and DeFi will be increasingly attractive as the cashless economy and increasing government surveillance becomes burdensome for increasing numbers of people.

Conclusion

Decentralized Finance is as yet young, with lots of potential for growth and innovation. Its open-source nature allows creative individuals to join in the action even without large amounts of startup capital, and its public ledger stored on the blockchain eliminates the need for vetting borrowers for trustworthiness.

Because it is permissionless, you do not have to have a good credit score or go through a bank’s procedures. All you need is to buy the initial cryptocurrency (usually Ethereum), and you are set to begin.

CryptoWhat
CryptoWhat was created in 2015 and has become one of the most trusted and well-respected sources of information on all things crypto. The blog's authors are dedicated to providing clear, concise, and jargon-free explanations of this complex technology, so that everyone can understand it.