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 take holidays. The assessment, because nobody looks at your payslip — what gets looked at instead is how much you put up as collateral. And the timing, because between the request and the execution there is no person who has to find time to read it.

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

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

That time hasn’t disappeared, though. It has been swapped out. 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 and asks instead for collateral worth more than the loan — usually half again as much — because the only thing it can do, if the price moves, is sell what you left with it.

So the honest comparison isn’t fast against slow. It’s “somebody takes the risk for you” against “the risk stays entirely yours, and nobody asks you anything”. They are two different products, not two versions of the same one.

What does open to everyone mean?

That same open door, though, works both ways. Nobody checks who you are, so nobody answers for you. There is no complaints department, there is no deposit insurance, there is no fourteen-day right to change your mind. Get an address wrong and the money has arrived at its destination — only the destination was the wrong one.

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

It is worth holding on to before you start, because this is where the two voices in this trade part company. Whoever describes DeFi as freedom is telling the truth, and whoever describes it as a place with no safety net is telling the truth as well.

What does it mean that the control is yours?

The reverse is exact and symmetrical. Nobody can put it right. You hold the keys, so if you lose them the coins stay there for ever, visible to everyone and out of reach. Sign the wrong transaction and the signature is valid. Authorize a contract that later turns out to be badly written and the authorization was yours.

On fees the promise holds up better. There are no hidden costs, and before you confirm you see what you are paying. But one line has to be added that doesn’t exist at a bank — gas, which is what the network takes to execute. It doesn’t depend on what your operation is worth but on how much traffic there is at that moment, and 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: swap one coin for another without handing them to anyone. On a dex you connect the wallet, pick the two coins and confirm. There is no account to open and no identity to verify, and nobody holds your coins while it happens. You pay the network fee and the price slippage your own order produces.

The third: make your coins available to whoever is swapping and take a share of the fees. That is the liquidity provider’s trade, and it is the one that looks simplest and isn’t. The fees are real, but they have to be set against impermanent loss — what you lose because the pool rebalances itself. Our guide on liquidity does that arithmetic in full.

The instant loan — what happens overnight?

Then eth falls thirty percent overnight, which happens more often than the word “overnight” suggests. Your collateral is now worth $7,000, the loan is still $6,000, and the ratio between the two has gone to 86%. You have crossed the threshold, and at that point nobody is needed. Programs competing against each other close the position in a fraction of a second, sell the collateral and keep a penalty usually worth 10%.

The defense exists and has an unromantic name: keep the loan well under the limit, and watch the position. Which means, translated, that the loan “with no paperwork” asks you to do the work the bank used to do for you — watching the risk — and asks it of you 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 are worth. That token was at a cent, so the million comes to ten thousand dollars — so far the promise holds. But to collect it you have to sell, and you notice everyone is selling alongside you, because that is all the token is for. The price falls to a tenth, and your ten thousand becomes one thousand. Meanwhile the pool has rebalanced and impermanent loss has taken another two thousand dollars. You finish 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 somebody using the protocol, the yield is low and real. If it comes from an issuance, the number is high and you are the source.

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 is six or seven different services, a dozen transactions, as many network fees, and an afternoon. The intermediaries haven’t gone. They have become protocols, they are paid in gas instead of fees, and not one of them answers if the piece next door breaks.

This is composability, the most powerful thing about onchain finance and its most fragile point at the same time. The pieces fit together like bricks, and every joint adds a way of breaking. Our guide on liquidity shows where they break for real, with the May 2022 chain as the example.

Who is it worth it for, then?

It doesn’t suit anyone looking for somewhere to put savings and forget them. That is a product DeFi doesn’t offer, however much the big numbers on the interfaces seem to say otherwise. And it doesn’t suit anyone unwilling to understand the mechanism, because here the mechanism isn’t a technical detail to delegate. It is the product.

The sensible way to start is obvious and it works: small amounts, big old protocols, one thing at a time, and the sums done first. The two guides sitting alongside this one are there for exactly that — one explains where the money is lost in pools and loans, the other how you tell whether a token is worth anything.