Powered by blockchain technology, decentralized finance or DeFi is one of the original and most promising use cases of the cryptocurrency ecosystem. It seeks to disrupt finance and reshape how the global economy views money. DeFi directly connects users via crypto networks, easing barriers to access.
There will be no need for “middlemen” like a central bank, a clearinghouse, or a verification service. The first iteration of DeFi was the creation of the bitcoin blockchain, enabling simple transactions on a secure and transparent network with a decentralized digital ledger. Nowadays, the blockchain technology behind DeFi and its use cases has evolved considerably. Let’s dive deeper to see what DeFi 3.0 is all about and how you can get in on the action.
- Decentralized finance or DeFi is built on smart contract blockchain technology.
- DeFi 3.0 is about bringing together yield farming protocols across different crypto chains and traditional asset classes all in one easy-to-use place.
- The advantages of the DeFi ecosystem include transparency, free access, open-source development, speed, and flexibility.
- Participating in the ecosystem is quite risky due to security issues, high levels of complexity, regulatory uncertainty, and scalability problems.
- Investing in DeFi and crypto is betting on the success of emerging technology. Do your research and test out different protocols before fully jumping in.
Decentralized Finance & Its Promise
DeFi promises to shake up the current financial system by:
- Sending and receiving funds in minutes
- Eliminating middlemen and their fees
- Enabling anyone with an internet connection and crypto wallet to use it without approval
Let’s dive into the foundations of DeFi 3.0.
The Vision Behind it All
Founded by the mysterious Satoshi Nakamoto, Bitcoin launched in 2009 as the first truly decentralized asset. Since then, the cryptocurrency scene has exploded to a ~$2 trillion market cap (that’s 12 zeroes) with over 19,000 known currencies, as of this article’s writing.
Satoshi’s vision for a trustless, decentralized currency is summed up with these two quotes:
With e-currency based on cryptographic proof, without the need to trust a third party middleman, money can be secure and transactions effortless.
A lot of people automatically dismiss e-currency as a lost cause because of all the companies that failed since the 1990’s. I hope it’s obvious it was only the centrally controlled nature of those systems that doomed them. I think this is the first time we’re trying a decentralized, non-trust-based system.
This vision is the force behind the development of DeFi and the larger crypto ecosystem. Though bitcoin brought us the vision, SCPs are the tools making that vision possible.
Smart Contracts 101 – Programmable Money
DeFi 3.0 projects are built upon smart contract platforms (SCPs), such as Ethereum (ETH), Solana (SOL), and Avalanche (AVAX). Smart contracts are digital contracts on a blockchain where their rules are written and executed as code. Once a contract is finalized, it cannot be manipulated by humans. In crypto, it’s said that code is the law. SCPs are the layer 1 (L1) solutions upon which DeFi protocols are built.
The founder of Ethereum, Vitalik Buterin envisioned it as a platform to develop applications on the blockchain. Ethereum is the second cryptocurrency and the first smart contract platform to bring the potential value of blockchain technology to its users. New projects that use SCPs build DeFi projects on top as L2 or L3 solutions. For instance, Uniswap, the largest decentralized exchange is a Layer 2 protocol built on top of Ethereum. PancakeSwap, a peer of Uniswap, is a protocol built on the BSC or Binance Smart Chain. SCPs are the underlying technology for a variety of other Web3 use cases such as NFTs.
Innovations of DeFi
Following the emergence of SCPs, the first wave of DeFi enabled more complex use cases such as lending and cross-chain exchanges. Protocols such as Uniswap and PancakeSwap formed decentralized exchanges (DEXs) where users can buy, sell, and swap their cryptos with other users. Users can earn high-interest rates for lending or staking their coins.
Using SCPs like ETH or SOL, people can form decentralized autonomous organizations or DAOs that are governed and operated by code embedded in the blockchain. Plus, DAO operations are transparent as they happen on the blockchain. Over time, the DeFi 3.0 ecosystem will grow in complexity and mirror the functions of traditional financial markets. In tech, each layer or next wave of innovation is built upon the previous one to enhance its functionality. The Internet was built this way. Each wave of DeFi solves problems from the prior layer. DeFi 3.0 does this while adding flexibility and more options to the ecosystem.
Other innovations include:
- Flash Loans – that last as long as it takes for the next block in a chain to be formed
- Tokenization of Assets – representing existing assets like stocks, bonds, or real estate as crypto-token equivalents
- Virtual Land Leasing – Leasing virtual real estate in the Metaverse (i.e. virtual reality)
- Start of GameFi – players of blockchain-based games can earn crypto rewards as they play
DeFi 3.0 Advantages
All actions take place on the blockchain so the interactions are viewable to anyone. This focus on total visibility does away with any need for third parties to vet network participants. For instance, 90% of DeFi usage is processed on ETH, making the actions visible to all users.
SCPs and other projects are open-source so anyone can audit the code, suggest changes, or build upon it. Dev teams can develop crypto products and link them together to create new, advanced products on their own.
Blockchain transactions take a matter of minutes to complete. An ACH transfer from one bank to another can take 2 to 3 days or longer, depending on the amount. More complex financial transactions take even longer and involve more middlemen. Crypto offers an efficient and low-cost alternative to using banks or other payment processors.
High Yield Farming
DeFi 3.0 presents plenty of opportunities to earn high-interest yield, much more than what you’d get from any savings account. Crypto.com reports that leading DeFi solutions such as Curve or SushiSwap earn 2-15% on BTC, ETH, stablecoins, and other cryptocurrencies. You can earn via staking, lending, or depositing tokens into a protocol’s liquidity pools, among other ways of investment.
Total Value Locked (TVL) is the total value of crypto assets locked into a DeFi project through the above ways. The more user funds that are locked into a protocol the more user interest there is in it. TVL is an indicator of a project’s attractiveness and of comparing its success to other protocols.
You can use crypto tokens in more ways than you can use fiat currencies. Smart contracts make tokens into “programmable money.” They can be used as a means of exchange, collateral for loans or investments, voting rights in DAO decision-making, etc. Token holders may participate in Web 3.0 opportunities such as online gaming, NFTs, or the Metaverse.
Custody of Assets
Users have direct ownership over their digital assets by moving them to self-managed wallets. Token holders can remove their assets whenever they want (depending on the protocol). In contrast, participants in traditional finance (TradFi) store their money with banks and other financial institutions, where access to funds is controlled.
DeFi 3.0 Challenges
DeFi has several challenges, such as:
High Transaction Costs & Wait Times (Scalability)
Blockchains experience scalability issues due to low transaction limits and periods of high demand. ETH has a max of 15 transactions per second, which drives up gas fees due to the high demand for ETH-based apps.
Liquidity is based on the number of available assets to buy and sell. It stems from funds staked in a blockchain. Because coins are attached to certain chains and specific markets, there is an issue in maintaining liquidity across platforms to ensure their smooth usage.
DeFi protocols grow fast and use open-source code making them vulnerable to hackers. Plus, the very technical nature of many DeFi 3.0 projects presents a hurdle for users when they evaluate each protocol.
There is a risk if you deposit your coins into a market maker pool and take them out later at a lower value. You could have made more by holding your coins in a wallet. Any loss is only realized once the owner withdraws from the pool. In the meantime, an impermanent loss may disappear as the market moves.
DeFi exhibits more volatility than the rest of the crypto ecosystem and is riskier than simply holding a coin like BTC or ETH. DeFi protocols take on speculative investments, risk-on strategies, and are vulnerable to hackers. It is the Wild West of the financial world. Some reasons include:
- The ecosystem is highly sensitive to market shifts in traditional asset and crypto markets. BTC and ETH correlate with the NASDAQ-100 and S&P 500 indices — following their movements. High levels of institutional investment in the stock market and select cryptos form this connection.
- Complex systems are prone to more vulnerability than simpler ones. DeFi 3.0 protocols are aggregators that participate and sit on top of other protocols that generate returns. These returns are passed onto the DeFi 3.0 protocol which gives them to its users. This design simplifies investing for the DeFi 3 protocol user while exposing them to the risk and reward possibilities of the underlying protocols.
- Key market events happen very fast. For instance, Anchor protocol offered 20% returns but was called out for not making enough to meet its expected returns. The user deposits were in Terra Luna’s US dollar stablecoin (UST). When UST lost its peg, it started a market panic leading to large outflows. The protocol lost $10.3 billion of its $14 billion reserve in a matter of hours. This loss contributed to the plunge in bitcoin’s price to its recent lows.
DeFi 3.0 – The Leading Players
DeFi 3.0 is also known as farming-as-a-service (FaaS). Its value is in helping users to maximize their crypto earnings across different chains, i.e. yield farm. As a new layer built upon the existing DeFi sector, it brings users more control, convenience, and flexibility to yield farm.
Here are some of the leading FaaS smart contracts projects:
Empire Capital Chain ($ECC)
Part of the cross-chain EmpireDEX, ECC is a bridge between DeFi and TradFi. ECC stakes and yield farms using crypto and non-crypto means, blending both novel and old-school businesses. It can issue NFTs, buy into IPOs, invest in startups, or create tokenized versions of stocks. These synthetic assets lower barriers to entering traditional asset classes like stocks, bonds, etc. With a variety of means to earn yield, ECC has a more diversified business model than its competitors.
ECC’s investment style is more like a hedge fund. If you buy an $ECC token, you join the smart contract and earn yield from staking and DEX operations.
Cross Chain Capital ($CCC)
Based on the Avalanche (AVAX) chain, CCC is similar to ECC in that it invests in a wide range of assets in and out of crypto to maximize its return for token holders. Its holdings include staking, yield farm, and reserve currency projects (e.g. Terra USD, USDC).
Cross Chain Capital changes its investment strategy by expanding its lines of business to maintain a sustainable high yield. CCC plans to expand into the Metaverse by buying into virtual real estate and high-value NFTs. It also seeks to launch IDOs (Initial DEX Offerings) and private placements (private sales) of other cryptocurrencies as another income source — mirroring the IPO process on the stock market.
CCC operates as a mix between a hedge fund and a DAO, so holding its token gives you the right to govern the fund and contribute to its management, while earning yield. Note that the DAO gives out profits in an equal manner to disincentive whale manipulation.
In essence, DeFi 3.0 brings more of the sophisticated aspects of traditional markets to the crypto universe, closely mirroring their stock market counterparts. There is a lot of room to collaborate and create innovations and services to realize DeFi 3.0’s potential.
DeFi 3.0 Alliance – Setting a Foundation
The DeFi 3.0 Alliance is a global collective focused on bolstering the development and adoption of the DeFi ecosystem. They seek to bring transparency, security, and ease of access to DeFi 3.0 and other FaaS products.
The Alliance has 8 founding members, including:
- Reimagined Finance ($REFI)
- Cross Chain Farming ($CCF)
- Inu Capital ($INC)
- Aggregated Finance ($AGFI)
It has several key focuses to improve the overall ecosystem, including:
- Creating common security standards to outline minimum security thresholds for launching DeFi 3.0 services.
- Devise a technical framework to build products that promote multi-chain access, such as through bridges like Polkadot.
- Operating a Y-Combinator-like accelerator program to provide direct investment and liquidity to launch new projects — getting them on their feet.
- Promote sharing information on market and business trends amongst its members.
Financial regulators all over the world are planning on how to regulate digital assets and coordinate their laws. As a result, there is uncertainty in the crypto markets as users, platforms, and developers await new changes. Here are some of the latest developments:
- The SEC has gone after crypto lenders such as BlockFi, Gemini, and Celsius for not registering their lending products as investment securities. Their products are now limited to accredited investors while existing users are grandfathered in.
- FATF, an anti-money laundering organization, issued a rule on the transfer of digital assets over $1,000 in value. The digital asset platforms must tie user identities to their assets and report these findings to their national regulators. Major platforms such as Coinbase, Gemini, etc. plan to comply with this rule.
How to Hop Into DeFi
If crypto is an emerging trend, then DeFi 3.0 is its bleeding edge. Here’s how you can jump in.
- Setup a wallet with a service like Coinbase, Gemini, or Metamask.
- Research the protocols you want to use and what tokens you will need. Make sure your wallets support the coins you want.
- Buy tokens from exchanges and send them to your wallets.
- Set up an account with each protocol, connect your wallet, and follow each one’s instructions to test them out.
- Track your asset transfers and returns to monitor your financial positions.
Common and reputable apps to try include Compound, AAVE, Uniswap, and MakerDAO. Compound offers interest-generating opportunities for your US dollars and crypto assets. AAVE is a liquidity pool protocol where you deposit assets that earn interest from users who take out loans on them.
Uniswap is a decentralized exchange (DEX) where you can buy, sell, swap, or loan your crypto. MakerDAO is a DAO that acts as a lender, granting loans to users at preset interest rates.
My Experience in Crypto & DeFi
Though I’ve spent several years in the crypto scene, learning about DeFi is the next phase in my journey. Last year, I consolidated my crypto position by buying into coins I believed in, staking some, and exploring lender services such as Celsius and BlockFi. Through these crypto lenders, I have some exposure to DeFi 3.0. Currently, I am satisfied with my crypto investments and am not set on aggressively expanding my portfolio.
As I continue my research into DeFi protocols, I may decide to test some out.
I am a buy-and-hold style investor but I see DeFi as more suitable for active investors given the fast pace of change and volatility. I’ve set up a few personal wallets for my jump into DeFi.
Currently, the high volatility across markets makes me wary of taking on more risk for an unexpected return.
The Bottom Line
The experiment posed by crypto and the DeFi sector could be the next big step in the digital revolution. Participating in DeFi 3.0 is the bleeding edge of crypto, making it much riskier than simply holding a token. The lack of guardrails, use case complexity, security issues, and regulatory uncertainty pose significant barriers to its future success.
However, its advantages and recent developments make it increasingly attractive. According to Blockworks.co, the total value of assets locked (TVL) in the DeFi ecosystem was $601 million in 2020 and now stands at $239 billion — 40,000%+ growth.
If you choose to participate in the ecosystem, do your research, consider your risk tolerance, join helpful communities, and play around with small amounts you can afford to lose. Like anything crypto, investing in DeFi 3.0 is placing a bet on the future of emerging technology.