What Are DeFi Tokens?
What is DeFi? An Overview
The DeFi, or “decentralized finance” ecosystem consists of many decentralized, non-custodial financial products including decentralized exchanges and lending protocols. Decentralized essentially means that there isn’t a single point of failure or source of power in the system because identical data is stored across thousands of computers on a peer-to-peer network. This takes out any middleman or choke-point that would otherwise control the data or protocols, and who has access to them. DeFi aims to be censorship-resistant, and give everyone an equal opportunity to access many financial services such as savings, loans, trading, insurance, and more.
With the change in power handed to the community and potentially large payoffs, it is no surprise people continue to flock to this movement in crypto. In this article, we take an in-depth look at what Decentralized Finance is and why DeFi tokens are so important to this ecosystem.
How is DeFi decentralized?
So what is DeFi? And couldn’t you consider all of crypto decentralized finance? To a degree, yes. All crypto is decentralized, but “DeFi” has a specific set of standards that not all crypto products meet. DeFi refers to a specific type of financial product that prioritizes decentralization above all else. Traditionally in the realm of finance, the money is controlled by a small group of central banks who then work with another small group of corporate banks to keep the world running. DeFi is founded on the opposite principle by being a financial system that’s global, permissionless, and accessible for all people. The tokens created by DeFi protocols operate in the same fashion by giving you visibility into all parts of the protocol, and give token holders the opportunity to shape the trajectory of the network. Traditional cryptos don’t offer that capability, and the power and direction of the project remains with those in charge, not with the community.
How does DeFi work?
Among the most popular projects in DeFi are lending protocols, including names you’ve likely heard such as Aave and Maker. “Lending protocol” is a general term for a type of decentralized debt marketplace and get their name simply because they exist at a level where anyone can interact with the software that lives on its blockchain. These protocols let you borrow cryptocurrencies instantly, and often in large amounts if you can prove you can pay back the loan in one transaction. Lending out cryptocurrencies also gives you an opportunity to earn interest at a fairly quick rate.
There are two key criteria for determining whether a project or protocol is considered “DeFi.” What earns certain protocols the DeFi tag is that they are both (at least in principle) decentralized and non-custodial.
Non-custodial means that the companies or teams don’t manage your crypto on your behalf, and that you retain possession of your keys and wallets directly, the exact opposite of depositing your money in a bank. With DeFi protocols you will always have control over your cryptocurrency and digital assets.
Decentralized means that the creators of these protocols have given power over their smart contracts to the community to decide the trajectory of the network instead of choosing to hold all of the power themselves. The creators of these protocols are no longer the ring leaders, and give control to users as soon as it is possible to do so. This gives the users an opportunity to have a say and vote on the future of the network.
What are DeFi tokens?
Similar to other blockchain projects, many DeFi platforms (such as exchanges and lending platforms) have their own token. These tokens are particularly valuable because they not only hold financial value, but also contribute to how these platforms function on a larger scale. These governance tokens which were created alongside DeFi platforms aim to decentralize certain aspects of governance within the project, and encourage community participation in the future of the network. Users holding these tokens can stake them on voting platforms to decide key administrative rules such as new features and other policies. Additionally, users can be incentivized to use a platform’s native token by being offered a lower interest rate, or receive free tokens for specific actions involving the project.
In short, DeFi tokens are valuable assets because they offer both financial value as well as give the holder a vote on how these projects and protocols will move forward.
Is true DeFi Possible?
As you can imagine, the DeFi space can often fall short of its ideals. When the team hands over power to the community, the smart contracts set can be vulnerable to manipulation by bad actors. As a result, many of the issuers retain control over the systems instead of truly “decentralizing” them. It’s a catch 22, as there isn’t yet a way to hand community control safely without compromising the integrity of what they’ve built. Even with these limitations, money is pouring into DeFi trading and tokens. In June 2020, $1 billion was locked up in DeFi protocols, according to metrics site DeFi Pulse. By the end of August 2020, investors had $9 billion worth of cryptocurrencies in different DeFi smart contracts. The investment boom in DeFi protocols is largely due to these lending protocols offering extreme interest rates that are bumped even higher by the marvel of yield farming.
What is Yield Farming?
Yield farming is a blanket term used to describe the process of putting in efforts to make your crypto assets generate the highest possible returns. Yield farming, also known as liquidity mining, earns money by allowing you to stake or lock up cryptocurrencies in return for rewards. Although most Defi projects have different mechanics to determine pricing and payout, most offer users a small share of transaction fees for contributing liquidity to a particular application, such as Uniswap or Balancer. In return for your service, you earn fees in the form of crypto.
These lending protocols will even offer additional tokens to lenders in the form of a “governance token.” The governance tokens can be used to vote on a proposal to change the network, and are tradable on secondary markets. This is one of the key ways that DeFi “decentralizes,” by allowing open participation in governance to anyone holding the governance token.
The Future of DeFi
With the robust number of investments in DeFi during 2020 alone, and millions of people supporting it, it is safe to assume that this is just the beginning of a massive DeFi wave that the whole world is eagerly watching.
Decentralized Finance is the purest implementation of the ideals of crypto that we’ve seen so far, but still has some kinks to work out before it is fully functional. Crypto enthusiasts are well familiar with this waiting game though and believe that it will pay off in time. While there may not be a crystal clear path forward to free DeFi from its current limitations, it is groundbreaking tech that has the potential to change crypto forever. Shift Markets continues to support the DeFi movement and aims to build the bridge between traditional finance and decentralized finance. Our mission is to create equity in trading by connecting these global markets, and we believe continued decentralization is a key piece of that puzzle.