A Beginner's Guide to DeFi: Lending, Borrowing, and Earning Yield

Intro: What is DeFi?

Getting to the Basics

It's called the Decentralized Finance, or DeFi for short. It's a fantastic means of exchanging funds without banks. That does sound hyperbolic, but believe it or not, it's a real revolution.

 

Just picture this: you open a crypto wallet and set it up on a protocol, rather than entering a bank, getting in a line, completing a barrage of forms, and hoping a manager blesses your loan or deposit account. It's done. Period. Because everything's regulated through preprogrammed programmable smart contracts, basically chunks of code on a blockchain that program themselves in preordained situations approval isn't needed.

 

With that, you can exchange assets, collateralize against your holdings in cryptocurrencies, lend your tokens to a person, or pay a dividend in a couple of minutes. And frankly, velocity, explicitness, and not having to ask for permissions are desirable.

Why DeFi Matters

So why does it matter? Banks are not of the people, but DeFi is open to whoever you are in so far as you have a working internet. It doesn't matter much mind where you are. Transactions are on the blockchain for everybody to see, but returns? Those can easily be many times higher than you'd receive on a deposit account.

How Smart Contracts Power DeFi

Take a vending machine. You put in your token or coins, and instantaneously! The contract's rules are applied. No teller, no gatekeeper, and no wait for processing. It's fast and easy enforcement.

The Three Pillars of DeFi

Being the bank: Lending

Alright. Where do we start but with financing? Typically, you put money into your savings account and then the bank takes your money, lends it to somebody else, and you get the bulk of the interest in crumbs. DeFI is eliminating the bank from the equation.

 

You put in your tokens in a lend system, a liquidity pool in short. Somebody lends out from the pool, and the interest goes back to you. Human beings do not dictate rates; they are set through algorithms. If the demand for borrowing is high, you lend at higher rates and receive higher rates. If demand decreases, rates go low.

 

Compound and Aave are hands down the favorites in this space. Both are large communities, they both have deep histories, and they both have many audits on their records. Consumers believe in them because they've been through and are still standing after numerous market cycles.

Borrowing: Using Money Without Sale

It's in lending where things get interesting for DeFI. You go to banks and lend against income or credit score, but DeFI does not ask for your identification. It only takes care of your collateral.

 

Borrowing requires collateralising crypto assets that are valued higher than the debt. You owe $100 in stablecoins, you are requested to collateralise $150 in ETH. Sounds weird, isn't it? Why pay higher but lend lower?

Quite simply, you might not wish to sell your Ethereum. If you are convinced the price of your ETH is going to go up, then selling today might mean you'd miss out on the profits someday, so borrowing lets you have liquidity without having to forfeit your hold. Some invest in it again, while others use it on payments or even pay for their investment.

 

But it imposes a huge downside risk: liquidation. If the price of ETH falls and the price of your collateral falls below a threshold, the system liquidates it in order to pay you back for your loan. No exceptions. No waiting period. It's liquidation. It's rough but fair, and it makes the system stable.

Yield Farming: Maximising Returns                                

So let's discuss a bit regarding yield farming, the flashy, high risk cousin of lending. Here, you not only lend assets, you are also providing liquidity to decentralized exchanges. Those are networks like Uniswap where people are simply swapping tokens back and forth with each other.

 

In order for you to perform such a function, you are typically asked to provide two tokens at a time, say, you provide ETH and USDC both in the same values. As you leave your pool through trade, you are rewarded with a portion of the trading fees. Liquidity depositors are also typically rewarded with other governance tokens such as UNI or COMP.

 

Rewards are great and all, but income per annum at times can be in the double digits. But then there's temporary loss. If the price for ETH increases quite a bit. The pool rebalances your assets, and you have less ETH but more USDC. That is, you could have made more money having had your own ETH in your own wallet.

Principal Risks in DeFi

Let's keep it real, it's a risky environment.

Smart Contract Exploits

Smart contracts are only as good as the programmers who wrote them. Bugs are real possibilities. Hackers are taking advantage of those vulnerabilities. It was a draining of entire cash pots in a single night due to a minor coding defect.

Liquidation Risk

You are continuously on the hook for monitoring your positions. If your collateral asset's price takes an unexpected dive, you are liquidated. It's merciless, but it's the system.

Impermanent Loss

Looks temporary, does it? Not quite. If recoveries are not on the horizon, the word "impermanent" becomes very, very permanent.

Scams and Rug Pulls

Then there are scammers. Some are actual experiments. Others? Front for exit scams. A rug pull is when the developers siphon liquidity and are gone. It's terrible, and it's occurring way more than newcomers believe. That's why DYOR rather than a meme; it's survival.

Starting DeFi on a Secure Path

Then you'd want to dip your toes in DeFi without sinking?

 

• Start Small: Gosh, honestly, don't put money you might not be able to afford to lose. Test the waters first with small amounts.
• Stick with the Big Players: These aren't ideal platforms, but they are stress tested and a heck of a lot safer than your run of the mill new projects out there.
• DYOR, Always: Read the whitepapers, google and read up on the audits. Do not just gape and jump on the hype.
• Store your keys securely: Store your coins in a hardware wallet for your own protection. Hot wallets are easy to use but unsafe. 

Conclusion: Is DeFi for You? 

It's the real thing. DeFi is exciting, powerful, and bursting with possibility. It's also filled with peril. Lending, borrowing, and yield farming can earn you cash, but they can also leave you with an empty pocketbook unless you are safe.

 

It's not a get rich quick scheme. It's a constant money experiment. Some call it a revolution, and they are not wrong. Revolutions are not neat, however. Revolutions are untidy, chaotic, and dangerous. 

 

And so the question is not does DeFi promise a lot; it does. The question is, are you ready to dip your toes in? On both an understanding of the rewards and the perils.

 

This article is contributed by an external writer: Razel Jade Hijastro.

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