What DeFi is, and what it asks in return

What changes compared with a bank?

You feel the difference in three places. Opening hours, because a program doesn’t close at half past four and doesn’t go on holiday. The assessment, because nobody looks at your payslip, only at how much you put up as collateral. And timing, because between the request and the execution there’s no person who has to find time to read it.

That program is called a smart contract, and it’s worth understanding what one is, because everything else depends on it. It’s a piece of public code, the same for everyone, that nobody can change to do you a favor, or to cheat you either. When it works, it’s why DeFi is so fast. When it’s badly written, it’s why the money sometimes ends up somewhere else.

How long does it actually take, and what gets skipped?

That time hasn’t disappeared, though. Something else has taken its place. The bank spends it working out whether you can pay the money back, and if it gets that wrong, the risk is the bank’s. The contract works nothing out. It asks instead for collateral bigger than the loan, usually one and a half times, because if the price moves the only thing it can do is sell what you left with it.

So the honest comparison is between two different products. On one side somebody takes the risk for you. On the other the risk stays entirely yours, and nobody asks you any questions.

What does open to everyone mean?

That same open door, though, swings both ways. Nobody checks who you are, so nobody answers for you: there’s no complaints department, no fund insuring deposits and no fourteen-day right to change your mind. Get an address wrong and the money still arrives, only to the wrong person.

Put bluntly: “be your own bank” means that when you lose everything you don’t even have a customer service line to call.

Keep that in mind before you start, because it’s where opinions split. Whoever describes DeFi as freedom is telling the truth, and whoever describes it as a place with no safety net is telling the truth too.

What does it mean that the control is yours?

The flip side is that nobody can put things right. You hold the keys, and if you lose them the coins stay there forever, visible to everyone and out of reach. If you sign the wrong transaction, the signature still counts. If you authorize a contract that later turns out to be badly written, the authorization was yours.

On fees the promise holds up better, because there are no hidden costs and you see what you’re paying before you confirm. There is one line, though, that doesn’t exist at a bank: gas, which is what the network takes to execute the operation. It depends on how much traffic there is at that moment rather than on what your operation is worth. On small amounts it can eat the whole advantage.

What can you actually do?

Borrowing money asks for collateral worth more than the loan, and for watching the liquidation threshold. Swapping on a dex asks for the network fee and the slippage your own order produces. Providing liquidity asks you to set the fees you collect against impermanent loss.

The second is swapping one coin for another without handing them to anyone. On a dex you connect your wallet, pick the two coins and confirm. There’s no account to open and no identity to verify, and nobody holds your coins while it happens. You pay the network fee and the slippage your own order causes.

The third is making your coins available to the people swapping and taking a share of the fees. That’s the liquidity provider’s trade, which looks like the simplest and isn’t. The fees are real, but they have to be set against impermanent loss, which is what you lose because the pool rebalances itself. Our guide on liquidity does that sum in full.

What happens overnight to an instant loan?

Then eth falls thirty percent in a night, which happens more often than you’d think. Your collateral is now worth $7,000, the loan is still $6,000, and the ratio between the two has gone to 86%. You’ve crossed the threshold, and from there no human is needed. Programs competing with each other close the position in a fraction of a second, sell the collateral and keep a penalty, usually 10%.

The defense exists and has an unromantic name: keep the loan well under the limit and watch the position. In other words, the loan “with no paperwork” asks you to do the job the bank used to do for you, watching the risk. And it asks you to do it at three in the morning.

Put bluntly: you can watch the position, and that means waking up at night to check collateral ratios the way you would change diapers.

And the three-figure yields?

After a week in a pool that declared a thousand percent a year, the result in the example is a loss of a thousand dollars.

Then you look at what they’re worth. That token was at a cent, so the million comes to ten thousand dollars, and so far the promise holds. But to collect you have to sell, and you notice everyone is selling right alongside you, because that’s all the token is for. The price falls to a tenth and your ten thousand becomes one thousand. In the meantime the pool has rebalanced, and impermanent loss has taken another two thousand dollars. You end the week a thousand down, on a declared annual yield of a thousand percent.

The practical rule is the one from the guide on a token’s value: ask where the money paying you comes from. If it comes from the fees of people using the protocol, the yield is low and real. If it comes from new coins printed for the purpose, the number is high and the source is you.

Ten thousand dollars in a pool at a thousand percent a year produce a million tokens in a week; at a cent each they are worth ten thousand dollars, but selling them drops the price to a tenth and one thousand dollars is left, while impermanent loss takes another two thousand. The net result is minus one thousand.

How many steps does a simple round take?

That’s six or seven different services, a dozen transactions, as many network fees and a whole afternoon. The intermediaries are still there, only they’ve become protocols. They get paid in gas instead of fees, and none of them answers for it if the piece next door breaks.

This is composability, the most powerful thing about onchain finance and also the most fragile. The pieces fit together like Lego bricks, and every joint adds a new way to break. Our guide on liquidity shows where they really break, with the May 2022 chain as the example.

Who is it worth it for, then?

It doesn’t suit anyone looking for a place to park their savings and forget about them, because DeFi doesn’t offer that product, whatever the big numbers on the interfaces say. And it doesn’t suit anyone who can’t be bothered to understand how it works, because here the mechanism is the product itself, and you can’t hand it off to anyone.

The sensible way to start is simple: small amounts, big protocols with a few years behind them, one thing at a time and the sums done first. The two guides next to this one are there for exactly that: one explains where the money gets lost in pools and loans, the other how you tell whether a token is worth anything.