What is DeFI: the main ways to make money Skip to content

What is DeFi and how to make money on it

Что такое DeFi и как на нем заработать
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People who follow the blockchain industry have probably heard about a new trend called DeFi. In this article we will tell you about DeFi and methods of making money on it.

What is DeFi

DeFi stands for Decentralized Finance. This is the name for applications that use blockchain and provide financial services. DeFi projects perform almost the same functions as traditional financial institutions, but they do it automatically using protocols and smart contracts. 

What is included in DeFi ecosystem
The DeFi ecosystem consists of apps that duplicate the functionality of financial institutions and instruments.

For example, there are DeFi applications for lending, insurance, creating stablecoins, and managing cryptocurrency assets. DeFi has its own decentralized exchanges and payment systems.

How to make money on DeFi

There are ways to make money on DeFi which are similar to the traditional financial system. The classic methods include trading on decentralized exchanges and investing in DeFi tokens. And there are ways that are not possible anywhere else. 

DeFi-specific earning strategy is the so-called «Yield Farming». The point of this strategy is in earning DeFi tokens. In order to receive these tokens, you must support the DeFi protocols. These projects need liquidity — user’s funds locked inside a smart contract in order to work successfully. DeFi protocols have a reward mechanism to those who provide this liquidity. We will take a closer look at this and other ways to make money on DeFi below.

Liquidity providing at interest

Let’s say a user wants to take out a loan on a DeFi platform or buy ERC20 tokens on a decentralized exchange. The platform must have assets already in order to issue a loan or sell tokens. Liquidity is the asset that DeFi needs to function properly. These assets can be placed in so-called liquidity pools. Protocols pay a return percentage on blocking funds in such pools. For example, you have provided liquidity to the pool at 3% and the protocol blocked it. This pool contains the assets of all users who have put liquidity into this specific pool. When other users would want to take a loan in the protocol, they will take it from this pool. But they will pay more than 3% for it. This percentage difference is necessary in order to protect the protocol from fluctuations in the cryptocurrency rate.

How do liquidity pools work
A liquidity pool consists of assets that liquidity providers have placed in it. They get an interest for it. Other users can borrow assets from this pool and will pay interest on it.

For example, the Compound app allows you to make money on loans. The interest rate depends on supply and demand and is adjusted with each new Ethereum block, that is, every 12-15 seconds. Interest is paid in ERC20 COMP tokens. In the Compound’s case, you can return the loan you have provided at any time.

In decentralized exchanges, liquidity pools are a pair of two coins. You can either create your own liquidity pool or join an existing one. For example, you can block the ETH/DAI pair on Uniswap, the largest decentralized exchange by trading volume. To do this, you need to block the ETH cryptocurrency and DAI stablecoins in the protocol’s smart contract.

You can provide liquidity not only to exchanges and lending projects, but also to decentralized insurance, payment systems, betting and gambling platforms. There are DeFi projects that track the percentage of other projects’ liquidity pools and automatically move the user’s assets to the pool where this percentage is higher at the moment. For example, Yearn Finance tracks the percentage on the Compound, Aave, and dYdx liquidity pools.

If you want to become a liquidity provider, you need the cryptocurrency of DeFi project’s blockchain. DeFi projects mostly run on the Ethereum blockchain and therefore require ETH as liquidity. You can buy ETH with fiat currency on Bitzlato P2P-exchanger.

Cryptocurrency secured loan in stablecoins

Decentralized finance lending is different from traditional lending. You need to provide a collateral that will exceed the loan amount by a certain percentage in order to get a loan. The exact percentage depends on the specific DeFi platform. For example, the minimum loan collateral percentage in MakerDAO is 150%, in MonolithosDAO it is 125%. Excess collateral is necessary to protect the loan from fluctuations in the cryptocurrency rate. If the rate falls below the collateral percentage, the system will sell your collateral.

These loans are useful for two reasons. First, you can block a part of the investment portfolio from fluctuations in the exchange rate. Loans are issued in stablecoins that are pegged to fiat currency at a one-to-one rate. For example, MakerDAO’s DAIs are pegged to the US dollar, while MonolithosDAO’s MCRs are pegged to the Russian ruble. When you have taken out a loan in stablecoins, you can be sure that their price will not change. If the cryptocurrency rate falls and you lose your collateral, you would still have stablecoins that will not fall in price along with the cryptocurrency. If the cryptocurrency rate rises, then the value of cryptocurrency assets left as collateral also rises.

DeFi lending
When fixing a portfolio, the user fixes the loan funds, since they are stored in stablecoins.
When using leverage, he buys more ETH to trade.

Second, traders use these loans to gain leverage. For example, you expect the ETH rate to rise. You take out a loan in MCR and collateralize them in ETH. Then you buy more ETH for MCR. If the rate increases, then when you return the deposit, you will receive even more ETH. The profit increases because the rate of the collateralized cryptocurrency has also increased. You can buy ETH to get a loan on DeFi platforms at Bitzlato P2P exchange.

DeFi tokens as an investment asset

In addition to investing in cryptocurrency, you can also invest in DeFi tokens. Most DeFi projects have so-called governance tokens. These projects work automatically, so you need to vote to make changes to them — for example, to fix an error in the code or to change fees. Governance tokens give owners an opportunity to vote for protocol changes. In some projects, owners can use them to pay commissions or interest on a loan. Such tokens can be obtained in exchange for a certain action, like liquidity providing. They can also be bought on centralized and decentralized exchanges.

The DeFi tokens’ feature is their high volatility — many of them change in price more than regular coins. The most exponential example is the YFI token of the Yearn.Finance app, which increased more than 130,000% in the first 2.5 months. In this example, you can see that governance tokens often show growth in the first few months, after which their price fluctuates within certain limits, but no longer shows growth by thousands of percent. This is due to the fact that in the first few months it becomes clear whether the DeFi project can be trusted, and the tokens themselves are listed on large centralized exchanges.

Soon you will be able to buy MDT, the governance token of the MonolithosDAO DeFi project, on Bitzlato.

Trading on decentralized exchanges

One of the DeFi segments is decentralized exchanges or DEXes. Compared to conventional centralized exchanges like the Bitzlato exchange, they have two distinct features.

First, there is an automatic listing procedure. In centralized exchanges, the token verification and the listing decision is made by a person, while in DEX it is made by a smart contract. Because of this, fake tokens can be found on decentralized exchanges. They have the same name and logo as the original ones, but do not have the functionality of the original tokens. For example, you won’t be able to use them to pay in-app commissions or sell them on a centralized exchange. In order to buy an original token, you need to enter into the search bar not the name of the token, but the address of the smart contract, which can be taken from the project website or from a large cryptocurrency aggregator like CoinMarketCap.

Secondly, the DEXes’ trading process doesn’t require the use of the order book, but goes down directly between users’ wallets. Decentralized exchanges use liquidity pools provided by users to have volumes of assets at the asking price. Therefore, it is more difficult to find assets on DEX at the right price and in sufficient volume than on a centralised exchange.  The speed of order execution and transaction fees on DEXes are higher than on centralized exchanges due to the fact that such exchanges work automatically and use the blockchain. But to trade on DEX, you don’t need to register and go through a verification process.

In 2020, there are more than 100 decentralized exchanges that differ in functionality and the amount of available liquidity. The largest DEX by trading volume is Uniswap on the Ethereum blockchain. It has an analogue on the TRON blockchain called JustSwap. Among decentralized exchanges, there are platforms with the ability to trade with leverage — for example, dYdX. The Synthetix exchange makes it possible to trade derivatives — tokens that are tied to the value of real assets, such as gold or an exchange index.

Summary

DeFI is an infrastructure of decentralized applications that provide services similar to the classic financial system. Such applications work automatically via smart contracts and protocols.

The main ways to make money on DeFi:

  • liquidity providing to the liquidity pools as an analogue of a bank deposit;
  • lending gives you the ability to block a part of an investment portfolio or to get a leverage;
  • investing in DeFi tokens as an alternative to investing in cryptocurrencies;
  • trading on decentralized exchanges, including the ability to trade with leverage and derivatives.

You can buy ETH for fiat currency on Bitzlato and try to make money on DeFi projects on your own. Soon, you will be able to buy MDT — the governance token of the MonolithosDAO project.

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