BlogJan, 2021

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DeFi Shakes the Crypto Market

When your token price goes up by 450% percent, you do not remain a secret.  That is the adage appropriate for DeFi, which stands for Decentralized Finance. DeFi not only beat CeFi (short for "Centralized Finance"), they also became the crypto market darlings and remained so.

What DeFi did was feared by the "Fiat" financial industry, namely banks, it devised a decentralized way to create traditional financial instruments in a permissionless, decentralized market.

What's even better is that in terms of crypto assets, most DeFi platforms don't even demand you to hand over the custody of crypto assets.

Why did DeFi become so popular?

Good Question! With prosperity back to crypto markets and prices of most currencies going through the roof, investors wanted to find an additional way for their idle crypto investments to earn money.  To do so at a traditional financial institution, they'd have to cash in their crypto assets, which is growing by the hour.
That may be the reason why coins for DeFi platforms like Aave and Compound (COMP) are going through the roof.

What the Heck is DeFi anyway?

Oh yes! Before we get ahead of ourselves, let me explain what DeFi is and does.

Usually, traditional banks' long-term lending and borrowing use instruments like a mortgage, a car, or a student loan. Similarly, short-term lenders in money markets use instruments such as CDs (certificates of deposits), Repos (repurchase-agreements), Treasury Bills, and others. Both lending and borrowing are different in the DeFi world. Not only do traditional banking and short-term market lending instruments have legal definitions, but the agreements are legally enforceable. Thus all functions are centrally connected, and the process is permissioned.

In DeFi, lending and borrowing occur through Compound and Aave protocols that are essentially decentralized and permissionless and do not require both parties' identity and financial history.
Some of the lending transactions occur via Decentralized Exchanges (or DEXs), which facilitate these transactions through peer-to-peer without the interference of a central bank or intermediary that retains the custody of cryptocurrencies lent.  

The magic in the case of most of DeFi's leading contenders occurs through Decentralized Apps. As explained by Michael Beck, Project Lead at DeFi risk management firm UNION, "DeFi apps are built on smart contracts, like traditional DApps, but they strive to decentralize the role of governance and the custodial role of the application."

These features and a speculation boom are the reason why upwards of $10B was invested via DeFi smart contracts in the first month of 2021, according to DeFi Pulse.

The People Who Made It Happen:

Idle hands do the devil's work.  But, in terms of keeping DeFi markets booming, it may be just the ticket.  "Yield Farming" or "Liquid Mining" is what got the whole DeFi phenomenon started and remained one of the top reasons why the rally remains strong.

What is Yield Farming?

In the simplest terms, "Yield Farming" is the technique to put your crypto assets, through a program, in someone else's hands to help you earn more money.  DeFi is primarily based on putting their idle crypto assets into a pool of investment from which money is lent. But, for the most part, these pools use variable interest rates; a "Yield Farmer" is someone who is continually moving their assets around different pools depending on who pays the most interest.

What else keeps its "Mojo Working"?

In two words, "Flash Loans!"

In a speculative market with unusually volatile assets whose values swing wildly, what matters is how quickly you can recover and how long you can hold your position.

Speculators have been pushing the limit of how far they can leverage their existing crypto assets to new heights in the crypto world, and "Flash Loans" is a godsend for them.

It is a recent phenomenon in Decentralized Finance (DeFi) that allows loans without collateral for a brief period of time and is only available on the Ethereum network.

How does a Flash loan work?

The unprecedented rise of Aave is centered around a service that is helping fuel the unchecked speculation in the crypto market. It's called "FLASH LOANS." Yes, free money!  

These are very short-term loans of just a few seconds that require no collateral. But, to Aave, it provides a steady revenue of 0.3% on each transaction. But, for the speculators, Flash loans have been a godsend. 

It provides safe and secure arbitrage opportunities, which are many, at zero cost to the speculators.

Within the last year, Aave has loaned out over $2B in Flash loans.

Yet, its defenders argue that it provides an innovative and unique tool for arbitrage in finance that wasn't available before blockchains.

  • Flash loans use smart contracts that are programmed into the Ethereum network in such a way that it does not let the ownership of crypto assets change hands until certain conditions are met.
  • Most loans require collateral, such that in the event when the loan is not paid back allows the lender to liquidate. Flash loans do not require collateral to be put up as they are unsecured loans. In this instance, however, if the loan is not paid back, the loaned amount is sent back to the lender through a different mechanism.
  • Because the loan's nature is to exploit an arbitrage opportunity, the loan is both made, and the loan amount is retrieved in the same smart contract and during the same block of transaction where the loan originated. So the entire operation of providing the loan and the payback needs to happen almost instantaneously.

Cryptocurrency arbitrage opportunities provide a window of only a few seconds to both purchase and sell the same assets, and thus Flash loans make an ideal instrument for it.

This type of loan does not have its equivalent in the real world since they are made possible only through the mechanism of how Ethereum networks work and the innovation of smart contracts. 

In conclusion, the DeFi phenomenon is keeping crypto assets hot and, to some degree, responsible for the price of cryptocurrencies where they are today.  It is undoubtedly a more risky proposition, but it has also balanced out the risk and rewards equation for many lucky investors for now.