with algorithms and smart contracts. A further advantage is that there is no need to trust to hold your assets in custody or to rely on a third party to settle transactions.

One of the key factors for any market to be able to function and offer scale is liquidity. DeFi liquidity is provided by ‘yield farmers’, i.e. owners of  crypto assets who lend cryptos to decentralised anonymous organisations (DAO), The DAOs offer varrious financial services via DeFi applications (DApps) which are run using complex computer codes and executed via smart contracts. The DApps need liquidity and reward owners of cryptos assets by paying them interest/yield i.e. a return, in the form of tokens. Binance states, “Yield farming is a way to make more crypto with your crypto. It involves you lending funds to others through the magic of computer programs called smart contracts. In return for your service you earn fees in the form of crypto.” The amount of capital tied up has grown enormously since the beginning of July 2020 - $1.1 billion rising to, at one stage, over $9.2 billion.

Total value locked in DeFi

Source: DEFI Pulse.com

The way fees are generated for yield farmers is that DeFi exchanges offer the ability to lend, borrow or exchange tokens for a fee. In effect, yield farmers are being paid to provide the liquidity. More important is that the DeFi borrowing, lending and exchanging of tokens is only possible if there are lenders, borrowers and those who wish to exchange assets, meaning there is no reliance on a third party which may, or may not, have the liquidity required. In effect, DeFi has a created an autonomous, computer-based way in which to match buyers with sellers. 

But, as ever, DeFi is not a risk-free panacea and there are risks of which to be mindful:

• crypto volatility - to avoid undue turbulence in the event of the price of cryptos suddenly falling, there is often the necessity to place considerably more than you are able to borrow, i.e. if you wanted to borrow $100 you would need to deposit $200 (200% capitalisation ratio). However, some DeFi exchanges ask for 500% or even 750% capitalisation ratios to try and avoid a sudden fall e.g. flash crashes in the price of a crypto; 

• software bugs - while DeFi is not reliant on third party central clearing houses or financial institutions to settle a transaction it is vulnerable to errors in smart contracts, such as Yam Finance which lost $500,000 to $750,000;

•  systemic risk - as many of the DeFi projects look to exploit the best yields being offered, they generate compound returns by lending and borrowing from each other. So, one major collapse could have serious repercussions in DeFi market;

• stablecoins – these are often used by yield farmers, and Tether (which has grown to over $13 billion) is one of the more frequently used cryptos despite the fact that it is facing an investigation by the New York Attorney. Were a major stablecoin found not to have sufficient assets then its price could fall, impacting on the value of collateral and, in turn, the DeFi sector;

• Oracles reliance - the smart contracts which run DeFi protocls rely on Oracles such as ChainLink, UMA, Witnet for information (e.g. the price of different crypto currencies) since, if the price of a crypto that was being held as collatoral were to fall this could result in breaches  capitalisation ratios thus leading to the need to close a DeFi exposure. Were these Oracles to be hacked or provide erroneous data, it would undermine the DeFi sector;

• transaction costs - currently the DeFi sector is very reliant on the Ethereum blockchain and, due to the massive volume of transactions, this has resulted in the cost of processing transactions on Ethereum to sky-rocket from $116 on 17th March 2020, to over $475 on 1st September 2020.

The amount of electricity Bitcoin mining consumes

Source: Digiconomist.net

Of note, one of the ways to reduce the cost of electricity has been introduced to Texas where miners sign up to the Electric Reliability Council of Texas “controllable load resource”(ERCOT) which means users of power are paid to cut their consumption of electricity when the cost of power spikes. Texas has spent a considerable amount of monies on building solar and wind-renewable power generation which has led to cheap power but big spikes on cloudy days, or at night, when the wind is not blowing. In these meteorological conditions, Texan power is supplemented by expensive gas turbines in an attempt to smooth out volatile electricity prices. 

Cost of electricity in Texas

Source: Genscape

Earlier this year, Lancium, a company owned by Royal Dutch Shell, claimed to be the first firm to sign up to a load-only Controllable Load Resource as it is typically a user of power, not a generator. However, by decreasing the amount it consumes when electricity prices spike and are high, and using more power when electricity is cheap, Lancium claims it can reduce its electricity bills by 50%. Meanwhile, in order to take advantage of cheap power, a Bitcoin mining firm called Layer1 (backed by PayPal co-founder and crypto-billionaire, Peter Thiel) has set up a Bitcoin mining firm in Texas. Layer1 claims it has increased its profit margins by 700% by taking advantage of load-only Controllable Load Resource. However, this has not escaped the attention of Lancium, which has filed a law suit against Layer1 for an infringement of its Lancium’s patent for controlling the amount of power being used during peak electricity prices. Wow, could we see Shell take on PayPal’s co-founder in court - who will blink first?

Either way, the above demonstrates that Bitcoin mining use of electricity is a little more complex than it first seems. Since crypto miners can be programmed to increase or decrease their power requirements depending on power prices they may indirectly be able to help reduce the cost for other electricity users, such as keeping the air conditioning on during a hot summer’s day in the Lone Star State!