Decentralized Finance has become the new hot thing in cryptocurrencies. It allows anybody to offer Wall Street-like financial products without the oversight of regulatory bodies or the costs to set up shop. This may be hard to see at first glance. After all, how do you ensure somebody pays back a loan?
This guide will cover thoughts on how to evaluate pricing these new, crypto-backed financial products. While not an end-all, be-all, it will serve as a jumping off point for those curious.
What is Decentralized Finance?
While I've covered this before, the basic premise is that permission-less cryptocurrencies enable permission-less finance.
How does that work and is that different from normal financial products? The base DeFi product, a loan, has a user put up more collateral than he is borrowing. In exchange, they receive the borrowed amount. The interest is accrued on the amount they borrowed until they reach some percentage of the collateral, typically 70%. At that point, the collateral is sold to cover the loan.
This creates interesting distortions. It means anybody can borrow money without a credit score. It also means "you can't lose" -- there's no risk in cryptocurrency terms as the collateral is always worth more. Note that this collateral may or may not be the same currency.
What are the risks?
There's the risk of hacks or bugs -- but that's inherent in any cryptocurrency.
One unique risk to DeFi loans revolves around oracle price manipulation. An oracle is the "source of truth" -- its used to determine the price of the collateral. That price may get hairy and its an open problem in the crypto world with products like Chainlink seeking to solve it.
What other DeFi is there?
People are coming out with novel ideas all the time around this. PancakeSwap for instance issues a token for participating in its ecosystem, allowing for a liquid behind-the-scenes exchange that enables unique DeFi products like a lottery.
How do I invest in these DeFi products & protocols?
There's a few ways and more come out every year. They come down to two parts: own the token or participate in the protocol.
Owning the token means buying one of many governance tokens used in voting (amongst other things -- more on this later). That would include \(AAVE](https://www.coingecko.com/en/coins/aave), [\)DUCK, and $UNI to name just a few. Owning these tokens enable the users to participate in voting proposals on the protocol, benefits when using the protocol, and/or a portion of the fees involved.
All tokens that I'm aware of allow for at least voting on protocol changes. These fall into a broader discussion around Decentralized Autonomous Organizations (DAOs) but for our purposes this will most affect the fees incurred by usage that are dispursed or through collateral changes.
The other way is through participating in the protocol. This, again, differs from DeFi to DeFi but it tends to center around providing liquidity to the protocol so it functions. For a DEX like Uniswap, this would be becoming a Liquidity Provider (LP). For a platform like Aave, this would mean staking and loaning out for returns.
What should I invest in?
I am not a financial advisor, but there are a few ways you could value your crypto activities.
It's paramount to know that the disbursment of fees from protocols can be thought of as dividends. DUCK, for instance, pays out from the collateral sales when loans are defaulted. The proceeds then go to holders of the token. You can see these transfers here.
A token could be priced as a discounted cash flow model. Tally up all the expected inflows of cash across a given time period, adjust for inflation, adjust for possible increases in returns. What would cause an increase in returns? Perhaps an increase in activity?
Some tokens like Aave don't pay out anything but do offer discounts on using the protocol to token holders. Such a token's value could be derived from what the activity is on the protocol and what the discount to its services would be for potential users. Again, its tied to general activity on the protocol.
Some tokens do not pay out anything. Uniswap would be among these. What would be the benefit in owning it then? In the future, the protocol may decide to pay out something from, say the fees. Or it could offer different financial products later on.
Unlike in the world of company stock, you know up front how many tokens will eventually be in existence. It's hardcoded. That's a huge boon to calculating these numbers as it removes an uncertainty.
What if the DeFi takes the money and runs?
That is a threat -- and one I've given thought to before -- but I'm ultimately not too concerned. Most DeFi developers have skin in the game because they own tokens that programmatically locked up. The developers cannot sell. It's in their interest to make sure the ship sails right, so to speak.