We may look back on 2020 as defined by its many bizarre contradictions. Millions of small businesses closed permanently while many of the world’s biggest companies got bigger. Stocks rallied despite the global economy experiencing an upheaval from the COVID-19 pandemic. People spent more time at home, yet working more time than ever.
However, one of the strangest contradictions of this year came from Wall Street. A new generation of investors hijacking markets and turning them into their play toy challenged the unabashedly traditional institution. In fact, millions of individual investors (with stimulus checks in hand) beat index funds and active strategies from major banks by simply investing in what they thought would be trendy or cool.
One of the cool and relevant investments from these players included cryptocurrencies. You may have heard of Bitcoin or Ethereum before. Maybe your weird uncle even tried to get you to invest in crypto in 2017 when it broke out and went on an unprecedented bull run. Well, it’s back. However, unlike in 2017, traditional bankers on Wall Street have changed their tune and become receptive to its potential. Suddenly, cryptocurrency is not seen as unorthodox or strange. It’s not a pyramid scheme anymore. It’s a meaningful store of value.
In truth, few fads last a decade. Yet cryptocurrency has captivated the world once again. It has become a staple of business journals, casual conversation and bizarre one-on-ones with libertarians on Twitter. However, there’s more to the crypto craze than the “big coins.” Below the conventional pinnings of the crypto space lie a fast-growing field of finance applications using the backbone of cryptocurrencies. They might be the next big thing.
What is DeFi?
Under all the money talk, cryptocurrencies like Bitcoin and Ethereum are essentially networks. All cryptocurrencies have their own blockchain, a decentralized ledger that can store information. These ledgers are powered by thousands of computers connected to each other. Each coin is like its own operating system. They have their own rules and features that make them distinct, much in the same way Macs are different from Windows computers.
Early implementations of blockchain technology were used exclusively for making transactions between parties. Now, blockchain technology can be used to store information, build apps and even create and execute contracts. These advancements are especially obvious on the Ethereum blockchain, which has become the source of a microcosm in crypto called decentralized finance, or DeFi for short.
DeFi’s earliest developments root from decentralized exchanges.These online apps allow you to trade crypto assets for other assets without having to sign up or verify your identity. However, DeFi has expanded its horizons to include payment networks, lending platforms, prediction markets, insurance, stablecoins and crypto derivatives. DeFi’s goal is to create decentralized alternatives to all elements of our current financial system. That means making hundreds, maybe even thousands, of apps and protocols. But how does it even work?
How does DeFi work?
Almost all DeFi protocols are powered by decentralized contracts called smart contracts. Smart contracts are publicly auditable codebases which govern the rules and behaviors of an application or protocol. The code is essentially the backbone of a DeFi app. Smart contracts work to cut down on the amount of middlemen, increase transparency and build efficient decentralized apps.
Most DeFi projects start with a core development team exclusively managing or building an app or protocol. Over time, as a protocol or app matures, a core team might decide to turn control of the protocol over to the community. This handoff is where DeFi gets its unique twist: it allows users or contributors to a protocol or app to get a say in the creation or growth of a protocol.
The most common way of democratizing control and access to a protocol is through the creation of a token. There are many types of tokens. For example, tokens can be used to track the price of other assets, represent shares of a company or determine ownership of a piece of art or collectable. Because of their versatility, their use cases are seemingly infinite. However, a commonality among DeFi protocols are “governance tokens,” which can be divvied out to users or contributors in a specific protocol.
Governance tokens entitle their owners to a say in the operation or development of a protocol. At their core, governance tokens offer a way to grow with a platform and shape its future. Big enough DeFi protocols might actually see their governance tokens have real value on exchanges. For example, the governance token Maker is worth over $1,000 as of this writing.
How can I invest in DeFi?
There are hundreds of protocols and apps cropping up in the DeFi space. There was only $800 million in DeFi in January 2020. As of this writing, over $24 billion is wrapped up in the broader DeFi ecosystem. This value is being exchanged, hedged against other assets and used to create collateral-backed loans and payments. This $24 billion represents considerable growth and interest in the problems and opportunities the broader DeFi community is attacking.
There are two core ways to invest in DeFi. The first is by buying DeFi governance tokens on crypto exchanges like Coinbase. There’s no rhyme or reason to choosing which protocol or app to back. However, you might get some ideas from investing in the second way — by actually diving into the world of DeFi and using its apps and protocols yourself. In DeFi, there are alternatives to insurance, shopping websites, exchanges, payment systems and lending.
Keep an eye out for our breakdown of some of the most exciting DeFi projects, the opportunities they’re creating and how to invest in them.