DeFi crypto: the decentralized finance

How does DeFi crypto work? Smart contracts

To understand how crypto DeFi works, we need to find out what “smart contracts,” the real pillars of the industry, are. We will only need to understand the broad outline operation of two different but similar things: an IT function and a contract.

If we summarize a contract at its most basic, we can see it as a series of IFs and THENs. For example, a rental contract works like this: if you give me €400 then you can use my house for this month.

If, on the other hand, we want to understand briefly what a computer function is, we can summarize it like this: it is a string of code that will perform an action taken upon the occurrence of a given input.

A trivial example of a computing function we can find within an Excel calculation: if a box contains a value greater than 100, then that box will turn red.

If we combine the operation of a contract and a set of computing functions, here we get a smart contract. In fact, the smart contract is nothing more than an algorithm running on blockchain that receives specific inputs, processes them according to the rules it contains, and eventually returns outputs.

Smart contracts share all the features seen above on the blockchain:

• Immutable: the developer who develops a smart contract will no longer have the ability to modify it once it is created (minted);
• Visible: smart contracts are built on the blockchain and are open source, so anyone will be able to see the programmed operation within these contracts;
• Autonomous: just like the blockchain, smart contracts do not require an intermediary; instead, they are programmed to perform actions autonomously upon the occurrence of a certain situation defined by the developer during the initial programming phase;
• Indispensable: what is written within a smart contract is law; consequently, a third party will not be needed to interpret it.

What is the reason we need to know them if we are approaching the DeFi crypto world? Because smart contracts are the basis of every DeFi platform. They work precisely because of the combination of multiple contracts, each of which has its specific role in the operation of decentralized applications.

As the Ethereum ecosystem grew, people began to think about the first decentralized financial services platforms (so-called DeFi decentralized finance).
They could not be developed on the basis of a single smart contract, whose functionality would have been too limited.

Therefore, different logics were thought of, achieved by combining several of them together, optimizing their execution and enabling previously unthinkable operations.

Today it is all before our eyes: from loans to cash management via collateralization, DeFi protocols propose very complex services.

How to invest with DeFi?

As we mentioned, the basis of DeFi crypto is smart contracts built on top of the blockchain.

In order to use a decentralized application, we will not need to create an account or go through any registration and KYC process (i.e., enter our own data and ID).

In fact, to interact with a decentralized application we will only need to connect with our crypto wallet.

Through the use of the wallet we will be able to link the funds held within it, begin to interact with smart contracts, and use the functions that the platform makes available to us.

At this point we will be able to exchange coins, give credit, open a debit or in some cases purchase NFTs. On the latter, for example, OpenSea is one of the biggest apps out there, although we cannot talk about decentralized finance.

In addition to not having to register, all these actions will also be possible without having to deposit our private keys within the platform.

Quali sono le piattaforme DeFi?

To date there are numerous types of DeFi platforms; they are built on different blockchains and have completely different functions from each other.

Let us begin by listing some of them, which we will then elaborate on later:

• Stablecoin-issuing Lending & Borrowing: platforms for issuing stablecoins through collateral;
• Lending& Borrowing : platforms for lending and borrowing through collateral;
• DEX: cryptocurrency exchange platforms (like exchanges but decentralized and without a middleman);
• Combo Farming: aggregators of DeFi platforms that allow us to increase the return on our assets;
• Derivatives: DApps that allow us to create derivatives (copies) of other assets such as stocks, commodities, real estate or cryptocurrencies;
• Insurance: platforms that allow us to insure our funds deposited in CeFi or DeFi platforms.

Let’s get to know them in more detail.

Stablecoin Lending & Borrowing

Let’s find out how decentralized applications work starting with the first category on the list.

These realities are at the base of the DeFi pyramid. Through collateralization* of one or more assets they allow the contraction of a debt to the platform, issued in stablecoins created by the platform.

Collateralization consists of tying one’s asset to a protocol, so as to borrow a portion of the countervalue of the collateral.

Through these DApps it will be possible to deposit some of our crypto, thus becoming a creditor of the platform in question and earning an annual interest. To this income is often added an additional incentive called Liquidity Mining.

Once we have deposited our assets, which will serve as collateral (as if they were a kind of collateral), we can open a debt position (CDP=collateral debt position), tying part of our currencies to the platform and borrowing in stablecoins.

The amount frequently follows the ratio of 1.5:1 to our collateral.

The stablecoin is minted, i.e., created out of thin air, and its value is guaranteed by the debt collateral.

Let’s take an example:

If I wanted exposure to Bitcoin, but in the process had fees to pay, I could use a platform that provides this service, such as MakerDAO, to bind 1 BTC worth $40,000 and take a loan equal to: $40,000/1.5 = $26,666 in DAI (MakerDAO’s stablecoin).
In this way I would have the ability to pay any expenses with the borrowed money and, once I have repaid the flat (including interest), I would unlock the BTC placed as collateral initially.

"We provide liquidity, earn and borrow stablecoin with which to maximize the yield"

DeFi crypto Lending & Borrowing

Lending & borrowing platforms on decentralized finance are very similar to those above, but with one difference: they do not have the ability to issue their own stablecoin.

In fact, if we wanted to borrow on these DApps, we would have to buy stablecoins issued by other platforms; or other coins put in farm within the application I want to borrow from.

Platforms such as AAVE or Compound are perfect for leveraged exposure to some coins, clearly if we think these will go up in the short or medium to long term.

However, let’s not forget that there will be daily interest to be paid on the loans issued by the platform. So it may not be convenient to keep a position open for too long if it is not necessary.

"In this case, we do not buy platform-native stablecoins but take external ones (or other cryptos)"

DEX DeFi crypto

As their name implies, DEXs (decentralized exchanges ), are cryptocurrency exchange venues, exactly like Binance or Coinbase but decentralized, so without a company behind them.

If we wanted to exchange our coins avoiding registration and without having to hold within the platform our private keys, DEXs are for us.

These entities are at the heart of DeFi crypto and move large amounts of capital.

Platforms like Uniswap or PancakeSwap are famous in this context and use an exchange method called AMM, Automatic Market Maker. With it, the user will not be able to set a limit buy, but will have to settle for the current market price in order to make an exchange between two coins. It is done through specially developed algorithms and not through the classic order book.

How do these platforms that do not hold private keys enable the exchange of cryptocurrencies?

Thanks to liquidity providers. Liquidity providers are those who give liquidity to the platform to enable the exchange. In return, they receive part of the fees from trades.

We too can become liquidity providers: all we need to do is put our tokens in the liquidity mining category. We will find pools composed normally 50/50 of two different tokens, for example ETH/USDT.

By placing a defined amount of Ether and an identical USDT countervalue within the pool we will be able to allow other people to trade this token pair.

As a result, the platform will reward us by giving us a percentage of the fees paid by the user who made the exchange; to this amount is often added a certain amount of tokens from the platform itself, given away as an incentive not to remove the liquidity we provided.

Of course, there are also DEXs that allow Limit Buy and also include pools composed of different percentages than the classic 50/50, such as Curve‘s Tricurve , composed of WBTC/ETH/USDT.

Let us dwell for a moment on the impermanent loss. This is nothing more than an uncertain loss of the total value of the tokens we pool. In fact, it will not always be favorable to place within a smart contract a currency pair composed of 1 or more volatile assets.

While it will always be favorable to deposit currencies that do not have price volatility between them.

These are some examples:

• The USDT/USDC pair, has no impermanent loss since the value of the two coins in relation to each other will never vary;
• The ETH/USDT pair, might be subject to impermanent loss since the value of the two coins in relation to each other might vary;
• The BTC/WBTC pair, has no impermanent loss since the value of the two coins in relation to each other will never vary.

We are therefore very careful when we put part of our coins into a pool because it may not always be favorable for us as investors.

Decentralized finance (DeFi) is also this: prudence and study, not just sky-high returns.

"DEXs are probably at the heart of the DeFi"

Combo farming on the DeFi

DeFi’s combo farming platforms, also known as yield farms, are aggregators that monitor yields and interest from platforms and, by combining them together, find the best conditions in the market.

It will then be possible to place tokens within one of these platforms such as Beefy Finance and, at the same time, use both their smart contracts and those of other DApps, linked by these very aggregators.

The returns are higher than in the original pools. As is often the case, as the returns increase so does the risk.

For example, if Yearn Finance used a 3Crv pool from Curve, by depositing tokens into this smart contract we would be exposing ourselves to both the risk of hacking on the smart contract of both the combo farm platform (Yearn Finance) and the DEX platform (Curve), increasing the chances of that happening.

It will then be up to us investors to assess whether it is worth exposing ourselves to such risks in exchange for increased interest.

"Yield farming platforms offer convenience and advantages, but also higher dangers"

Derivatives in decentralized finance

These DeFi platforms are slightly more complex to understand than those seen above. Basically they are born with the idea of allowing people in the crypto world to create derivative products of any type of asset.

Thanks to some platforms we are able to create synthetic assets of gold, stocks, cryptocurrencies and commodities; all in a completely decentralized, low-cost and 24-hour manner.

Let us remember that trading on some of these assets is only possible during the days when the stock exchanges are open; moreover, some markets are not accessible to everyone.

So here is where decentralized platforms dedicated to derivatives come to our aid.

But what are synthetic/derivative products? Essentially, when we talk about such products we are referring to copies of digital or physical assets , which emulate the price of that asset. When we talk about synthetic products, trading is usually preferred to investing. This is for two main reasons:

• If the company issuing these synthetic products were to go bankrupt, our assets would no longer be worth anything;
• Platforms create synthetic products by collateralizing an asset and, consequently, by opening a debt to the creator of the asset.

It will therefore be less expensive to create a derivative product to speculate in the short term than to invest with a longer time horizon.

In addition, these platforms allow us not to cash out of the crypto world, staying within it without having to switch from fiat currencies.

"Derivatives/synthetics are copies of digital or physical assets, emulating their value"

DeFi Insurance

As DeFi aims to create a decentralized alternative to all categories of centralized finance, the variant to insurance could not be missed .

In fact, several platforms allow us to insure our cryptocurrencies, whether they are within smart contracts, CeFi platforms or otherwise.

It will be possible to both play the role of the one who insures the funds and the one who allows the platform to have funds to return to those who have been defrauded. We will potentially be both insured and insurer.

Of course, in the first scenario we will have to pay a premium, while in the other we will be rewarded for holding our capital within a smart contract of the platform.

Since this DApp is also a DAO, that is, a Decentralized Autonomous Organization, the owners will all be the token holders of the platform itself.
Through this governance token we will receive compensation as a result of:

• Smart contract risk assessment;
• Evaluation of complaints as a result of fraud;
• Voting through the Governance of the platform.

Staying on risk, let’s take a closer look at it.

What are the risks of DeFi?

As we know, risks and returns are sides of the same coin, and as one increases or decreases, the other will also increase or decrease, respectively.

It is very important to assess the picture well when we make the decision to deposit annuity currencies within DeFi.

These platforms have very high returns compared to CeFi, in the face of greater dangers. So let’s look at some of the main risks we expose ourselves to:

• Rug Pull: one of every investor’s worst nightmares. A pair formed one capitalized token and one not very capitalized token is placed in a pool. It is then filled with lots of cash by someone with a lot of capital, so as to “guarantee” the safety of the pool.
  Once other people have deposited assets into it, the one who has deposited most of the capital exchanges most of the non-capitalized tokens for the capitalized tokens, causing the price of the first asset to drop to zero and not allowing the people inside the pool to be able to trade the two coins.
• Smart contract bug : a hacker can exploit the possible bug in a smart contract to his advantage to empty the crypto content.
• Flash loan attack : this is a type of attack in which a hacker exploits a flash loan (i.e., an unsecured loan) to manipulate the price of a coin within a pool to his or her advantage.
• Impermanent loss: this type of risk we have already mentioned under the DEX section. It is implemented only in this category of DeFi crypto platform and only when we are dealing with a pool that has at least 1 volatile token compared to the others contained in the pool.
• Scams (scams): any platform or token could be a very big scam because a smart contract could be redirected to a scammer’s address. Extreme caution when using platforms or tokens that are not very well known.

What is DeFi: conclusions

In this article we have taken a good look at what current decentralized finance is, what its risks, returns, and most importantly how it works. We hope we have helped you better understand what DeFi is.

It is a very innovative field that is evolving and developing in unexpected, interesting and profitable ways. It is undoubtedly worth learning about it and delving into it.