Diving into DeFi: a Beginner’s Guide

Saying that cryptocurrencies are an alternative to traditional money is somewhat commonplace. Similarly, one might argue that DeFi is an alternative to traditional finance as DeFi defies (pun intended) the centralization and red tape inherent in the traditional financial ecosystem. After all, you don’t need a bank account to access cryptocurrencies and decentralized finance apps running on public blockchains. All you need is internet access, which makes DeFi truly borderless. On top of that, it is transparent, trustless, censorship resistant, and available 24/7. Traditional finance does not pack as much.

However, what DeFi and traditional finance have in common is that both of them can bring opportunities to make money to their users. Today, there are at least three basic ways to profit with DeFi:

  • Leverage.
  • P2P lending.
  • Liquidity providing.

Without further ado, let’s take a closer look at them.

If you never encountered leverage, there’s some preliminary explanation to be made. Understanding how leverage works is challenging without knowing basic trading strategies known to professional traders as ‘going long’ and ‘going short.’

Both of them pursue the same goal: make a profit from buying and selling assets. In this case, you can earn money if you correctly predict the price dynamics of a crypto asset. It doesn’t matter whether it is plummeting or skyrocketing: you may profit either way provided you chose your strategy wisely.

If you expect an asset to gain in price, you go long. It means that you buy the asset just to sell it once it becomes more expensive. For example, you can buy 1 BTC for $5,000 and sell it when the price hits $6,000. Your profit in this case will be $1,000.

Similarly, if you expect the asset to cheapen, you go short. It means that you sell the asset just to buy it back when it becomes cheaper. For example, you sell 1 BTC for $6,000 and buy 1 BTC when its price hits $5,000. You have your bitcoin back as well as $1,000 of profit.

It all sounds pretty simple but the real trick is to know which way the price will go in advance. Some find themselves up to the chin in fundamental or technical analysis in order to shake the charade. Some just keep their finger on the news, while others use insider scoop to choose their strategy but then they risk going to jail because that is considered to be fairly illegal, at least on all regulated markets.

Now that we know what going long and short means, let’s take a look at leverage. In brief, leveraging is trading assets with borrowed funds in addition to your own. In the U.K. and Australia it’s sometimes called gearing.

If the exchange where you’re trading offers you a leverage, it usually looks like 10x or 5.5x. It means that the exchange can lend you 10 times (or 5.5 times) your own deposit to trade. You cannot withdraw that money, though, you can only use it to buy and sell larger quantities of assets.

For the sake of explanation, let’s say that the exchange offers a 1x leverage, which means that the exchange lends you as much as you have deposited. Then, if you go long by buying 1 BTC for your own $5,000 as in the example above and add 1 BTC for $5,000 you have borrowed, your potential profit doubles: now you have $2,000 after you return the money to the exchange. Needless to say, it happens only if you were correct in thinking that the price will go up.

The same works with going short as well: you may double your revenue if you sell the 1 BTC you own and the 1 BTC you borrowed.

But here’s the most crucial catch: leverage can increase your profits only if you guess the price dynamics right. If you choose poorly, your losses will increase just as much: you lose someone else’s money on top of losing your own. Cryptocurrency exchanges have their own methods of preventing their money from going to waste but we’ll omit that for clarity.

DeFi today has several methods for leveraging your cryptocurrency position. You can borrow the asset of your interest directly at a decentralized exchange that supports margin trading or in a p2p lending app. Alternatively, you can buy the asset for a stablecoin you issued with the crypto asset as collateral.

Unlike leverage, you don’t have to buy or sell anything here. You just transfer your crypto assets into a smart contract and enjoy passive income. This makes p2p lending and liquidity providing somewhat similar to traditional bank deposit, however, in this case you don’t have to trust a financial intermediary: a smart contract works perfectly in their stead.

In the p2p lending model, you actually profit from the interest paid by the borrower of your crypto assets. You may lend volatile assets or stablecoins. The interest rates may vary depending on the platform, so spending some time to choose the most profitable option might be a good idea.

An advanced user may even build arbitrage strategies by borrowing an asset at a lower price at one money market and lending it at a higher price at another.

In case of liquidity providing, you’re not a creditor but a kind of a market maker. It means that you deposit a trading pair of crypto assets in an exchange smart contract dedicated to this particular pair. Just note that anyone else can do it as well.

For instance, you deposit ETH/DAI, i.e. a certain amount of ETH and the respective amount of DAI. Anyone can exchange their ETH for your DAI and their DAI for your ETH in this smart contract at current exchange rate. Of course, it’s not free for them: they have to pay the fees set up by the code of the smart contract. In this case, you profit from the fees other users pay for exchanging their assets in the smart contract.

The profitability of different liquidity pools may vary as well, so we highly recommend that you thoroughly study the market before proceeding.

In this post, we looked at the most popular ways to profit with DeFi. Apart from them, there are myriads of other ways like creating prediction markets or selling insurance policies. You can invest in automatically rebalanced token baskets. Staking and DAO security tokens are also sometimes considered DeFi revenue sources.

Finally, financial derivatives that enable one to hedge various risks are a source of income. The party that wishes to hedge their risks buys a financial derivative from another party that agrees to bear the risk. While derivatives are well developed in the traditional finance, it is one of the most neglected parts of DeFi. We believe that forgetting derivatives is a serious gap in DeFi, so currently we are working on a product that will fill it. We will present it soon.

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