An Intro to Decentralized Finance (DeFi)
I've been on a kick of the decentralized Web 3.0 topics lately, but I think today will be my last for a while. For starters, they are challenging to write about in an understandable fashion. Not to mention, Web 3.0 still has a lot of underpinning to develop. Even with the amount of money being dumped into this space (more on that in a sec), we have many dots to connect.
Needless to say, I'm as bullish as ever on blockchain. I even have plans to start experimenting with the development side, as well as continuing investing. A big target for me is the sector we'll discuss today: decentralized finance (DeFi).
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An Introduction to Decentralized Finance
Of all the Web3.0 topics I have written about, decentralized finance (DeFi) is the most beneficial to understand. After I wrote Solving Trust in Tech, many of you expressed your interest in DeFi. We can attribute this to the fact that everybody will be affected by DeFi's rules at some point.
I iterate this anytime we dive into tech topics, especially with Web3.0. I write about these topics to help myself understand them. In that sense, I am on the same level as you on decentralized finance. I've never built anything with it, and I am not actively invested in the number of startups in this space. Like most of the world, I am still actively trying to learn how this will manifest. So let's figure it out together.
Decentralization vs. Centralized
First, I want to drill down on the decentralization nucleus of the blockchain. The importance of that buzzword is critical, and it can sometimes go over my head. The example I always reference is Facebook (centralization) vs. Reddit (decentralization).
When Facebook was still young, Zuckerberg never foresaw suspending a United States President's account based on harmful content. The early days were millions of people updating their statuses to answer the default question of, "What's on your mind?"
Facebook didn't have much moderating to do in the days of embarrassing pictures and meaningless statuses. What feels like overnight, Facebook morphed into a centralized intermediary for speech when they censored content that could and could not be posted. In my opinion, the Facebook model won't last forever. Zuckerberg, being the intelligent guy he is, knows this and has adopted an aggressive acquisition strategy.
The complete opposite of this model is Reddit. It's tough to describe exactly what Reddit is. I think even Reddit has a hard time, so they just came up with the genius description of "The front page of the internet." But it's a giant message board categorized by areas of interest called "subreddits." These subreddits are controlled by moderators (the creator of a subreddit and then others through an application). Reddit gives complete control of the subreddits to that community. The moderators set the rules of posting along with other criteria for interacting with the subreddit. Reddit is taking its platform and decentralizing it to its user base.
I go to Reddit over Facebook every time for meaningful information. Decentralization produces better quality.
Can the same be said for finance?
What is DeFi?
Unless you experienced the Great Depression, you keep your money at the bank. There has never been a panic since then to make us think otherwise. Your bank is a centralized finance structure; meaning, it serves as a subset of the Federal Reserve, which is the United States central bank. All 9,000+ branches across America that litter your town adhere to the Federal Reserve money supply. It's wildly complex, so let's not get any more granular than that (and know that DeFi can simplify it).
The significant benefit to banking is knowing that your money will be there when you go to withdraw. The physical security of your money has always been enough to subsidize any other risk. Money security is paramount in life, so this isn't a hit piece aiming to disassemble the current centralized financial system. It's a thought piece of how decentralization can work just as well, if not better.
DeFi is targeting your idle money. Once you deposit money with a bank, the cash spreads in ways that rarely benefit the depositor. Once you deposit money in a DeFi application, a series of protocols use it intending to benefit the depositor.
So how does DeFi start to transform the centralized financial system? First, what is it?
DeFi refers to an ecosystem of financial applications that are built on top of a blockchain. Its common goal is to develop and operate in a decentralized way – without intermediaries such as banks, payment service providers or investment funds – all types of financial services on top of a transparent and trustless blockchain network (DeFi 1).
Essentially, DeFi can take financial institutions and remove them entirely. I have been inside my bank maybe five times. I don't carry cash and rarely need any personal assistance. Banks have gradually adopted FinTech solutions which is what we use today. What happens when the rules change to DeFi? Instead of financial institutions adapting, DeFi will take out the middlemen completely. It's a whole new financial system.
And it's happening right now. Here is the 1-year trend of USD locked into the DeFi space:
DeFi has soared from a $3.5 billion value in August 2020 to almost $90 billion in May 2021, also known as a 2,400% increase. I guess that's what all this to the moon talk is about. Alright, let's go a layer deeper.
Money Legos
Looking at the graphic above, the starting point and the backbone of any financial system is money. Whether that is a dollar bill in your pocket or a Bitcoin, money is an agreed-upon social construct for value. This premise does not change for DeFi. The thing that changes is how we get to the end result of you transacting with it.
Blockchain, through the use of smart contracts, would replace the bank as the intermediary. This creates a system of various decentralized finance applications (Dapps). The result is more return to the depositors. When presented like this, it makes DeFi a no-brainer to pursue.
But a financial system is very tough to build. Let's use personal finance as an example. Once I moved out on my own, my finances got a lot more challenging to manage. There are more costs incurred, more investments made, and more uncertainties to save for. These financial decisions are like" money legos." Every move pieces together toward the goal of maximizing my money.
Your personal financial structure functions similar to the central bank. You and your bank want to stay not only solvent but profitable. But what happens when your finances become too complex? People who are financially sound obtain professionals to help with smart money managing. In other words, using a decentralization (of information) strategy is most effective for smart money management.
The DeFi structure follows the same "money legos" framework. Anyone can build whatever they want in DeFi, and anyone with the internet can use it, with the only bounds being the constraints of a blockchain's size. We are in the cycle of building right now. There have been a few widely adopted solutions, but for the most part, everyone is still piecing together the money legos to create this financial system. Since this is the case, DeFi must incentivize users to adapt their services.
Let's look at a few of my favorite DeFi applications.
DeFi Application
Maker DAO (Lending - Stablecoin)
The most popular topic in money and finance right now is inflation. I've written about inflation in the past and how the Federal Reserve keeps cornering itself by printing money. The stimulus everyone enjoyed led to the most significant prices hikes since 2009. DeFi wants to solve inflation. MakerDAO is leading the charge.
MakerDAO launched in 2015 as Ethereum (the blockchain that introduced smart contracts) was introduced into the blockchain world. The premise was to lend to anyone a specific cryptocurrency (Dai) by leveraging Ethereum (ETH) as collateral through unique smart contracts called Collateralized Debt Positions (CDPs). Dai is a decentralized, unbiased, collateral-backed cryptocurrency soft-pegged to the U.S. dollar.Dai minimizes price volatility, as opposed to popular cryptocurrencies that see rapid price fluctuations. Thus, Dai is a "stablecoin," or a stable cryptocurrency.
So how does this work?
By keeping a conversion rate of 1.5/1, this, in theory, would protect against inflation and deflation. Of course, there is always the threat that cryptocurrencies fluctuate in price. Ethereum, the chain Maker operates on, has seen a dip in price over the past few months. As this happens, the smart contracts of the Maker protocol know to liquidate your position and convert some of your Ether (ETH). You would receive 50 ETH back in a perfect scenario, and now, you would obtain less back if you were to liquidate. The 100 Dai stays in your possession, but your collateral diminishes. This process allows the value of the stablecoin Dai not to fluctuate.
There are a TON more moving parts to the Maker Protocol. I am grabbing the basics from the Whitepaper that layout all of the logistics. It's a head-scratching read, to say the least. The use case for stablecoins is an effective way to use cryptocurrency by hedging the volatility of the price. (Maker 2)
Aave (Lending):
The Aave Protocol mirrors a more "traditional" lending framework. Initially, Aave was set up as a decentralized peer-to-peer cryptocurrency lending framework. Now, Aave has since shifted to the concept of "liquidity pools." Lenders will contribute funds to a pool for use as loans to borrowers. At the same time, borrowers will contribute collateral to obtain the loan. Liquidity pools effectively provide cryptocurrency at a fixed rate or a variable rate, much like a bank.
Similar to Maker, if the price of the contributed collateral by borrowers, in this case, Ethereum, drops below the liquidation threshold, then liquidation of the position is triggered. Like everything on the Ethereum blockchain, Aave accomplishes this through coded smart contracts.
I thoroughly enjoyed this podcast episode (Kevin Rose – Modern Finance) with the Aave creator Stani Kulechov as a starting point to learn more. (Aave 3)
yearn.finance:
Yearn.finance is a suite of products in DeFi that provides lending aggregation, yield generation, and insurance on the Ethereum blockchain. It's an all-encompassing DeFi solution aimed to "bank" anyone with an internet connection.
Yearn Finance Bit (YFBT) is a decentralized token under the ERC-20 (Ethereum) protocol. When purchased, it allows users to: (1) earn a yield by staking it, (2) borrow assets, and (3) vote in the decentralized YFBT ecosystem on governance issues within the community.
Staking consists of keeping tokens in a cryptocurrency wallet in order to 1) earn a reward (25% APR,) and 2) support the security and operations of the blockchain network. Simply put, staking is the act of depositing cryptocurrencies in a cryptocurrency wallet and keeping them there in order to receive rewards.
Yield Farming, or the "Agriculture of Yield", is an activity carried out by users (investors, traders) who have assets in cryptocurrencies to use these to invest them and obtain the highest possible return on their investment.
All members of YFBT/YFB2 who hold at least 1 YFBT/YFB2 are eligible to vote in the community through our platform.
Yearn.finance wants you to hold your crypto (staking) in a wallet (much like a bank wants you to deposit in the bank). They then want you to borrow and contribute assets. In addition, they will issue governance to keep the platform decentralized to the users. The more I read about it, the more this is becoming my favorite DeFi application.
Counterargument
These are endless. I'm not going to spend a lot of breath on these because it would be another 2,000 words. Chances are, if you made it this far, you thought of several counters—everything from usability concerns to security concerns to process concerns. In my opinion, someone can always figure those out. The place I am the most concerned is with regulation.
Regulation Concerns
The closest thing we have to gauge the regulation of cryptocurrency markets is credit cards. Edward Bellamy conceptualized credit cards in 1887. It wasn't until 1958 that American Express created the first "charge card" that was a singular card for all uses (previous charge cards were store-specific). Shortly after, Bank of America and MasterCard surfaced in the 1960s to compete in the credit card industry. The U.S. didn't release its first regulatory guidance on credit cards until the Fair Credit Reporting Act of 1970, or twelve years after AmEx began its credit card system.
My point being, these processes don't play out overnight. Although, we are getting into the window of time where crypto regulation will become more evident. Bitcoin launched in 2009, and the past half-decade has seen an unbelievable amount of volume in cryptocurrency.
Recently, Congress's infrastructure plan shows the Senate harshly taxing crypto markets for funding. Additionally, it includes more regulation for any business involved in crypto. It was severe enough to send shock waves through the crypto community. Not to mention, China has already outlawed any crypto trading and forced crypto miners to cease operations.
Web 3.0 will go as far as governments will allow them, which doesn't seem promising at the moment. But there is always light at the end of the tunnel for technological progress. All it takes is one big breakthrough.
1. DeFi Whitepaper
2. MakerDAO Whitepaper https://makerdao.com/en/whitepaper/#introduction
3. Aave Whitepaper https://github.com/aave/aaveprotocol/blob/master/docs/Aave_Protocol_Whitepaper_v1_0.pdf
4. yearn.finance Whitepaper https://yfbit.finance/YearnFinanceBit_WP_v_1.pdf
5. https://andrecronje.medium.com/building-in-defi-sucks-b8fdfda0ef58
6. https://medium.com/totle/building-with-money-legos-ab63a58ae764