Decentralized finance ("DeFi") is transitioning from something only cryptopunks were excited about to something people outside of the crypto elite are beginning to notice and discuss. NFTs, which have captured the public's attention, are one factor responsible for accelerating that transition (see my post on the basics of NFTs for more info). People are also attracted to the possibility of earning returns on DeFi platforms. This article discusses why token holders can earn a return on their crypto on DeFi platforms if you're curious. That is one thing that attracted me to DeFi. I had been a casual crypto investor for several years and I started to hear the rustlings about liquidity mining and yield farming, which are various methods of earning returns on DeFi. Since I had a bunch of crypto anyway, I figured I may as well check out DeFi, and I dove in headfirst. Thus, I learned the following three things about DeFi the hard way. I hope I can ease your transition to using DeFi by informing you of these facts before you start using it.
The vast majority of DeFi transactions take place on the Ethereum network.
What is DeFi?
For anyone who is knew to DeFi, let's first defined DeFi. Decentralized finance is a restructuring of our financial system without centralized financial intermediaries, where financial services are provided through smart contracts on blockchain trustlessly, permissionlessly, and transparently. DeFi is transparent because the blockchain is public and anyone can access it (at least in the case of Ethereum, the primary DeFi network). DeFi is trustless and permissionless because all you need to interact with a given smart contract (say, to get a loan) is an ETH wallet that can interact with DeFi protocols - you don't need to create an account with the platform and they don't need a bazillion pieces of personal information the way that CeFi institutions do. Transactions that can take days or weeks at a CeFi institution (or cannot be completed at all due to regulations or the institution's assessment of the risk of the transaction) can happen in seconds on DeFi. Sounds like a dream, right? DeFi is an incredible innovation, and I believe it will change the world (although it is still in its nascency and a number of kinks need to be ironed out before it is ready for prime time), but there are still some things I wished I understood about DeFi before I started using it.
High Ethereum fees are a big drag on DeFi transactions.
The vast majority of DeFi transactions at this time take place on the Ethereum network. Several other ventures are working on smart contract protocols (or on bridges between smart contract protocols), but there really aren't any other smart contract providers that are anywhere near Ethereum in terms of use and number and variety of projects. Ethereum is king. Unfortunately, that has some negative consequences because the Ethereum network is extremely congested. You have to pay Ethereum miners to process your transaction, and the more congested the network is, the more it costs to get your transaction processed (you are essentially competing with other transactions to get included in the next block).
You may hear about the next big thing in DeFi and spot a great opportunity to earn a big return but are you accounting for the fees to withdraw your crypto from wherever it is and deposit it into the new protocol? What about any fees to swap your crypto from one coin to another (since new protocols often only take specific coins)?
Tip: Further, keep in mind that if you exchange one token for another (say, you change ETH for stablecoins), your exposure changes. You no longer have ETH exposure and now just have coins pegged to the USD. You can keep your ETH exposure by borrowing stablecoins against your ETH rather than exchanging them but then you have to pay interest and you have to pay more fees for the loan.) The return on the new protocol might still be worth it (especially if you are crypto whale) but you can easily end up paying hundreds of dollars in fees (plus interest if you borrow coins) to move from one project to another.
You may have to pay additional fees once you're on the new platform to claim tokens you have earned, to stake tokens you have earned, to vote (if you wish), etc. Also, a very irritating thing about Ethereum is that you often have to pay two fees to put tokens on a DeFi protocol. The first is to approve that smart contracts' spending of your tokens, and the second is to actually deposit your tokens. The approval fee used to be like a few dollars but now it is often more like $20 (see below regarding setting the fee lower).
Several upgrades are planned to the Ethereum network to mitigate this problem. But at the moment it is a significant drag on moving from one protocol to another for a substantial number of people. Note that there are certain platforms, such as Yearn Finance or Harvest Finance, that address this problem by gathering crypto for a large number of people and investing it according to various strategies (which makes it more efficient because you're sharing some of the fees with other people). But you still have to pay to get your crypto onto their platforms. Also, note that you can set your fees lower if you wish by adjusting the gwei. If you're using MetaMask, click on the "advanced" tab when you get the prompt to approve the fees, and you will see a box where you can change the gwei. (Gwei is a unit of Ether (i.e., ETH), kind of like a penny to a dollar, and it is one component of calculating the fee you pay.) However, the lower you put gwei, the slower your transaction will process. If it is too low, it may never process, so it is a delicate balance. The other component of your fee is the gas limit. Don't change that number as that can make your transaction fail.
Tip: If a transaction gets stuck, you can try the "speed up" button in METAMASK (which increases your fee) or you can go to Advanced --> Reset in Metamask to reset and try the transaction again. Note that if you have an unprocessed transaction in your wallet, the next one won't process until that first one has been processed, so you need to reset if one is stuck.
The ways to mitigate all these fees (unless you are a whale who does not care) is to try to stay select a few protocols and stay in them for long periods of time or to put your crypto into yield aggregators like Yearn but realize that, generally, with something like Yearn, you will not earn a return of more than like 30-50% at most. Yearn does not yield farm nascent DeFi projects that have the highest potential return and the most risk. It sticks mostly with safer DeFi investing which means a lower return. Not a bad return at all, especially on stablecoins. But a lot of people want the huge returns. ?\_(?)_/? This is understandable because a 50% return is not that life-changing if you are starting with like $5,000.)
Unless you are a crypto whale, don't spread yourself too thin.
If you get involved in DeFi, and you start following some crypto social media profiles, you will begin to hear about many new DeFi projects. You will also learn that, generally, getting in on the ground floor of a new project is one of the best ways to get huge returns because new projects frequently distribute their tokens to early users or liquidity providers on their platforms as a way to incentivize people to use their platforms, and sometimes those tokens blow up in value. (Tip: At the same time, new projects are super risky and, if you don't know how to diligence them, you might lose all your crypto to a rug pull - i.e., when scammers pretend to start a new DeFi project but actually run away with all the crypto deposited - or a hack of a poorly coded protocol. An audit can help mitigate these risks, but many early projects don't have their audit yet, and it does not mean it is automatically a scam project.)
You might want to get in on the ground floor of every new project you hear about. You will be tempted to take some crypto out of one protocol and move it to a new one, over and over, until you are in many protocols but with not a large amount of crypto in any of them unless you are a whale with tons of crypto. This not a smart approach for two reasons. (I know this from personal experience, unfortunately - what can I say??? I am a degen chasing the next big thing but that doesn't mean it is a rational approach.) The first is fees as described above. Putting a small amount of crypto into many protocols is expensive af and will cut your return substantially. Second, if you only have a small amount in a protocol, say, $2,500 or $5,000 of crypto, even if the return happens to be huge, say, 500%, after a year you will only have $12,500 or $25,000. That is an excellent return but it isn't life-changing money. Also, not every protocol will have a return anywhere near 500% and, even for the ones that do, you will likely need to pay fees to harvest your gains and fees to exchange them into ETH or stablecoins and further fees to change that fiat. That's in addition to the fees described above in point #1. This is why it is generally better to pick a few protocols and stick with them for a long period of time or to go with a yield aggregator, again, if you are not a whale.
DeFi platform Curve Finance on Ethereum is a beautiful thing.
DeFi has some not-so-obvious risks (but you generally get a high return).
It can seem too good to be true - you put your crypto or even stablecoins (i.e., coins pegged to the USD or another currency) on a DeFi platform and it generates a return, depending on the token, ranging from 20% to sometimes hundreds or thousands of percents. But DeFi is fairly risky and those risks are not always obvious. One risk is that a protocol gets hacked. This has happened several times, even to pretty high profile protocols such as Yearn. In the case of the hack on Yearn, Yearn refunded all impacted parties all of their money. Many protocols also purchase insurance or have a pool of tokens for insurance purposes to compensate people in case of a hack. You can also purchase your own insurance through projects like Nexus Mutual and Cover. Audited protocols should be at a reduced risk of being hacked.
I also mentioned above that a DeFi protocol can be rug pulled when its founders create a project (and usually a lot of hype and shilling and a very high promised return) and then once a bunch of people deposit on their platforms, they take the money and run. Now the good thing is that this is only possible if the smart contract underlying the protocol allows the founders to do this, and the smart contracts are public. Anyone can look at them, and often people who are familiar with smart contracts will look at them and post on social media if they see that a rug pull could happen. Just to be clear, there are some DeFi protocols that have been around for a long time, have been audited, have well-respected and public devs, etc. and the chance of a rug pull is effectively 0 (e.g., Yearn Finance; Synthetix; MakerDAO and many more). The risk of a rug pull applies to new unestablished projects. Again, audits can help mitigate this risk but not every new project has one yet.
DeFi will change the world once the kinks in execution are worked out.
All the new people attracted to DeFi are right in their sense that DeFi is a huge opportunity right now. It is still super early. Only 3.5% of ETH wallets have even interacted with DeFi and that says nothing of use of other smart contract platforms. (On the other hand, shudder to think of fees on ETH if it gets more congested - thank God for the Ethereum improvements coming down the pike). But DeFi newbies should be cautious about where they put their hard-earned crypto and be hesistant to constantly move their crypto around to the next big thing because of fees. If you are thinking of joining a project, join their Discord and Telegram. Make friends in the crypto community (I recommend Discord, Telegram & Twitter) and consult with them about their opinions on various projects. Ask if a project has been audited. Make sure to have your shill sense on high alert. Find out who is behind the project if you can and investigate them (note that some devs are anonymous and it doesn't necessarily mean the project can't be trusted). You can reach out to me on Twitter @defihotaf if you have questions. Happy DeFi-ing!
About the Author: Harvard grad and former corporate lawyer is passionate about Ethereum and DeFi and has been investing in and using cryptocurrency for many years. She was inspired to write this blog covering the basics of DeFi, liquidity mining, farming, and tips and tricks and mistakes to avoid for DeFi newbies, as well as other Ethereum-related topcis, to increase the number of people using ETH and DeFi by making it more accessible.
