This is part 14 in my cryptocurrency educational series.
⭐ Each part builds on the previous ones, so I suggest starting with:
Cryptocurrency 101 series (i.e., core principles and Bitcoin):
- Part 1: Why should I care? What’s in it for me? Why is crypto important (it’s about a lot more than just making money!)?
- Part 2: How crypto actually works, why Bitcoin is valuable (even if it’s just “made up!”), and what you should know about blockchains (the tech behind them and how they could influence the future of our world)
- Part 3: How the blockchain keeps running, where new Bitcoins come from (i.e., how mining works), and concerns about Bitcoin’s environmental impact
- Part 4: How crypto offers autonomy, why it can’t be stopped, and the value of decentralization
- Part 5: How to store and use cryptocurrency, some basic cryptography, how wallets work, identity management, and the future of democracy
- Part 6: Overview of the different types of wallets, which one is best for you, what to be careful of, and why a hardware wallet might be worth the investment
Cryptocurrency 201 series (i.e., intermediate principles, Ethereum, and other coins/tokens):
- Part 7: Ethereum (the #2 most popular cryptocurrency, and the one I’m most excited about), smart contracts, dapps, gas (and the high gas fee problem), Proof of Stake (PoS), and Ethereum 2.0
- Part 8: Coins vs. tokens, and some real Ethereum use cases—oracles and DEX’s
- Part 9: Intro to NFT’s (collectibles, research funding & historical significance, and music)
- Part 10: More categories of NFT’s (art, video games, virtual reality)
- Part 11: Wrapping up NFT’s (what you can actually do with them, upsides, downsides, risks)
- Part 12: DAO’s (organizations managed by algorithms, governance tokens, collective ownership, and the “network state”)
Cryptocurrency 301 series (i.e., advanced principles, investing):
- Part 13: DeFi & CeFi, reinventing banking with peer-to-peer finance, stablecoins, and borrowing & lending
- Part 14: More DeFi (insurance, payments, derivatives, blockchains, exchanges, liquidity staking, and impermanent loss)
- Part 15: Wrapping up DeFi (LP tokens, yield farming, calculating return, yield aggregators, and major risks)
- Part 16 (in progress): Investing (principles, risk/reward, and my favorite options for making money in crypto)
Part 14 Reading Time: 30-36 minutes
In this post, we’ll dive even deeper into DeFi (decentralized finance); so, please first read the previous post (Part 13) if you haven’t already.
Let’s go through four more categories of DeFi use cases.
DeFi use case #2: Getting insurance
In the previous post, I outlined some of th ebig risks with lending money through DeFi.
One way to mitigate those risks is to buy insurance from an organization like Nexus Mutual.
This is similar to when you buy insurance on anything—for example, you might get insurance on your house, so if it burns down, the insurance company sends you money.
Nexus Mutual (and other insurance platforms) offers something similar with crypto. These platforms not only insure crypto products, but they themselves are built on the blockchain as well. And compared to traditional insurance companies, they’re much simpler and far less bureaucratic.
Here’s how it works:
- In the case of Nexus Mutual, they operate kind of like a grocery store coop. You first have to become a member of their DAO to participate (if you don’t remember what a DAO is, check out Part 12 of this series). Joining the DAO just takes a few minutes and cost about $7 when I joined. This does involve KYC though (“know-your-customer” regulations), which just means that you have to verify your identity with something like a driver’s license.
- Next, from their dapp, you select which DeFi platform you’re using (e.g., to lend out your money) and enter how much you have invested; then, it’ll show you how much it costs to protect that investment (it’s often less than 3%). Just like with any DeFi product, you pay them that 3% (or whatever it is) in ETH using something like MetaMask.
- Once you’re set up, if your DeFi lending platform’s smart contracts fail in some way and you lose your money, all you have to do is submit a claim, and they’ll reimburse you in ETH.
As you can see, getting this kind of insurance is far easier than buying something like homeowner’s insurance in the TradFi world. This kind of DeFi insurance shaves a little off your yield, but it keeps you safe if something goes wrong.
Personally, I own Nexus Mutual insurance on just one of my investments—Anchor Protocol, which I’ll describe in a future post on investments. My basic reason is that Anchor offers an especially high yield, so it makes me feel less nervous to own insurance on its potential points of failure.
Finally, I want to emphasize an interesting point here: Nexus Mutual is a DAO, the kind of decentralized corporation that I explained in Part 12. You can join the DAO and participate in governance by buying the NXM token. When users submit claims, it’s DAO members who collectively vote to decide which ones pass. You don’t have to participate to this degree, though. Members who help with the assessment process are rewarded with NXM tokens. And, any DAO member can, of course, submit and vote on proposals.
In other words, Nexus Mutual is run completely by its members; you have to become a member to buy insurance from them; and, everything is transparently recorded on the public blockchain.
DeFi use case #3: Handling payments
I haven’t been inspired to look into this space much, but I’m including it for the sake of completeness.
The Flexa network offers people a way to spend crypto at physical stores without conversion fees or risk of fraud. Since it’s based on crypto, you just need your wallet, and you can pay without having to submit any information about yourself (e.g., zip code), as you sometimes have to do with credit card purchases. It’s also better for the businesses since it reduces fraud and provides reduced fees and faster payment settlement. Supported companies include GameStop, Nordstrom, and Petco.
DeFi use case #4: Working with derivatives
In finance, the word “derivative” refers to an asset that represents (and derives its value from) a different, underlying asset. In other words, when the value of the underlying asset changes, derivatives based on that asset change too.
For example, a gold derivative derives its value from the underlying asset of gold. If you buy that derivative, you’re not buying gold itself, but rather a kind of option or agreement to buy or sell gold at some point in the future.
It’s kind of like making a bet on whether the price of gold is more likely to go up or down in the future. If you believe it will go up, you can buy a derivative that will allow you to get it at a lower price in the future.
Here are two examples in crypto:
- Synthetix is an Ethereum-based protocol for an ecosystem of “Synths” (synthetic assets), which are ERC-20 (Ethereum) tokens that represent other assets.
- It uses oracles to track the prices of those assets, which could be anything from gold (the sXAU Synth), to Euros (the sEUR Synth), to traditional stocks (e.g., the sMSFT or sTSLA Synths).
- I’m not at all an expert on derivatives, but the basic idea here is risk management. My understanding is this: You might buy a derivative of an asset rather than the asset itself if you want exposure to that asset in your financial portfolio, but you want something less risky than owning the actual asset. (Don’t worry if you’re confused here—you definitely don’t need to understand how derivatives work to be successful in DeFi.)
- Also, because the Synths are ERC-20 tokens, you can trade them, store them, or invest them, just like any cryptocurrency.
- NFTX is an Ethereum-based protocol for an ecosystem of fractionalized NFT’s, or what you might think of as NFT index funds.
- The idea here is that, since many popular NFT’s have become extremely expensive (up to millions of dollars each), most people can’t afford to buy one. Instead, NFTX offers access to Vaults, which contain one or more of those expensive NFT’s—for example, a CryptoPunk or Autoglyph.
- You can then buy that Vault’s ERC-20 token to own a small fraction of the NFT or NFT’s contained inside. If those NFT’s go up in value, so too does your Vault token.
- And again, because your Vault token (e.g., PUNK for the CryptoPunks Vault) is an ERC-20 token, it lives in your Ethereum wallet, and you can trade it or even invest it in a different DeFi platform that might allow you to lend it out or use it as collateral on a loan.
So far, we’ve gone through four big categories of DeFi, and we’re about to dive into a fifth category that I consider high-reward and high-risk.
This stuff gets complicated fast, and I won’t claim to fully understand every piece; but, I’ll try to explain it as simply and accurately as I can. Again though, I’m not an expert in either finance or crypto, so I apologize if I get anything wrong.
(And again, I’m not an investment advisor, and this isn’t investment advice.)
Before we get to use case #5, though:
Quick interlude about gas fees and alternative blockchains:
- Pretty much all this DeFi stuff is running on the Ethereum blockchain network.
- But, Ethereum competitors like Solana, Binance Smart Chain, and Tezos have also been growing their DeFi offerings. (By the way, I think that all of those can happily coexist—there doesn’t need to be just one winner.)
- Those other blockchain networks are similar to Ethereum in that they allow for “programmable money,” smart contracts, dapps, and so on.
- One big reason those other networks have been popular lately is how high gas fees are on Ethereum right now.
- Gas fees are high because Ethereum has been exploding in popularity; and, since the blockchain network can only process so many transactions per second, gas fees go up because of supply and demand.
- So, when you’re playing in the DeFi space and making a lot of transactions (e.g., to reinvest your gains), gas fees can really cut into your earnings if you’re not careful. I’ll get into this more in a future post on investing.
DeFi use case #5: Exchanging currencies, and liquidity staking
The last major category of DeFi that I’ll cover is DEX’s, or decentralized exchanges, which I first touched on in Part 8. You might remember that dapps like Uniswap and SushiSwap allow you to exchange one type of crypto (e.g., ETH) for another type of crypto (e.g., SUSHI).
That might seem simple enough on the surface, but stop for a moment to consider this:
Remember that the whole point of these exchanges is that they’re decentralized. There’s no bank behind the scenes that has a vault full of SUSHI readily available to give me, the user. So if I open Uniswap to trade some of my ETH for SUSHI, where does that SUSHI come from?
Zooming out even further, Uniswap supports literally thousands of different coins and tokens. So how can it possibly have enough of each one to trade me, right when I want it?
To answer that, I need to explain what “liquidity” means.
Think of “liquidity” as how quickly and easily you can convert something to cash.
For example, let’s imagine a scale from “most liquid” to “least liquid”:
- Money in a traditional checking account is extremely liquid. It’s very easy to convert that to cash via a debit card or ATM.
- Money in a savings account might be a little less liquid if your bank imposes rules like a limited number of withdraws per month.
- Stocks are even less liquid since converting them to cash requires selling them, allowing the sale to settle, and then transferring that money to your bank account. A stock like Tesla will be pretty liquid because it’s in high demand and it’s being traded constantly. So, as soon as you want to sell it, someone will be there to buy it. But if you own stock in an obscure, tiny company, that stock is less liquid because it might take a while to find a buyer.
- Your house is not very liquid at all since converting it to cash would require you to hire a real estate agent, find a buyer, close the escrow, etc. All that might take months.
- A rare painting is extremely illiquid because it would likely take you a while to find someone willing to pay you the right price, then you’d have to have an expert inspect it, etc. In other words, with an illiquid asset like fine art or land, it can be very hard to extract its value when you need it—for example, if you need cash to pay a bill.
To put it simply then, if there’s low liquidity, transactions take longer because there’s more of a gap between the people who want the asset and the people who have it. If someone wants to sell something, they have to wait for a buyer to appear.
Say I want to convert US dollars into BTC, but no one who owns Bitcoin is willing to sell it right now. Or, maybe I’m willing to offer $50,000 for one BTC, but no one is willing to sell theirs for less than $60,000.
Either way, this means there’s no liquidity in the USD-BTC market. But that’s rarely the case in reality since there’s so much USD and BTC out there and so many people willing to buy it and sell it.
But, say a new cryptocurrency just started up, and there’s only a small supply of its tokens available. Those tokens are not liquid, so if you want to get some, you’ll have to find someone who has them and is willing to sell them to you.
Don’t worry—this is easier than it sounds.
Back to Uniswap and other DEX’s.
The basic idea is that they should hold a lot of each popular type of cryptocurrency—so when you want to trade, say, UNI for SUSHI, they don’t need to stop to find a buyer for your UNI. They should already have enough SUSHI lying around that they can just buy your UNI immediately and give you SUSHI.
So how do they do that?
Uniswap relies on its users to provide liquidity.
So, where do all the tokens and coins come from that you can exchange for on Uniswap?
From other users.
If a user wants to support the Uniswap ecosystem, they can lend it some of their crypto, which is called “providing liquidity.” It’s also called “supplying liquidity,” “liquidity mining,” or “liquidity staking” (those are all synonyms—yeah, it’s confusing).
But Uniswap is a huge platform used by a lot of people every day. So when you provide liquidity, you’re not directly lending your crypto to another user. Rather, you—and many other people—add crypto to lending pools (in other words, vaults containing a certain type of crypto). Then, when someone wants to swap for that crypto, the system pulls it out of the relevant pool.
Ok, so why would you decide to provide liquidity to Uniswap?
Because every time someone uses the Uniswap dapp to make an exchange, they’re charged a fee. And that fee is distributed to all the members of whichever pool that desired coin or token was drawn from.
In other words, liquidity staking can be a great way of making passive income—if you do it right (and you can accept a certain level of risk, which can often be very high).
Here’s how it works:
- To provide liquidity on a DEX like Uniswap, you first have to decide which pair of cryptocurrencies you want to support.
- Pools are not just made up of a single cryptocurrency, but rather a pair: the one the user has and the one they want. The order doesn’t matter (A to B or B to A)—it’s the same pool. For example, imagine you were running a DEX for traditional currencies—you might have one pool for USD/YEN and another for YEN/YUAN. The USD/YEN pool would contain 50% USD and 50% YEN, and the YEN/YUAN pool would contain 50% YEN and 50% YUAN.
- Here’s a list of the most popular pair pools on Uniswap. The top one at the time of this writing is USDC/ETH. That pool is used whenever a Uniswap user wants to exchange their USDC (the stablecoin representing the US dollar) for some ETH (Ethereum), or vice-versa.
- By the way, if you see a “W” in front of something, like “WBTC,” that usually stands for “wrapped.” For example, WBTC is an ERC-20 token (i.e., a token on the Ethereum blockchain) representing Bitcoin. It can’t just be BTC because BTC lives on the Bitcoin blockchain and isn’t an ERC-20 token. So, to allow Bitcoin to be used on Ethereum-based DeFi platforms, BTC is “wrapped” into WBTC, and it’s pegged to the value of the real BTC on the Bitcoin network. A similar example is LUNA from the Terra blockchain network being wrapped into WLUNA.
- As you can see on that pool list webpage on Uniswap, the TVL (total value locked) of that USDC/ETH pair pool is currently over $300M USD, meaning that the total pool value (a combination of USD and ETH) is $300M.
- It’s deceptively easy to provide liquidity to a pool like that. You just click the pool, click the Add Liquidity button, connect your wallet, and deposit a combination of USDC tokens and ETH tokens (typically an equal value of each).
- On some platforms, you can choose to just deposit one half of the pair (i.e., either USDC or ETH), and the system will automatically convert half of it to the other token for you.
- Here’s where it gets confusing, though—at least on Uniswap—and where it becomes easy to make a costly mistake. Once you’ve deposited your crypto, you have to choose the price range, which is basically the range of values of USDC and ETH you want to be playing in.
- For example, let’s say that the value of ETH has been rising and falling over the past few weeks between $2,000 and $3,000 USD. You might decide to provide liquidity for that entire range or just for exchanges when ETH is between $2,800 and $2,900.
- You can adjust this range in the future, but you’ll need to pay gas fees, which can be costly.
- This gets very confusing very quickly, so I’m not going to claim to fully understand it (experts write lengthy economics papers exploring this). But the basic idea is that you’ll make more profit if you define a tighter range. But, if the price of the assets moves outside that range, you make nothing.
- (Again, other DEX platforms don’t require this step, but I’m pointing it out here because Uniswap is so popular.)
- Once you’ve set it all up, the Uniswap smart contract will take your USDC and ETH and give you a new ERC-20 token in exchange. This token is referred to as an “LP token” (liquidity provider token).
- This LP token represents the pair you’ve provided liquidity on, and you can even trade that token with other people. More on this in the next post.
- Whenever you want to get your USDC and ETH back, you go back to the Uniswap Pools page and choose to remove your liquidity.
- Your wallet will then swap your LP token for your original assets—plus any profits you made from your share of the fees paid to that pool.
You can read more about all that on Uniswap’s page here.
By the way, DeFi is technically non-custodial, meaning you don’t actually send a company your crypto. It stays in your wallet.
But, you are entrusting your crypto to the platform’s smart contract to manage it. And that smart contract was programmed by a human. So keep this in mind: If the platform wasn’t properly audited by a third party (which Uniswap has been), that smart contract could do anything with your crypto.
Now, USDC/ETH is of course a common pair. But, there are lots of pools for less-common pairs too.
Because those less-common pools have fewer coins or tokens in them, there’s less liquidity. So, if a user tries to exchange for that less-common crypto on Uniswap, the fees will be more expensive.
If you provide liquidity on one of those pairs, you’ll get less volume (i.e., users paying the fee) since the pair is less common; but, you’ll be able to collect higher fees due to that rarity.
If the pool runs low enough (or there’s no pool of that type), users won’t be able to exchange for that crypto on Uniswap until liquidity increases (i.e., if other users provide liquidity by lending Uniswap some of that less-common coin or token that they own).
You might be thinking: This probably seems like a whole lot of work to learn and manage.
It is. Anyone who makes it sound easy is either highly experienced or in way over their head without realizing it.
Again though, this stuff is so enticing because some people manage to make hundreds or thousands of APY on liquidity staking—at least for a little while.
There’s one more huge risk here: You also need to be careful of “impermanent loss.”
One of the biggest risks in providing liquidity (that a lot of people don’t realize until it’s too late) is impermanent loss. I’ve read multiple articles about this, and it’s still confusing to me. But it’s important to understand since it can decimate your potential profits.
To put it simply, impermanent loss refers to the common situation where you would have made more money simply by holding a token in your wallet rather than contributing it to a liquidity pool. It’s called “impermanent” loss because it can sometimes recover; but, don’t count on it. (So, “impermanent loss” is a crappy name.)
Here’s the basic idea with a bit more detail:
- Say you provide liquidity on the pair ABC/DEF.
- Impermanent loss occurs if the ratio of the values of ABC to DEF changes while you’ve locked them into providing liquidity. So, if either ABC or DEF goes either up or down in value while the other one stays stable (or moves in the opposite direction), you’ll experience impermanent loss.
- Whenever you decide to stop providing liquidity and pull out your ABC and DEF, you’ll have less of one of them than what you put in.
So, again, this is all very confusing, but what’s important is that you would have been better off just holding your crypto in a wallet rather than providing liquidity.
What can you do about it?
There are various calculators out there that are supposed to help you figure out if the fees you’d get from providing liquidity would offset the impermanent loss, but I personally haven’t found them very helpful (APY.vision is the most promising one I’m currently investigating).
In any case, because impermanent loss happens when one of the coins or tokens in the pair is more volatile than the other, the best way to reduce it is to provide liquidity on a stablecoin pair—for example, USDC and USDT, or USDC and DAI. If the stablecoins are operating as they’re supposed to, they’ll of course remain consistent in value.
Naturally, that would be a better investment in a bear market (when the value of cryptocurrencies isn’t rising quickly). In a bull market (the opposite), you’d probably make a lot more profit by putting your money into something like ETH rather than providing liquidity on a stablecoin pair.
Another way to avoid impermanent loss is to use an innovative DeFi platform like Bancor that allows single-sided exposure to certain liquidity pools, meaning you only have to provide one of the coins in the pair.
Say you provide liquidity on the USDC/BNT pool (BNT is the Bancor token). When you provide a certain amount of USDC, Bancor automatically mints the same amount in BNT. Then, when you eventually pull out your USDC, Bancor sells some of the BNT to cover the impermanent loss and destroys the rest.
By the way, at this point—as with many things in DeFi—you should be asking yourself: “That sounds too good to be true; what’s the catch?” There are several with Bancor, one of which is that you have to hold the investment for 100 days to get the full impermanent loss protection. (Plus, Ethereum gas fees are very high right now, so all your transactions on Bancor will add up.)
So, again: Do your homework before trying out liquidity staking, or anything in DeFi.
But wait, the rabbit hole here goes even deeper. Next time, we’ll finish up DeFi by exploring the next level of liquidity staking: yield farming. I’ll also go into detail about the major categories of risk inherent in DeFi.