Updated: Jun 20
Discovery Path - DeFi Investing Series: Part II
Billions of dollars worth of cryptocurrency are flowing through DeFi applications, and the market is growing exponentially and offers an exciting new field with many opportunities that users with the right amount of knowledge, experience, and insight, could deploy wisely their funds and earn healthy returns.
The building blocks of the crypto-financial system
Decentralised finance (DeFi) is reinventing the foundations of traditional financial systems (TradFi), from investment to borrowing, by digitising capital market instruments. Securities, bonds, money markets, currencies and any type of tangible or intangible asset now have their "hologram" thanks to blockchain technology. Indeed, the crypto financial system offers far more possibilities than just buying and selling crypto-currencies. Users can directly execute financial transactions such as trading, lending and investing, using a wide range of blockchain applications not limited to crypto-currencies, but also coins and tokens.
Bitcoin is one of the first and best known, but not the only applications of blockchain technology. Tokenisation of real assets and securities is currently the other main application. This is an innovative and efficient solution that leverages blockchain and other distributed ledger technologies (DLTs) to issue tokens representing common financial and investment instruments. Among other benefits, it expands the universe of investable assets and strategies in the crypto-financial system for asset managers; or increases the liquidity of assets considered illiquid and out of reach for most retail and professional investors in the traditional financial system.
Overview of crypto-financial system capabilities
A major difference that sets DeFi apart from traditional finance is not so much in terms of the types of service it provides, but rather in the way it performs them. The DeFi ecosystem revolves around two elements:(i) novel protocols for trading, lending and investing, and (ii) stablecoins, which are crypto-assets that facilitate fund transfers and aim to maintain a fixed face value vis-à-via fiat currencies, mainly the US dollar. Although the main vision of DeFi proponents is intermediation without centralised entities, there is still some form of centralisation (CeFi), which could serve as a bridge for investors who are still hesitant to embrace this development and/or who, for personal convictions, legal or compliance reasons, are not comfortable with full disintermediation of financial exchanges.
Crypto-asses trading can take place on both centralised exchanges (CEXs) and decentralised exchanges (DEXs). The CEXs system is structured around the same principles as its conventional counterparts. Unlike the DEXs system which operates by matching counterparties to a trade - through so-called automated market maker (AMM) protocols - the CEXs system maintains off-chain registers of outstanding orders posted by traders - known as limit order books.
Many crypto transactions still fall under the centralized finance (CeF umbrella because the average crypto exchange is centralized and uses a third party to conduct transactions. For instance, a centralized exchange holds the crypto wallet key for the users. Conversely, DeFi wallets are non-custodial. The user retains possession of its crypto and is responsible for the private keys that let you access the wallet. But a major disadvantage is that if the keys are lost, the user cannot request a new one as they would for a new password in a centralized wallet.
Some common DeFi instruments
Decentralised finance already offers dozens of different financial applications. Among the most significant applications of DeFi that can be used by investors to manage their investment portfolios are
Coins: DeFi coins transfers value in a financial transaction. They are built on and often named for their unique native blockchain networks. Some of the most popular coins are Ether (ETH), Cardano (ADA), Solana (SOL), and Polkadot (DOT).
Stablecoins: are cryptocurrencies that are pegged to an actual asset to stabilize their prices. The actual asset can be a fiat currency or even an asset like gold. egging cryptocurrency to an actual asset helps in controlling the extreme fluctuations and price changes.
Wrapped coins: For instance, wrapped bitcoin, is a type of Bitcoin that can be used on the Ethereum network. Put simply it enables the bitcoin holders to use DeFi wallets and other DeFi applications without liquidating their Bitcoin holdings.
Most of the DeFi tokens run on the Ethereum blockchain. Users can trade, get loans, earn interest, and more. Despite its hype and outstanding yields, DeFi tokens are considered high-risk investments with high volatility.
Tokens: DeFi tokens are an asset similar to coins and can also be a type of cryptocurrency. For example, Ethereum’s coin is Ether, while tokens like UniSwap and Compound are non-native cryptocurrencies constructed on the Ethereum blockchain. Tokens can come in many different variations, like payment tokens, governance tokens, and utility tokens. Some popular DeFi tokens include Uniswap (UNI), SushiSwap (SUSHI), PancakeSwap (CAKE), Wrapped Bitcoin (WBTC), Dai (DAI), Compound (COMP), Avalanche (AVAX), Chainlink (LINK).
Non-fungible tokens (NFTs): are unique digital assets built on the same blockchain technology that powers cryptocurrencies, but they are not a cryptocurrency. At a basic level, an NFT is a synthetic asset that links ownership to unique physical or digital items, such as real estate, stocks, videos or songs or arts. NFTs can be considered modern-day collectables. They're bought and sold online, and represent digital proof of ownership of any given item.
Futures/Options Contracts: are still relatively underutilized. But some crypto exchanges (such as BitMEX ) have started offering the ability to hedge and speculate with derivatives instruments. The Futures contracts traded on these exchanges are perpetual contracts that do not bear an expiry date. The underlying asset is never delivered, and traders pay fees to maintain their position. Examples of non-custodial futures/options exchanges include Hegic, Perpetual Protocol, dYdX, and OPYN.
The crypto-financial system is rapidly developing with a rich array of tradable assets, tools and strategies being applied. The ever-evolving blockchain technology has opened the door to an increasing level of sophistication and a more diverse set of investment opportunities, beyond the simple buy/sell/HODL strategy on coins or tokens ("HODL" is an acronym for "Hold on for dear life"). As with traditional and alternative assets, there are different levels of risk to consider, including market risk, tracking risk, counterparty risk, programming risk, security risk and future regulatory risk, which everyone should keep in mind.
Disclaimer: This article is provided for information purposes only and does not constitute an invitation to invest. Please seek advice from your investment advisor before investing.