What is DeFi? And how can Canadians invest in it?

by Ann deBruyn

Close-up of the enter key on a computer keyboard.

Photo by Marta Branco from Pexels

If 2020 was a transformative year for cryptocurrencies, 2021 saw the digital currency landscape evolve and expand with disruptive innovations. One of the hottest and most impactful areas of the blockchain economy is decentralized finance, or DeFi.

DeFi is fast emerging as a borderless, friction-free, cheaper and faster alternative to the current financial system. At its core, DeFi is a network of applications that are designed to replicate traditional financial instruments such as lending, borrowing and investing but with cryptocurrency, which doesn’t require intermediaries such as banks or brokerages to make decisions or approve transactions.

DeFi’s practical and financial appeal has drawn attention and dollars from tech enthusiasts, app developers and crypto investors. The DeFi market is booming. The estimated value of funds locked into DeFi-related contracts is US$240 billion, up from about US$21 billion at the end of 2020, as of Dec. 31, 2021, according to Defi Llama.

At its current growth rate, DeFi is set to become a major element of the digital assets economy. Crypto experts claim we’re about to see the global shift towards decentralized finance move up several gears.  If you’re an investor looking to explore DeFi’s income opportunities and learn how to participate, this definitive guide to DeFi has you covered.

How does DeFi work?

DeFi applications use blockchain-based smart contracts to provide traditional financial products without relying on centralized authorities like banks.

“Smart contract blockchains, such as ethereum, allow developers to build financial applications on top of them, which function autonomously and easily interface with each other,” says Henry Elder, head of wealth management at Wave Financial, a digital investment manager.

Entrepreneurs responded by building hyper-efficient, incredibly profitable businesses such as exchanges, banks, insurance markets, derivatives markets, art markets, robo-advisors and asset managers, among others, that inter-operate seamlessly and require no human interaction.

“The efficiencies of decentralized finance are driving new product innovations, such as lossless lotteries, self-repaying loans, automated market makers, yield farming, flash loans and decentralized governance, all of which continue to provide incentives for faster and better innovation,” says Elder.

DeFi vs. CeFi

In DeFi, you can carry out financial activities without a middleman, which effectively allows you to be your own bank. “You can use platforms to earn yield in a similar way to your savings account but without an intermediary,” says Marcus Sotiriou, a trader at digital asset broker GlobalBlock.

If you hold cash in a bank savings account, inflation will erode your purchasing power over time. By contrast, DeFi transactions offer lucrative rewards that can offset inflation. “You can earn yields of well over 10% on various cryptocurrencies, but in a traditional savings account, you’re lucky if you get 0.5% these days,” says Sotiriou.

DeFi lending allows users to loan or borrow cryptocurrency, just like banks and other providers do with fiat currency in the traditional financial system. As a lender, you would earn interest. As in conventional banking, the interest rate in DeFi goes up and down based on demand, but instead of using hard assets as collaterals, DeFi borrowers provide crypto assets in a process that is entirely anonymous and without human intervention. And since the bulk of CeFi operational costs, such as bank branches and employees, are dispensed with, DeFi can be very cost-efficient.

Where the two systems contrast most sharply is when someone defaults. Unlike in the conventional financial system, borrowers using DeFi apps don’t repay with physical assets if they default on their debt. In fact, debt defaults aren’t allowed. If the price of crypto assets used as collateral falls sharply, a preventative measure is triggered, which involves liquidating collateral to cover the loan before the value of the collateral falls below the loan value.

DeFi also bears many of the same risks as cryptocurrencies, including the prospect of closer regulatory scrutiny, wild asset price swings and the technology itself. Since no intermediary is involved in transactions, there’s no way to recover funds if they get lost due to a technological or transactional error. A fault in the original smart contract code could also cause irreversible losses.

How to participate in DeFi

Billions of dollars’ worth of crypto is flowing through DeFi applications, and the market is growing exponentially. So how can you invest in the DeFi ecosystem?

Since DeFi is built with smart contracts that run on the ethereum blockchain, the easiest way to invest in it is to buy ether (ETH), ethereum’s native coin, or other digital coins that use DeFi technology. You can deploy your ETH on one of many decentralized apps (dApps) to access DeFi instruments such as lending, yield farming and trading, among others.

Canadian investors can buy ETH and other crypto assets from a reliable online trading platform such as CoinSmart, a regulated entity that facilitates crypto purchase in Canadian dollars. The platform provides a safe and user-friendly interface for both new and seasoned investors, and there’s a $15 referral bonus.

The leading DeFi-powered coins include chainlink (LINK), aave (AAVE), uniswap (UNI) and curve DAO token (CRV), among others, some of which can be purchased via CoinSmart. A popular way to play the DeFi field is through yield farming, a process of generating interest by lending on crypto lending platforms.

The current environment of historic low interest rates across all leading economies has further prompted many investors to turn to DeFi. Apart from yield on deposits, certain protocols offer an additional reward, in the form of a new token called the liquidity provider (LP) token, which the owner can hold, use on DeFi apps or sell for cash.

“The innovative nature of the DeFi sector has allowed it to rack up more than US$200 billion,” says Sotiriou. “Over the next decade, I expect this number to be many multiples higher.”

The road ahead

With the ongoing convergence of blockchain technology and financial applications, the DeFi ecosystem will keep expanding. And, as newer technologies and greater adoption help DeFi move from niche market to mainstream, institutional interest is likely to follow.

There’s much for crypto investors to look forward to as the burgeoning DeFi economy opens doors to more unique opportunities. It’s a whole new way to gain access to the cryptocurrency market for both experienced investors and those just dabbling in it.

Read more on crypto:

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