Decentralized Finance (DeFi) – also consider risks!

Decentralized Finance (DeFi for short) was and is the new big trend after ICOs. Independent, free trading platforms where users can trade peer-to-peer with other users. There is no need for a middleman in the process. The DeFi sector quickly experienced a boom, with new blockchains and DeFi applications emerging. However, newcomers, even in the USA or England, encounter many unfamiliar terms and functions. Piece by piece, we will go through the basic aspects in the following.

What exactly is decentralized finance?

Bitcoin is a peer-to-peer network based on its own blockchain. “Peer-to-peer” means the following:

• Users exchange Bitcoins (BTC) directly with each other.
• The coins go from one address to another without the need for a middleman, a central bank or a payment company.
• All transactions take place on the blockchain and as determined by the transparently accessible code.

Enhanced by smart contracts

This principle was later extended to include smart contracts thanks to Ethereum. In summary, these are programmed contracts that perform their functions on their own. They check if-then functions and act on their own depending on their programming. Again, there is no need for a middleman. So it didn’t take long for these concepts to lead to the emergence of independent, decentralized marketplaces. On DeFi platforms, users can do more than just send coins and tokens. They can trade them among themselves, lend cryptocurrencies, invest them, and earn interest.

How does decentralized finance work?

In most cases, you still trade through the browser. Most DeFi protocols have a website and web view. Here, you log in with your wallet and connect it to the platform. From then on, you use the holdings in the wallet to trade. Many DeFi platforms are built on Ethereum, which is why you can use Ethereum-based browser wallets. MetaMask, for example, is a good choice, for which a guide is already available. Depending on the platform, hardware wallets can also be connected.

What DeFi platforms are there?

The hype around DeFi has led to the emergence of a variety of DeFi platforms. Many of them are built on Ethereum or are Ethereum-based side-chains. Part of the basics of DeFi is getting an overview. Here are just a few of the larger platforms listed:

Aave: Aave (LEND) is a liquidity market specifically for lending cryptocurrencies. Borrowers use the coins and tokens for their trades. Aave allows lenders to earn passive income by collecting interest. Its own cryptocurrency is called LEND and acts as a governance token.

Uniswap: Uniswap (UNI) is a DeFi protocol for exchanging Ether (ETH) and other ERC20 tokens. So, the focus is on the conversion of one Ethereum token to others.

SushiSwap: SuchiSwap (SUSHI) is based on the code of Uniswap and therefore offers basically the same functions. However, users can create liquidity pools with their own token.

Curve Finance: another Ethereum-based DeFi platform, this time with a focus on trading stable coins. Cryptocurrencies such as USDT, DAI, USDC, BUSD, REN, sBTC can be traded here. Furthermore, there are bridges to Compound, so that the tokens held can be provided as liquidity. Speaking of Compound ..

Compound: Compound (COMP) is an Ethereum-based token lending platform. The tokens are c-tokens, special ERC20 tokens, which are representative of the actual cryptocurrency. For example, cETH, cDAI, cWBTC (wrapped bitcoin) or cUSDC.

MakerDAO: This platform is one of the early representatives of DeFi. Again, it is primarily about crypto lending. There are two tokens: the Dai token is a stable coin based on the US dollar, while the MKR serves as a governance token.

yearn.finance: in addition to crypto loans, yearn.finance (YFI) also enables yield farming. Users can use it to earn interest by diversifying their investments. Yield farming is considered particularly profitable, but more on that later.

PancakeSwap: This is an “Automated Market Maker” (AMM) that enables fast, automatic swaps of tokens. Furthermore, interest can be earned with liquidity farming. The basis for PancakeSwap (CAKE) is the Binance Smart Chain. Thus, one trades BEP20 tokens.

Serum: Serum is a decentralized exchange (DEX) on the Solana blockchain. Nevertheless, it allows trading ERC20 tokens. Serum has cross-chain support and its own token SRM. The token is once again used for governance on the network.

Terms explained in Decentralized Finance

Once you take a closer look at DeFi, you will inevitably come across some terms. Many of them are from the field of finance, but quite a few are a product of the crypto world. An understanding of the terminology is necessary to understand the basics of Decentralized Finance:

• Automated Market Maker (AMM): an AMM describes a smart contract-based protocol for DeFi. This automatically guides trading partners to each other by finding the best trades. In addition to trading, it is also used for liquidity pools. Basically, an AMM is a trading bot.

• Collateralized Loans: With a “collateralized loan”, the borrower has more time to deploy the loan. However, in order to do so, he must put up collateral. The collateral is deposited in a smart contract.

• Flash Loans: This is a particularly fast type of crypto loan. Disbursement and repayment of the loan are negotiated in one block. The borrower does not have to deposit any collateral for this.

• Lending: “Lending” simply describes the lending of cryptocurrencies by means of crypto loans. On DeFi platforms, you receive interest in return in the form of additional cryptocurrencies, for example, the native token.

• Liquidity Mining: DeFi platforms do not have their own capital. For this, they rely on the liquidity of the users. In so-called “liquidity mining”, users themselves provide liquidity in the form of cryptocurrencies and receive interest in the form of cryptocurrencies in return.

• Non-custodial: One of the advantages of DeFi is that you have control over your funds at all times. That’s why the platforms are “non-custodial.” The people in charge do not have your cryptocurrencies when you use them for DeFi functions. Unlike, say, a bank, where the bank gets access to your funds as soon as you open an account.

• Yield Farming: this is the name for a strategy where you spread your investment across different DeFi platforms and markets. This is to earn high returns. In yield farming, you pay cryptocurrencies into a smart contract, which then invests them in different markets. Basically, yield farmers offer liquidity to platforms. As high as the returns can be, the risk also increases. Yield farmers are often very knowledgeable about Ethereum and DeFi platforms.

Advantages and disadvantages of decentralized finance

There is a reason why hype has developed around DeFi, especially in 2020. Traders promise themselves especially fast transactions past regular brokers and exchanges. However, this concept is not free of flaws.

The advantages of DeFi

• Fast and inexpensive transactions, as no third parties are involved in earning money
• Anyone with an internet connection and some startup capital can participate
• Transparency: everything is in the blockchain code, no backdoors or pitfalls
• Automation: the functions and mechanisms do not rely on human intervention, everything happens as written in the smart contract

The disadvantages of DeFi

• Scalability: a common problem with blockchains, if the volume of transactions is too high, the network falters and trades are executed more slowly
• Liquidity: DeFi platforms rely on liquidity from users. If this fails to materialize, then there is a lack of coins and tokens for payouts and trades
• No responsible parties: There is no legal protection and there are no responsible parties to report to in case of a claim
• Errors and fraud: Blockchains are programmed by humans and are therefore not perfect. Bugs and exploits can cause users to lose their crypto holdings

Risks of Decentralized Finance

DeFi platforms offer many opportunities, especially for those who cannot connect to traditional financial markets. But interested parties should be aware of the dangers. The lack of a third party and the automation of all operations create some uncertainties. Weaknesses in the code of blockchains can be the gateway for hacked crypto assets. In April 2020, an exploit in Uniswap’s code resulted in a $25 million loss. This was made possible by a bug in the ERC777 token standard. With the launch of Uniswap 2.0, the exploit was fixed, but such risks remain.

Another coup was achieved by a group of hackers in February 2022, who exploited an exploit in Solana, which in turn was connected to Ethereum via a bridge function. In the process, they captured cryptocurrencies worth 320 million US dollars. However, an incident from August 2021 shows that it can also be done differently. A hacker captured 610 million US dollars from the Poly Network, but gradually paid back the sum.

DeFi and taxes
The taxation of cryptocurrencies remains a complex issue. New ways to make money with them are developing faster than the taxman can keep up. Uniform regulations are not always already in place. However, profits and losses are taxed in any case (or at least have to be declared in the tax return). If you have any questions, it is best to contact the authorities.

FAQ – Frequently asked questions