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What is DeFi, and How Do DeFi Crypto Projects Work?

What is DeFi? Learn about the different types of DeFi projects and find out how Cabital lets you take advantage of growth in the space.

DeFi, which means decentralised finance, covers a wide range of services like lending, borrowing and trading, which run on blockchain technology instead of relying on centralised financial institutions like banks, exchanges or cross-border remittance operators. 

This is in contrast to traditional financial services that require intermediaries to process services like loans, trades and payments while maintaining extensive customer support infrastructure. Because of the high cost of servicing customers in traditional financial institutions, smaller players like SMEs (small and medium enterprises) and small-time independent investors are often an afterthought. 

DeFi fills this gap in traditional financial services. According to Philipp Sandner, founder of the Frankfurt School Blockchain Centre, “The core of the initiative is to open traditional financial services to everyone, in providing a permissionless financial service ecosystem based on blockchain infrastructure.”

The popularity of DeFi is growing. Currently, there are 263 DeFi projects, with the bulk on the Ethereum blockchain. These include exchanges, stablecoins, asset management products, marketplaces, insurance, and lending. According to DeFi Pulse, around $80billion is locked across all DeFi projects at the time of writing, with almost half of these locked in lending. In DeFi, “locking” refers to the total value locked (TVL), which serves as a reference point, representing the supply of assets that are secured by DeFi applications (like lending). The TVL in DeFi breached the $100 billion landmark a few months ago, which is comparable to the GDP of some EU member states.

DeFi ecosystem
DeFi Ecosystem from defiprime

The potential of DeFi is not going unnoticed — DeFi news includes established companies from Morgan Stanley to Ubisoft are investing in and supporting DeFi initiatives. Meanwhile, the European Union is also working on a regulatory framework for DeFi, MICA, to provide improved security without stifling innovation.

What is DeFi?

DeFi is an umbrella term covering financial services (like borrowing, lending, and trading) that run on blockchain technology. As the name suggests, the lure of DeFi lies in how it is decentralised

Instead of having an intermediary governing the transactions, such as how a bank accepts deposits and facilitates business loans in traditional finance, smart contracts and blockchain ledgers make acting dishonestly impossible or futile.

What are Smart Contracts?

Smart contracts play a huge role in DeFi. They are pieces of code responsible for governing and managing the project’s ecosystem automatically. Smart contracts ensure decentralisation by defining what happens with the funds based on predetermined conditions. These predetermined conditions may depend on external data, which are received via data feeds (oracles). For example, the smart contract may specify a sell order when Bitcoin reaches $50K. To verify that conditions are met, the system will rely on data from oracles.

DeFi Applications

While there are many possible applications of DeFi, currently, most DeFi applications fall into three categories:

Decentralised exchanges

Decentralised exchanges (DEX) are governed by smart contracts and all funds are stored on the blockchain. All processes, such as your order and the matching process are stored on the exchange’s blockchain. Because of their decentralised nature, it’s impossible to compromise personal data or to steal funds. However, they can be unintuitive to most users and cannot deal directly with fiat currencies. In the latter’s case, stablecoins have emerged as a fiat solution for DeFi platforms.

On the other hand, centralised exchanges (CEX) are usually regulated. They can exchange crypto for fiat and vice versa and offer greater trading flexibility and friendlier user interfaces. Furthermore, customer support addresses technical errors and sign-in issues, which also enables accessibility and adoption. Still, they remain susceptible to hacks, as the centralised exchange handles all security matters.

Comparison between centralised and decentralised exchanges
Table 1. Comparison between centralised and decentralised exchanges

Stablecoins

Stablecoins play a key role in the DeFi ecosystem, especially since no fiat exchange is available on DeFi platforms. They serve the following functions:

  • Act as an alternative to fiat on DEX to simplify the conversion without risking the losses due to exchange rate fluctuations
  • As a unit of account to compare the value of different cryptocurrencies
  • As collateral in DeFi loans
  • Yield farming, when used to provide liquidity to cryptocurrency pools across multiple lending platforms to maximise returns
  • As a means of cross-border payments 

Lending platforms

Crypto lending is like fiat lending — just without banks or credit societies. DeFi lending platforms act as marketplaces where everyone can become a lender or a borrower using their assets. 

If you wish to become a lender, you put your crypto funds into a pool and then distribute them through smart contracts. This allows you to earn interest from those personal credits that you give out. On the other hand, you have to use your digital assets as collateral if you need to borrow crypto funds, though the collateral-to-loan ratio varies across different platforms.

Some of the largest DeFi lending platforms include Aave, InstaDApp, Compound, and Maker. Across these four platforms, the total value locked is US$41.44 billion. 

What Are DeFi Tokens?

DeFi projects can have native tokens that serve different functions. Depending on the project infrastructure and economic model, the exact scenario may vary. Still, one can either buy those tokens or get them as a reward in the form of interest on a loan. 

Most DeFi projects deal with several types of utility tokens (also referred to as DeFi coins):

  • The tokens can be used to pay for various features in the blockchain (LINK). 
  • Some DeFi  tokens also give their holders voting rights on the platform that had issued them, enabling the community to shape the project (governance tokens like MKR). DeFi tokens are often governance tokens. 
  • Finally, the tokens could represent a store of value and a medium of exchange (transactional tokens like DAI). 
  • For an idea of how different types of utility tokens fit together: Possessing the DAI stablecoin doesn’t give you the voting rights for MakerDAO, while the MKR token will give one the right to decide how the project will evolve.

The tokens of DeFi projects can also be locked in a liquidity pool or part of a DeFi staking strategy, for which the owner receives certain rewards.

DeFi tokens are a very popular asset among DeFi market players for two primary reasons.

  • Governance tokens provide the holder with actual power to influence the direction a certain project takes, which may increase profits.
  • If the project the DeFi token represents is successful, the price of the token increases over time, making it a good long-term investment or a valuable speculative asset.

DeFi Token List

The biggest DeFi tokens at the moment include the following: 

  1. MKR by MakerDAO. MakerDAO is one of the biggest DeFi apps and is governed by Maker Protocol. As MKR is a governance token, holders decide which way it will go, including the fate of the stablecoin DAI and how governance is executed.
  2. LEND by Aave is probably on par with MKR when it comes to popular demand. While using it for governance is on the roadmap, it is still currently used as a utility token to reduce platform fees and collateralise loans.
  3. COMP by Compound is also about lending. Its primary focus is governance issues, while its allocation influences interest amounts on the platform.
  4. UNI by Uniswap, one of the most prominent DEX out there. Created as a reward, its price gained over 1,000% in a matter of several months, effectively making the coin one of the best-performing DeFi tokens on the market today.
  5. LINK by Chainlink. Created by a project focused on developing oracles for smart contracts, LINK is closer to a utility token as it’s a way to pay for oracle data and fulfil the financial requirements of contact authors via depositing. 

However, should the project not take off as expected, there is also the risk that one’s investment will result in a loss, as the fall in token value can outstrip the promised gains, such as higher interest. That’s one reason we don’t issue platform tokens at Cabital, as we align our interests with our clients and avoid exposing them to unnecessary risks.

How to Choose a DeFi Project?

As the success of a DeFi coin directly follows the underlying project’s progress, any investment in DeFi should start with assessing the projects themselves.

First, when looking at a project, you should ask yourself the following questions:

  • Is the central idea behind the project a good one? 
  • Is the project model economically sound?
  • What is the project team’s history and experience?
  • Do you believe the project’s token is promising as an asset?
  • Has the project accomplished anything so far?
  • Is the project operating in line with its white paper?

Answering these questions to the best of your ability is crucial. While some considerations are subjective, such as your belief in the idea’s quality or the perspectives of the token, others can be cross-checked and verified. Here are some notions you should be aware of in advance.

Table 2. Some considerations when choosing a DeFi project

While the points above could be red flags, it should be noted that they are not necessarily ones. There are highly successful DeFi projects whose founders are anonymous, but the projects themselves are trustworthy based on other considerations. To that end, you should add economic and managerial considerations to your analysis. A promising project usually boasts the following:

  1. Transaction fees are reasonable within the project’s economic model.
  2. The project is liquid and has verifiable ways of sustaining the liquidity.
  3. The DeFi token has functionality beyond speculation or fundraising (or the team will be adding the functionality in the foreseeable future).

Risks of DeFi projects

In addition to the risks stemming from the considerations above, there are real risks in any DeFi project.

  1. Technological risks: These are the greatest risks in DeFi. As DeFi platforms rely on smart contracts written by people, there is always a chance there’s a bug in smart contracts or the possibility of fraud, which cannot be rectified due to blockchain technology.
  2. Market risks: Unexpected market swings can cause blockchain congestion, leading to operational risks.
  3. Operational risks: These include the reliability of oracles used to feed live data to the system, as it directly affects the execution smart contract. 
  4. Credit risks: While loans in DeFi are usually over-collateralised, the possibility of the inability to collect tokens from the borrower’s address remains. 
  5. Liquidity risks: Liquidity risks occur when short-term debt obligations can’t be met, and since DeFi platforms have low liquidity since most of their funds are locked up in collateral.

If you’re looking to enter DeFi, treat it as a high-risk investment, and remember to spread your risks

How Cabital Simplifies Investing in DeFi

Making investment decisions in DeFi can be difficult considering the nuances and the amount of professional expertise required to make a weighted judgment. Cabital has the necessary expertise and an investment team to do all the required checks and research, leaving you to enjoy the profits and crypto economy growth without worrying about whether you made the right bet. 

Factors to consider before investing in a DeFi project

Cabital has a threefold system of checks and estimations to select a project. Before investing, our team of seasoned experts engages in quantitative and qualitative analyses of the project’s details, including data-driven analysis, economic breakdown, and financial assessment. As an additional layer of insurance, all investment decisions are subject to prior approval by Cabital’s Risk Committee, consisting of legal, regulatory, technology, and asset/liability management experts. 

Post-investment, our asset/liability management (ALM) team works with the operation to monitor the daily profit/loss performance and risk exposures to ensure there are no excessive forex and basis risks. We also keep up with industry news and updates on regulations that relate to our investment target.

Afterword

Despite DeFi’s potential, mainstream accessibility remains its most significant challenge. After all, while DeFi offers high levels of data protection and security, the combination of risks, unintuitive interfaces, and the lack of fiat exchanges make it challenging for newer investors to take advantage of the industry’s growth. 

Which is where Cabital comes in. We have experts with the experience and industry knowledge to identify and invest in high potential DeFi projects. 

Find out more about our team and their experience here

All you have to do is deposit your crypto assets with us, and we’ll take care of everything else. With Cabital’s lack of preconditions, you can start with any amount and watch your savings grow with the interest received. 

Get started with Cabital today

If you’ve already started using Cabital, invite your friends and stand to earn up to 500 USDT.

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