Decentralized Finance (DeFi) is one of the hottest emerging niches in the crypto sector - this young ecosystem has been built with the goal of replacing the traditional finance model. At the very core, DeFi focuses on delivering a decentralized financial market where anyone can participate regardless of their location globally.
While DeFi has proven to be a promising niche, much of its inner workings remain complex even for the average crypto user. This article will breakdown some of the most common DeFi concepts to give you a better picture of this upcoming market or as some enthusiasts call it 'The future of finance'.
You might also want to check a more detailed article on DeFi fundamentals, use cases and challenges before diving into the technical concepts presented here.
Liquidity mining is the process of providing liquidity to an Automated Market Maker (AMM) pool by depositing your crypto assets in exchange for a reward in the form of Liquidity Provider (LP) tokens. Basically, these LP tokens are newly minted coins which may belong to a given DeFi project - they act as liquidity mining incentives to attract more funds into the smart contract.
This concept gained traction in the Summer of 2020 when DeFi lending and borrowing platform Compound debuted its governance token, COMP. Since then, DeFi projects have followed the same trajectory in the launching of governance tokens - most have created liquidity mining programs to facilitate the distribution of their governance tokens. An approach that seems to have worked for most successful DeFi projects.
So how does liquidity mining work? It is as simple as lending liquidity to a DeFi platform to facilitate its sustainability. With liquidity pools, DeFi protocols have built an automated way to solve liquidity challenges in crypto - these AMM's act as substitutes to the traditional order book model. On the other hand, buyers and sellers create demand and supply by providing or withdrawing liquidity from decentralized exchanges.
To put it into perspective, DeFi liquidity pools are mostly designed to hold two tokens so as to create a trading pair. Assume the example of a liquidity pool smart contract that can hold ETH and USDT - a user would have to deposit both tokens in equal amounts of equal value when providing liquidity. In the case of $100 worth of ETH, it will have to be balanced with $100 worth of USDT in order to be accepted into the liquidity mining pool.
The whole point of liquidity pools is to create an efficient marketplace where buyers and sellers can trade even when there is no counterparty to match their trades - though not a permanent solution, they are a perfect bandaid before the DeFi ecosystem grows to be as reliable as centralized exchanges. As highlighted earlier, liquidity providers who play the role of suppliers are incentivized with rewards in form of LP tokens and a percentage of the fees on trades within that particular pool.
Yield farming is a notch higher than liquidity mining - this process is designed to maximize DeFi returns by locking one's funds in return for rewards. Simply put, yield farming allows DeFi users to earn a fixed or variable interest on their locked funds. Today, there are some yield farms that offer as much as 300% in APY, although the value might not be guaranteed given that some of the tokens issued as rewards may become worthless at any time.
With most DeFi projects being built on Ethereum, yield farming projects leverage ERC20 tokens as fundamental building blocks - rewards are also issued in the form of these tokens. To get a better understanding of this niche, think of a banking ecosystem where users can lend or borrow from banks in fiat. In the case of yield farming, users lend their ERC-20 tokens in return for an interest which is paid out in tokens as opposed to fiat.
The first step of yield farming is becoming a liquidity provider - contributing funds to a particular liquidity pool. Once you have provided liquidity, you can then proceed to deposit the funds into a yield farm featured by the DeFi protocol you're operating on. In doing so, yield farmers have an opportunity to accumulate reward tokens which may be used for functions such as governance or be sold in the open market at higher prices.
Yield farming comes with the flexibility of moving one's funds around multiple protocols to maximize possible returns. DeFi enthusiasts who have been participating in this ecosystem often use various strategies and risk management approaches to make the most of available opportunities. One can actually reinvest their reward tokens in other farms and yield different reward tokens, simultaneously. It is also quite noteworthy that returns are mostly dictated by the amount you invest and the underlying protocol rules.
While the yield farming hype appears to have died down, there are still some active yield farms on DeFi protocols like Sushiswap and 1inch to name a few - returns on these farms are way superior to the offers in traditional finance instruments. However, this comes with a substantial amount of risk - price risk due to volatility in price, risk attributed to the legal uncertainties, potential hacks, technical issues and liquidity challenges in DeFi.
Just as the name suggests, governance tokens give the power to vote on the development of a given blockchain project. These tokens came up as a means to maintain the aspect of decentralization in DeFi projects - most have been distributed through liquidity mining and yield farming programs. In fact, they are already being used in the governance of prominent DeFi protocols including the likes of Uniswap and Compound.
With governance tokens as part of the DeFi ecosystem, participants in this market can voice their opinions by creating and voting on governance proposals. Such moves could involve alterations to the underlying smart contracts, improvements on the DeFi protocol, fees distribution, capital allocation and management.
Ideally, these tokens play a major role in shaping the future of DeFi and maintaining a decentralized architecture at all times - no wonder they are being used as the incentives to grow DeFi through liquidity mining and yield farming initiatives.
Yield generation is the simple process of generating some interest from your investment/capital. As we have seen, it is evident that you can earn interest in DeFi through the featured activities (liquidity mining and yield farming) - in fact, the returns are more significant than what is offered in today's financial markets.
Other DeFi niches where one can generate some interest include lending and borrowing platforms, derivatives trading and stablecoin yields. While they may be lucrative, it is prudent to do proper due diligence given the risks associated with DeFi - one could easily lose their entire capital in a matter of minutes.
That said, there are other lucrative and much simpler ways to generate yield in the crypto market, such as the Drixx interest account where users can earn up to 18% APY on their stablecoin deposits.
These are just but a few of the many concepts in DeFi - the ecosystem keeps evolving and new terminologies pop up every other day. Having such fundamentals, DeFi has been coined as one of the promising financial evolutions that could end up setting the stage for the next big revolution in the financial markets. However, there is still a lot to be done in terms of the technological developments, integration with the real-world ecosystems, legal aspects and the facilitation of the services to the masses in a user-friendly and intuitive manner.