Decentralized finance (DeFi) is an umbrella term for various apps that cut the middleman out of financial services, such as lending, borrowing, trading, and earning interest. DeFi continued to gain traction last year with increased adoption, more applications, and more money invested.
In some ways, DeFi cuts across the whole cryptocurrency industry. After all, Bitcoin (BTC), the first-ever crypto, was designed as a decentralized form of payment. But there are some DeFi specific tokens that are worth keeping an eye on.
1. Terra (LUNA)
Terra grew almost 13,000% in 2021, but -- like many cryptos -- its price has fallen in 2022. It's a DeFi ecosystem that's underpinned by algorithmic stablecoins -- dubbed the next generation of money. The idea is to be a complete digital financial system, based on stablecoins. Terra's Chai payment platform is accepted by thousands of merchants in Korea and its Anchor savings platform is proving popular.
A stablecoin's value is pegged to a non-crypto commodity like gold or a fiat currency like the U.S. dollar. And unlike a fiat-backed stablecoin which is backed 1:1 by a traditional currency, an algorithmic stablecoin keeps its peg by using a smart contract to issue or buy coins. Terra does this using the LUNA token to increase or reduce the supply.
2. Aave (AAVE)
Aave is a relatively well established player in the DeFi space. It is a decentralized lending platform where people can borrow, lend, and earn interest on their crypto assets. Users can deposit the crypto they want to earn interest on, which becomes part of a lending pool. Borrowers can then take out loans from the pools and the interest goes to the people who deposited their assets. It's similar to what a traditional bank does with money you deposit, but since there's no middleman, you earn a higher percentage of the loan interest.
There's always a risk older DeFi cryptos will be overtaken by new products. However, Aave remains top of DeFi Llama's list of lenders in terms of total value locked (the amount of money on the platform). It upgraded to Aave v2 at the end of 2020 and now operates on Ethereum (ETH), Avalanche (AVAX), and Polygon (MATIC) networks -- which means users don't have to pay Ethereum's huge gas fees for each transaction.
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3. Chainlink (LINK)
To understand Chainlink, we need to know about oracles and smart contracts. Smart contracts are tiny pieces of code that execute automatically when in certain circ*mstances. For example, a farmer might take out insurance against bad weather, and the smart contract would pay out in the event of those weather conditions. Oracles collect the data that feeds smart contracts -- without them, the smart contract wouldn't know when it should trigger. And Chainlink is the market leader in oracles.
Many leading DeFi platforms use Chainlink's oracle data. But so far, this behind-the-scenes workhorse has not captured investor interest. Even though several well-known analysts have pointed to its potential, LINK only gained about 70% in 2021. That's a solid increase but not as much as many others.
4. Clover Finance (CLV)
The cryptos above are all well-known cryptos that are in the top 100 by market capitalization. This means they are available from many top cryptocurrency exchanges, and carry less risk than smaller coins. However, if you're looking for smaller altcoins with potential, Clover Finance is one to watch.
Clover is all about interoperability -- working across different crypto platforms. As various Ethereum alternatives take market share, it becomes more important for them to communicate with each other. Clover's blockchain can support applications and assets from other top networks, including Ethereum, Solana (SOL), and Binance Smart Chain.
It also aims to solve another common DeFi problem: Accessibility. Right now, it is hard for new investors to use many of the DeFi products on the market -- they are not easy to understand, transaction fees can be prohibitive, and the risks are difficult to evaluate. The next generation of decentralized finance applications will likely be more intuitive, which is why this is a priority for Clover.
Decentralized finance is not for the faint of heart
All cryptocurrencies are risky investments, but there are some specific risks associated with DeFi. For example, the DeFi industry is rife with scams and fraud. According to crypto compliance company Elliptic, over $10.5 billion was lost to DeFi scams last year -- a 600% increase on the year before.
There's also the danger of faulty programming. If you take the trusted middleman -- such as a bank -- out of your finances, and replace it with sophisticated pieces of code, you need to be sure that code is well-written. And sadly, in some cases, it isn't.
Finally, there's the prospect of increased regulation. Authorities are concerned various decentralized finance products are operating as pseudo banks, but without any of the controls that apply to banks. Regulation will impact the whole cryptocurrency industry, but it will likely have an outsized impact on the decentralized finance sector.
If you're considering investing in DeFi coins, you might also consider using these platforms. It's one thing to buy the coins in the hope prices will appreciate, but these are products that are designed to be used. High Ethereum gas fees acted as a barrier to entry last year, but many transactions now use other networks and cost less than $1. There are risks involved, but you'll gain a better understanding of the tokens you've bought -- and potentially earn higher returns -- if you try to use these cryptos as they were intended to be used.
All in all, there's a reason billionaire investor Mark Cuban thinks banks should be scared of DeFi -- this sector could change the way we bank. But this industry is still in its infancy and a lot could change in the coming years. Do your research and don't invest more than you can afford to lose.
Emma Newbery owns Bitcoin, Ethereum, Terra, Aave, Avalanche, Polygon, Chainlink, Clover Finance, and Solana. The Motley Fool owns shares of and recommends Bitcoin.
