Earn interest on your crypto by depositing your assets into a DeFi protocol
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Stablecoins are tokens on the Ethereum network that reflect the price of the US dollar or other fiat currencies. The most popular are USDT and USDC. They are centralized stablecoins issued by companies who hold reserves of dollars in bank accounts. You also have decentralized stablecoins like DAI or sUSD which are collateralized by crypto assets. Stablecoins are practical if you want to invest your assets and earn interest without being exposed to volatility.
To use any of the protocols listed above, you first need an Ethereum wallet. The most popular and widely supported wallet is Metamask. Once you have set up your wallet, you need to buy Ether on a crypto exchange and withdraw it to your wallet. You need to have Ether (ETH) in your wallet to pay for transaction fees of the Ethereum network. You can then go to any of the protocols listed above and deposit your Ether to earn interest. If you prefer to earn interest on a stable asset like DAI or USDC you can buy those on most crypto exchanges or on a decentralized exchange like Uniswap.
Most DeFi lending protocols give you a deposit token that proves your deposit. For example, when you deposit $DAI into the Aave protocol you receive $aDAI. When you deposit $DAI into Compound you receive cDAI. These tokens represent your share in the asset pool of the protocol and they automatically get incremented every few seconds depending on the current interest rate. In other words, you can sit back and relax while your balance keeps accruing. The moment you want to withdraw your funds from the protocol, your aDAI or cDAI will be converted into the equivalent amount of DAI and sent to your wallet.
Like in traditional finance, lending rates in DeFi are ultimately determined by supply & demand. There are multiple reasons why the demand for borrowing is high in DeFi resulting in high interest rates. First, DeFi is global by definition so it brings borrowers from all over the world to the table. What might seem like a high interest rate for a loan to you might seem like a good deal to someone in an emerging market country where the cost of capital is much higher. Secondly, there are plenty of profit opportunities in the crypto space (partly because markets are still not 100% efficient). Traders pursuing these opportunities need liquidity and are willing to pay high interest rates for it.
Decentralized finance is an area in the crypto industry that tries to bring bank-like services such as trading, lending & borrowing of assets on the Blockchain. These applications are called protocols, because they are not controlled by a single company like most services in the traditional world. Instead they are governed by a community of token holders who collectively decide on the future of these protocols. They don’t need to be operated by a company because these applications are built in a way that doesn’t require you to trust them. Every operation is automated by code and users have guarantees that these applications are going to work exactly like intended.
Moreover, because the code underpinning these applications lives on the Ethereum Blockchain, anyone in the world with an Ethereum wallet can use them. There are no country restrictions or other barriers.
There are different models of DeFi lending protocols in the list we provided above. We'll give a short overview of how the most common model used by Aave and Compound works. Aave and Compound pool all lenders' assets in a smart contract. Borrowers can then borrow from these pools in a few clicks and without having to identify themselves.
The ratio of supplied to borrowed assets in the pool determines the interest rate. For example, when demand to borrow DAI is high but there is not a lot of DAI in the pool, the interest rate will automatically surge. This will incentivize more lenders to deposit their DAI and profit from the high interest rate.
However, borrowers need to deposit a security in order to get a loan. They can, for instance, deposit Ether as collateral and borrow DAI. The value of the assets they deposit must always exceed the value of the loan they receive to ensure that the protocol will not suffer any losses. This is called over-collateralization.
Since many of the assets borrowers deposit are volatile (like ETH) the protocols have mechanisms in place to liquidate borrowers collateral if it drops below a certain threshold.
It's worth mentioning that other protocols like yearn.finance work differently. Yearn is not a lending protocol connecting lenders and borrowers. It's more akin to a hedge fund that takes user assets and implements automated strategies to generate yield on the deposited assets. For example, they use your assets to provide liquidity on a decentralized exchange like Uniswap and use the earned $UNI rewards to buy back more stablecoins.
Assessing the risk involved in these DeFi lending protocols is not an easy task. Protocols like Yearn.finance often change their investment strategies so the risk involved changes frequently and requires investigating the strategy quite closely.
In general, the biggest risk comes from bugs in smart contract code. Since the smart contracts are open and public anyone with skills can scrutinize them and exploit security loopholes to drain the protocols funds. The good news is that with all the public scrutiny these protocols receive, you can assume that a protocol is safe the longer it exists.
Another rule of thumb is that the more assets a protocol has under management, the more secure it is. The Total Value Locked (TVL) shows how many people trust the protocol with their money and high TVL incentivizes hackers to look at the protocol.
Serious protocols also undergo code audits by professional firms before they deploy new code and publish bug bounties to encourage white hat hackers to battletest the code. DeFiscore.io does a good job at tracking audits and other relevant metrics of each DeFi protocol.
Finally, some protocols like Aave have built-in insurance mechanisms, whereby $AAVE stakeholders can earn rewards for providing insurance collateral to the protocol. In good times they earn rewards and nothing happens, in bad times their collateral is used to cover an exploit. This insurance gives additional guarantees to lenders that their deposits are safe. We expect more protocols will follow suit in the next couple of days.