DeFi can pay out high returns, but you need to understand the risks.
According to Chainalysis’s latest report into global cryptocurrency adoption, North Americans sent $276 million to decentralized finance (DeFi) platforms between July 2020 and June 2021. DeFi transactions made up 37% of North America’s transaction volume, and the U.S. topped the chart for global DeFi adoption.
So what is DeFi, and how can you get involved? Let’s take a look.
Getting involved in DeFi
DeFi encompasses a host of applications that take the middleman out of traditional banking. It means people can access things like loans, insurance, and crypto trading without a bank account, mountains of paperwork, or a credit check.
The Chainalysis report showed that large transactions — ones over $10 million — made up 60% of all DeFi transactions in the second quarter of 2021. It says that DeFi is “disproportionately popular” among bigger investors, although some retail investors in the U.S. are also getting in on the DeFi game.
As a retail investor, the first thing you need to do to get started in DeFi is open a decentralized wallet. The best known is MetaMask, which works with most applications. Make sure you keep your password and seed phrase in a safe place. If you lose your seed phrase, you won’t be able to access your funds.
Here are some of the most common DeFi activities.
1. Lend/earn products
Several of the best cryptocurrency exchanges and DeFi platforms offer lend/earn products. Essentially, crypto investors can deposit assets on the platform and earn higher rates of interest than they would with a traditional savings account. The way the platform generates those high returns is by lending the assets out and paying investors part of the interest.
On the other side, borrowers can use their cryptocurrency as collateral against a loan. Once they pay the money back, the collateral gets returned. One reason this is a popular step is that investors can get cash from their crypto assets without having to sell them. Selling crypto could incur capital gains tax, but borrowing against it does not.
2. Trading on decentralized exchanges
Decentralized exchanges, or DEXs, are another popular DeFi application. Unlike a centralized exchange, where the platform sits in the middle of the trade to make it happen, DEXs let people trade directly with each other.
One big attraction of DEXs is that they often trade coins you won’t find on centralized exchanges. They are usually anonymous, which appeals to traders who want to maintain their privacy. The downside is that DEXs aren’t subject to the same anti–money laundering rules as centralized exchanges. There’s little to stop scam coins from hooking unwary investors.
3. Contributing to liquidity pools
Liquidity pools are another way to earn passive income on your assets. It’s a little bit like having a storeroom in the back of a supermarket, ready to meet customer demand.
DEXs needed a way to ensure there are coins available for trading, since there’s no central platform to facilitate trading. This is where liquidity pools come in. Investors can contribute pairs of coins to the liquidity pool and earn a percentage of the trading fees.
Be aware that there are a number of risks associated with contributing to liquidity pools, and it’s important to understand how they work before you get involved.
Understand the risks
There are many advantages to removing intermediaries from transactions. It can make processing faster, build trust, and pay higher returns. However, you’re essentially becoming your own bank — which means you need to do a lot of learning, take steps to protect your security, and take responsibility for things like your passwords. There’s unlikely to be a handy “forgot password” button on your DeFi wallet.
It also means you don’t benefit from the consumer protections that have taken decades to develop in the financial industry. For example, if a bank fails, you’d be protected for up to $250,000 per account through FDIC insurance. This does not apply to DeFi platforms.
If you accidentally transfer funds to the wrong place from your bank account, you might be able to reverse that transaction with traditional banking. But with DeFi, there’s no going back. You also need to watch out for transaction fees. Many DeFi applications are built on the Ethereum (ETH) network, which means you’ll pay gas fees. Ethereum is struggling with network congestion, and the more congested the network gets, the higher the fees become.
Most of all, DeFi consumers need to be on guard for scams and fraudulent offers. In the first four months of this year alone, investors lost $83.4 million to DeFi frauds, according to CipherTrace. In a recent scam, Squid Game (SQUID) crypto fraudsters stole about $3.4 million in what’s called a rug pull. The coin’s value pumped 23,000,000% in a week and then the scammers pulled out and took the money with them.
Bottom line on DeFi
Increased DeFi regulation is on its way. This will likely cut into some of the crazy DeFi returns we see on certain sites, but also give investors more protection against platform failure and fraud.
In the meantime, there are some great opportunities to earn money in decentralized finance. But — as with any crypto investment — it’s important to understand what you’re getting into and to only invest money you can afford to lose.