DeFi is short for “decentralised finance,” an umbrella term for a variety of financial applications in cryptocurrency or blockchain geared toward disrupting financial intermediaries. DeFi generally uses peer-to-peer financial services. It involves taking traditional elements of the financial system and replacing the middleman with a smart contract. In layman’s terms, it can also be described as a merger between traditional banking services with blockchain technology. DeFi relies greatly on cryptography, blockchain, and smart contracts, with the latter being its main building block.
Some of the common applications of DeFi are as follows:
- Decentralised exchanges are exchanges that operate without an intermediary. They are not as popular as their centralised counterparts. With DEXs, users can connect directly with one another to buy and sell cryptocurrencies in a trustless environment. Assets traded under DEXs are never held in an escrow or third-party wallet, as is done with centralized exchanges. Some common DEXs include Uniswap, Curve and SushiSwap.
- DeFi proponents say the decentralised lending platforms are democratising the lending ecosystem. These platforms use smart contracts in place of intermediaries like banks — allowing borrowers and lenders to participate in an open system. Lenders can earn interest on their crypto assets by loaning them out, while borrowers can access liquidity without selling off their assets. Of course, from a Sharia perspective, such a use case is problematic.
Yield farming is a very popular activity within the DeFi space. Yield farming, also referred to as liquidity mining, is a way to generate rewards with cryptocurrency holdings. In simple terms, it means locking up cryptocurrencies and getting rewards. Some liquidity pools pay their rewards in multiple tokens. Those reward tokens then may be deposited to 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 have to do is to add your funds to a liquidity pool (smart contract), which is responsible for powering a marketplace where users carry out several procedures with their tokens, including borrowing, lending, and exchanging. Once you’ve locked up your funds in the pool, you’ll get fees that have been generated from the underlying DeFi platform or reward tokens.
Some of the common yield farming pools are as follows: Compound finance, MakerDAO, Synthetix, Aave, Uniswap, Curve Finance, Balancer and Yearn.Finance.
Uniswap and Balancer are the two largest liquidity pools in DeFi, offering LPs with fees as a reward for adding their assets to a pool. Liquidity pools are configured between two assets in a 50-50 ratio in Uniswap. Balancer allows for up to eight assets in a liquidity pool with custom allocations across assets. Every time someone takes a trade through a liquidity pool, the LPs that contributed to that pool earn a fee for helping to facilitate.
For the purpose of the Shariah 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 two below:
- Lending platforms
- Decentralised exchanges
DeFi lending platforms such as Compound, Aave and Maker have similar underpinning principles. At their core, they are lending protocols. On Compound, suppliers and borrowers don’t have to negotiate the terms as they would in a more traditional setting. Both sides interact directly with the protocol, which handles 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 built on Ethereum. Since the yield in yield farming on lending platforms is created through lending contracts, the yield is Riba.
In decentralised exchanges, LPs provide liquidity to a smart contract which is in essence an account. The account is the ‘pool’ which has rules and protocols by virtue of 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. In a two-token smart contract trading pair, let’s use Ether (ETH) and USD Coin (USDC) as an example. Liquidity providers contribute an equal value of ETH and USDC to the pool, so someone depositing 1 ETH would have to match it with 1,000 USDC.
For the liquidity mining to be Sharia compliant, the following conditions must be met:
- The tokens must be Sharia compliant.
- The return must not be guaranteed. The Liquidity Provider must have the ability to gain or lose their Liquidity.
- The Liquidity Provider must get a percentage share of the liquidity pool and not a specific amount. If a specific amount of tokens are guaranteed and can be recalled later, then this would not be Sharia compliant. If a specific amount of tokens were always recallable by the Liquidity Provider, then this would mean that the Liquidity Provider does not own a percentage of the pool, rather a fixed amount. That would result in the Liquidity provider not becoming a shareholder in the liquidity pool, but rather a lender to the liquidity pool. As such, the Liquidity Provider would not be bearing risk of loss, and therefore this would be a form of Qard (loan) to the pool. As such, any earnings would be Riba.