Most beginner’s guides to DeFi go deep on decentralized finance as a permissionless financial system, waxing poetic about lending, borrowing and banking without middlemen.
This narrative is important, and certainly explains why DeFi has captured the hearts, minds and wallets of the crypto community over the past year. But in a sense, this is the same crypto and blockchain story we’ve heard one way or another for over a decade.
This is not another one of those guides.
Exploring DeFi as a concept or as jargon doesn’t get us any closer to the real question at hand: what can DeFi do for me, and my money, right now? The answer is simple and we’ll cover how and why saving with DeFi is different from other financial plays in crypto and how it can work your money harder and smarter than pretty much any savings option available today.
If You’ve Saved with a Bank, You Know How DeFi Savings Works
The reason most people have opted to use banks for the past hundred years or so, rather than keep their money at home in a safe/mattress/sock drawer, is that banks pay you to hold your money. Banks lend this money out, charge interest on the loans and pay you back a portion of that interest. And for decades, this made sense.
Historically those interest rates have yielded meaningful gains for savers. In 1985, for instance, CD (certificate of deposit) rates averaged over 11% APY (annual percentage yield). Before the Great Recession, you could still expect APY in the mid-single digits. Today, you can consider yourself extremely lucky if you see more than 0.1% APY from a savings account.
DeFi savings works similarly. You lend a cryptocurrency, oftentimes a stablecoin such as DAI or USDC, to a lending pool and it collects interest, which grows your savings. The difference here is interest rates in these markets reflect different supply and demand curves than the dollar, which means higher interest rates—at this time of writing about 5x higher than ‘high interest’ savings products like Marcus by Goldman Sachs and 20x a typical savings account with Chase or Bank of America.
DeFi Savings is More Flexible and Efficient
In the world of CDs, the best yields typically come from fixed terms. Meaning a 5-year term will earn at higher rates than a 1-year term, which will earn more than a 6-month term. At the time of writing, the APY for a 5-year CD is just over 1%. Which raises the question, who would lock their savings up for five years to earn 1.05% interest?
When you save through DeFi, your money compounds interest in real-time (every 15 seconds) according to a real-time variable interest rate. Moreover, you can put money in or take it out on demand. This way you’re never locked in to a long term commitment in order to get a better return on your savings. If you ever need to access your savings, it’s always available to you.
But Isn’t Cryptocurrency Notoriously Volatile?
Bitcoin and Ethereum typically perform more like equities or commodities - they are riskier investments that vary frequently in the short term. While they’re great as part of a diversified portfolio, you wouldn’t want to hold things like debt payments, vacation money or an emergency fund in those markets.
DeFi saving, on the other hand, earns interest without the potential of going into the red.* This is a relatively predictable way to grow money vs. crypto investing, just as saving with CDs is considered a safer way to grow money vs. the stock market.
With Bitcoin, for instance, your investment could be up a large percentage over several years, but it’s possible on a given day that your holdings could be worth less than your principle—similar to shares in Apple or an index fund.
The DeFi rates, on the other hand, are variable minute-to-minute, sometimes higher and sometimes lower. Yet the average interest rate over a 6, 12 or even 1 month period is positive and often orders of magnitude higher than traditional savings options.
*except in the case of a negative interest rate, which has yet to happen in the history of these markets.
What’s the catch?
While there’s a lot to love about DeFi as a way to work your money harder, it’s not perfect. At the moment, bank accounts in the United States are insured by the FDIC, typically up to $250,000. This means under any circumstances, such as a bank closing or being compromised, a federal agency guarantees your money.
In DeFi, the security and integrity of the lending protocols (such as Compound) keeps your money safe. At the moment, the FDIC does not insure cryptocurrencies—so assurance that your money’s safe and sound comes down to trust in the blockchains themselves. Yet barring a failure in the smart contracts that govern DeFi lending, which are thoroughly audited by third parties, the systems for lending and borrowing will work as intended.
Furthermore, loans offered through protocols like Compound are highly collateralized. This means that borrowers lock up assets up to 2x the value of the loan. In this case, borrowers are far more likely to repay (to avoid losing their collateral) or, in the event of nonpayment, the liquidated collateral can fully cover the value of the loan.
DeFi offers a seemingly endless array of financial applications and while its many possibilities are fascinating, they’re ultimately speculative. Equally exciting are the existing ways in which you can already use DeFi services to save smarter and earn more with your money. In a time where the adage “a penny saved is a penny earned” barely holds true, DeFi is offering a way forward to make saving a more robust, productive part of anyone’s personal financial practice.
Sound interesting? To dig deeper into the technical side of DeFi, we recommend these great resources from Cryptotesters and Compound. To get started saving with DeFi today, check out the Donut App here.
Disclaimer: this article should not be construed as containing investment advice.