One of the applications for DeFi (Decentralized Finance) is providing new financial instruments that are a mirror of their traditional finance counterpart. For example, you can keep your funds stored on the blockchain and available for access through a digital wallet. That works much like a bank. The blockchain records your balance, and it is accessible through a smart contract user interface that allows users to spend their cryptocurrency asset. It performs functions similar to a bank, but it is not a tangible facility in the sense that you don’t need to be physically present in an office or interact with a person to withdraw your money or ask for a loan. Instead, it is all handled by smart contracts. When comparing rates and returns, it is a world of difference.
When you put your money into a bank, it is called a deposit. When you put your money into DeFi, you also deposit funds in order to access financial instruments provided by certain platforms like Compound, Uniswap, 1inch, Binance, etc. Those are just some examples. They are like banks in the sense that they take your money and allow you to invest in certain instruments. A bank allows you to perform currency exchanges, build portfolios for investments and take out loans. Money deposited into banks can be loaned out to other customers, and this is also true in the DeFi space when you deposit your cryptocurrency.
In DeFi, when you can deposit your money in cryptocurrency (i.e., digital assets) to create a savings account or provide it for liquidity, lending, and swaps (e.g., exchanges). You are putting your digital assets to work in order to yield returns and this is a process called yield farming. There are so-called farming protocols that allow users to find the best yields and returns on the amount of digital assets they have provided. Special smart contracts called AMM (Automated Market Makers) can take care of the entire process to discover and explore prices that provide the best returns.
In a sense, when you deposit your cryptocurrency, you are creating a collateralized position. In the Maker DAO protocol used in DeFi, you are collateralizing your digital asset to borrow against it. This is called a Collateralized Debt Position (CDP), and it is often over collateralized according to a rate known as the LTV (Loan-To-Value) ratio. It depends on the protocol used in the platform a user selects, but the LTV can be 150%, for example.
LV = Loan Value
CV = Collateral Value
R = Ratio or percentage rate
LV = CV / R
The concept here is that the digital asset as collateral can be very volatile, as is the rest of the cryptocurrency market. Therefore it is best to use a stablecoin to peg the value to fiat. When the digital asset’s value falls below the initial amount deposited or 150% of the collateral, it can be liquidated by certain protocols.
For example, if you deposit a digital asset worth $30,000 at an LTV of 150%, a user can borrow $20,000 against it. There are term loans that require payment upon expiry or perpetual smart contracts that do not have a term but require payment in order to recover a digital asset. In the banking system, payment of the principal amount is required along with interest accumulated over time (depending on the terms of agreement with the financier). In DeFi, the protocol requires payment of the principal amount and a certain amount of fees for holding the digital asset in custody. Some protocols call it a stabilization fee and are also a form of interest. It is the way that it is calculated that differs from banks.
The major difference between banks and DeFi when it comes to lending is that DeFi does not require documents to be submitted and loans to be approved. Decentralization’s benefits are it is more open with less barriers to entry. It does not matter how much you want to borrow as long as you can provide collateral. In the banking system, documents are required for background checks and credit history. Those requirements are not needed in the DeFi space or until there are more regulations set in place, but that is another topic for discussion.
In protocols like Compound, the interest rate is a function of the amount of crypto available (aka liquidity) in each market. The interest rate on payment decreases depending on the number of depositors (refer to the Compound website for more details). There are interest rates for payments on a loan that can be refinanced by another protocol, much like loans can be aggregated and paid to a third party for refinancing in traditional finance. DeFi provides different schemes for paying back loans against collateral, but they tend to be rather fair. If a user who borrowed against their digital asset cannot repay it, they are either liquidated or the funds are locked until a payment has been made.
When it comes to deposits, the interest rates that banks offer do not tend to be as high or beneficial to customers. It is like parking your money with minimum returns. The purpose of a savings account in a bank is exactly that. If you want higher returns, you have to create an investment portfolio to purchase stocks or get into the bond market. Banks tend to offer rates between 0.01% on the low to 3% on the high. You may rarely see banks offering rates above 1% in most cases.
Let’s take an example that you wanted to deposit $25,000 to a bank in the United States. You select the best quote offered when you check online. You explore the rates and calculate your returns over a certain period of time. At 0.50% APY (US) for $25,000, the return is $125 for 1 year. The deposit will grow to $25,125, which appears to be better than sitting there doing nothing.
In DeFi, it can be much better when it comes to returns. Protocols like Compound can accept digital assets like the DAI stablecoin. These are pegged to fiat currency (USD), which are much less volatile than most cryptocurrency. If you were to deposit 80,100 DAI worth $80,100, there is a higher yield interest rate of 8.19% APY. The yield on returns is $86,658.55 for 1 year, with an amount subtracted for fees. If we were to take the same example with the bank offering 0.50%, it is a night and day comparison. For $25,000 at 8.19% APY for 1 year, the return is $2,047.50 or a total amount (no fees subtracted) of $27,047.50.
Both banks and DeFi yield higher returns the higher the amount of the deposit. DeFi has a much higher rate than yield higher returns in comparison. Some platforms in DeFi implement compound interest that allows deposits to earn even more as the price of the digital asset increases. It also depends on the digital asset. If you were to compare Bitcoin to another cryptocurrency, Bitcoin will be deemed more valuable based on its market capitalization.
One of the reasons DeFi can offer higher or more competitive rates is due to its decentralized market-driven nature. Rather than having an entity like bank collecting fees, the fees are distributed across the network to incentivize liquidity and investment.
DeFi has higher returns but also a higher risk. Take that as a warning, especially if you have not yet used a DeFi product. Banks are much more stable when it comes to holding your money, but they offer the least returns on deposits and investments. The risk in DeFi comes from the volatility in the cryptocurrency market since the assets in use are cryptocurrency. Experienced users of DeFi have their own hedge against volatility by combining different protocols using money legos or more automated algorithmic trading. The more advanced users understand concepts of pairing certain digital assets together where one can offset the other. New users often lose money when trying something for the first time. Users should explore and understand the DeFi space before venturing into any of its financial instruments.