DeFi is short for Decentralized Finance, an umbrella term for a variety of cryptocurrency or blockchain financial applications designed to disrupt financial intermediaries[1]. DeFi generally uses peer-to-peer financial services. It takes traditional elements of the financial system and replaces the middleman with a smart contract. In layman’s terms, it can also be described as a fusion of traditional banking services with blockchain technology. DeFi relies heavily on cryptography, blockchain, and smart contracts, with the latter being the main building block.
applications
Some of the most common uses of DeFi are as follows:
- Decentralized exchanges are exchanges that function without intermediaries. They are not as popular as their centralized counterparts. DEXs allow users to connect directly to each other to buy and sell cryptocurrencies in a trusted environment. Assets traded under DEXs are never held in a third-party escrow or wallet like centralized exchanges do. Common DEXs include Uniswap, Curve, and SushiSwap.
- DeFi proponents say the decentralized lending platforms are democratizing the lending ecosystem. These platforms use smart contracts instead of intermediaries like banks – allowing borrowers and lenders to participate in an open system. Lenders can earn interest on their crypto assets by lending them out, while borrowers can access liquidity without selling their assets. From a Sharia point of view, such an application is of course problematic.
Yield farming is a very popular activity in the DeFi space. Yield farming, also known as liquidity mining, is a way to generate rewards using cryptocurrency holdings. Put simply, it means blocking cryptocurrencies and getting rewards. Some liquidity pools pay out their rewards in multiple tokens. These reward tokens can then be deposited into other liquidity pools to earn rewards there, and so on.
Yield farming requires liquidity providers (LPs) and liquidity pools. To become an LP, all you need to do is add your funds to a liquidity pool (smart contract) that is responsible for powering a marketplace where users perform various operations with their tokens, including borrowing, lending, and swapping. Once you’ve locked your money in the pool, you’ll receive fees generated by the underlying DeFi platform or reward tokens.
Some of the popular yield farming pools are: Compound Finance, MakerDAO, Synthetix, Aave, Uniswap, Curve Finance, Balancer, and Yearn.Finance.
Uniswap and Balancer are the two largest liquidity pools in DeFi and offer LPs a fee as a reward for adding their assets to a pool. In Uniswap, liquidity pools are configured between two assets in a 50:50 ratio. Balancer allows up to eight assets to be included in a liquidity pool with custom allocations between assets. Every time someone makes a trade through a liquidity pool, the LPs that contributed to that pool receive a fee for their support.
Sharia perspective
For the purposes of Sharia analysis, yield farming can be divided into two operations in light of this paper. However, there could be other methods of yield farming beyond the following two:
- lending platforms
- Decentralized exchange
DeFi lending platforms like Compound, Aave, and Maker share similar core principles. At its core, these are credit protocols. With Compound, suppliers and borrowers do not have to negotiate terms as they would in a more traditional environment. Both sides interact directly with the protocol that governs the collateral and interest rates. No counterparties hold funds as the assets are held in smart contracts called liquidity pools. Like most DeFi protocols, Compound is a system of openly accessible smart contracts based on Ethereum. Because yield farming on lending platforms yields income through lending agreements, the yield is Riba.
With decentralized exchanges, LPs provide liquidity to a smart contract, which is essentially an account. The account is the “pool” that has rules and protocols due to the smart contract.
The simplest version of a DeFi liquidity pool holds two tokens in a smart contract to form a trading pair. Other versions differ, but the underlying Sharia principle would be identical. Let’s take Ether (ETH) and USD Coin (USDC) as an example of a two-token smart contract trade pair. Liquidity providers contribute an equal value of ETH and USDC to the pool, so someone who deposits 1 ETH has to match it with 1,000 USDC.
In order for Liquidity Mining to be Sharia compliant, the following conditions must be met:
- The tokens must be Sharia compliant.
- The return does not have to be guaranteed. The liquidity provider must be able to gain or lose its liquidity.
- The liquidity provider must receive a percentage of the liquidity pool and not a specific amount. If a certain number of tokens are guaranteed and can be recalled later, this would not be Sharia compliant. If a certain amount of tokens were always retrievable from the liquidity provider, then this would mean that the liquidity provider does not own a percentage of the pool, but a fixed amount. This would result in the liquidity provider not becoming a shareholder of the liquidity pool but rather becoming a lender to the liquidity pool. Thus, the liquidity provider would not bear any risk of loss and it would therefore be a form of qard (loan) to the pool. Therefore, all income would be riba.
[1] https://www.coindesk.com/what-is-defi
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