The best ways to participate and operate

Decentralized finance (DeFi) is a concept that has received a lot of attention since the so-called DeFi Summer of 2020 because its usage, often measured in total value locked (TVL), has risen dramatically since that time. In the last year alone, TVL rose by over 240% to a current $209 billion in “value locked” within DeFi projects, according to DefiLlama. Not only has it become interesting for investors to get into promising DeFi projects through their tokens (hoping for capital gains), but also to use these platforms to generate a regular and steady income through various activities. And, it’s been even more attractive in bearish markets.

It is exactly this appeal of solid risk-free returns uncorrelated to crypto market movements that lures many investors out on to the thin ice. Remember: There is no such thing as a free lunch. In this article, we will break down the concept of DeFi and go deep into its ecosystem, strategies and the risks all of which are relevant for private and professional investors considering allocating capital to this space.

Related: DeFi can breathe new life into traditional assets

From TradFi to DeFi

Let’s start at the beginning by shedding some light on the transition (or disruption) from traditional finance, or TradFi, to DeFi. Explained simply, DeFi sets out to disintermediate processes traditionally run by banks and financial institutions like borrowing, lending and market making by cutting out the middleman. It allows investors to directly interact with each other on a peer-to-peer (P2P) basis by providing loans or liquidity for trading and assume those roles/functions in return for generating fees, albeit while also carrying the risks. “The disruption of the banking sector, which we have seen in the recent years driven by FinTech players, has now escalated to the next level with DeFi laying the groundwork for a peer-to-peer ecosystem” states serial tech entrepreneur and AltAlpha Digital crypto hedge fund co-founder Marc Bernegger. We will explore the DeFi business model and ways to participate in it shortly.

Common factors used to classify the TradFi space include that it is trust based, as you need to trust your bank as the sole counterparty, large barriers remain for entering the system, as many emerging nations still have populations where 50-70% are still unbanked, and they are often slow, expensive and not very customer friendly. What can you expect if they are only open Monday-Friday, from 9:00 am to 11:00 am and 2:00 pm to 4:00 pm? This stands in strong contrast to the DeFi world built on code that removes the need for trusted intermediaries; the agreed-upon terms are recorded on and executed through blockchain mechanisms. Accessibility has drastically increased with the spread of internet coverage and cheap smartphones. The digital assets space can be accessed 24/7/365, with services and global network coverage being constantly expanded and improved.

While it might all sound wonderful, there is still a long way to go. The topic remains complex and hard to grasp for many. User interfaces and processes still have plenty of room for improvement and simplification, fees can vary, resulting in unreasonably high charges for smaller transaction amounts, DeFi hacks have been on the rise and being your “own bank” welcomes an entire slew of operational challenges and risks.

The elements involved in DeFi

Looking at DeFi as a whole, much like building a house, you have various layers that come together to form a new digital service offering.

Using the house as our example, the first layer, the underlying blockchain technology which could be Ethereum or Solana (layer-1 protocols), is like our basement or cellar. Depending on which blockchain is used, you will need to make certain trade-offs. This is known as the blockchain trilemma, a phrase coined by Ethereum co-founder Vitalik Buterin.

Think of a triangle with security, scalability and decentralization at each of the corners. You can only optimize two corners while making a compromise on the third corner. Putting this into a practical context, Marius Ciubotariu, founder of the Hubble Protocol, states:

“Both Solana and Ethereum do not compromise on security, but as opposed to Ethereum, where almost everybody with a laptop can run a node, Solana nodes are much more demanding. However, in a world governed by Moore’s law, this doesn’t seem to be much of a trade-off anymore.”

He continues: “Solana, as a blockchain, was designed for high frequency (financial) activity. Everything in Solana’s design is geared towards performance, choosing to prioritize speed over cost.” This gives you more color for the nuanced views developers and investors must take when deciding for an ecosystem. To tackle these challenges, developers are working on either creating new “base layer” blockchains to solve these constraints, which you see with Polkadot and their layer-0 approach or by introducing layer-2 scaling…