Ultimate Introduction to DeFi

Ultimate Introduction to DeFi

Defi is growing rapidly and shows no sign of stopping (Source: Defi Pulse)

DeFi is a new form of banking

When I was a poor student at University, my account balances teetered on the edge of overdraft at the end of every month. It was a battle to see if I could stay out of negative, not for my own sake, but to evade the constant fees assessed by my bank. If I went even a dollar below $0, my bank would administer a $35 dollar overdraft fee, a lot for a young student.

After leaving university, when I started working in the crypto industry, it was only a few weeks before my bank, with whom I had been with for nearly a decade, notified me that they were closing my accounts due to transactions with crypto exchanges and other related businesses. My loyalty to the bank meant nothing, I had no way to fight back. The account was closed and I had to move my money somewhere else.

Access to good banking depends a lot on where you were born. As an American, I can access the best banks in the world with ease. My wife, who is Russian, must jump through a lot of hoops to access the same services only due to where she was born and the political relations between our two countries.

Even today I've yet to find a bank that completely meets all of my needs. Banks close on the weekends, their fees are high, accounts can get shut down for opaque reasons and the savings rates are low. Up until recently there was no viable alternative to "exit" the banking system.

Decentralized Finance or DeFi is the deployment of financial software on to the blockchain enabling a new form of banking; encompassing saving, borrowing, lending and all of the other services a traditional bank would offer.

While it can be argued that all crypto is a form of Defi, Ethereum is primarily where the majority of development and transactions occur.

Defi it leverages all of the properties inherent to Ethereum:

  • Permissionless: Any person can access all DeFi services without a third party preventing interaction. A user does not have to seek permission to interact with a smart contract.
  • Censorship Resistant: No person is restricted from using DeFi services due to any identifying characteristics such as nationality, gender, or political beliefs.  When a DeFi transaction is broadcast to the Ethereum Network, no one can stop it.
  • Programmable: Any service which can be coded into a smart contract, can be introduced as a DeFi service.
  • Transparent: All smart contracts are available for analysis and verification. Additionally, all user interactions can be tracked, making DeFi the first fully transparent bank.
  • Compostability: DeFi services can leverage each other to create new offerings and servers. Bankless calls them "lego" blocks.
  • Trustless: All transactions and interactions with the smart contract are visible on the ledger and secured by the underlying blockchain.

Compare that to my previous banks' attributes: permissioned, censorable, opaque decision making and incompatible with most other financial service products (a growing sector).

These properties enable every person to be their own bank, eliminating the need for intermediaries. As a consequence, fees are greatly reduced and DeFi is accesible 24/7. It's the open banking solution for the age of decentralization.

At the end of 2019, DeFi is primarily based on the Ethereum platform. Big Brother Bitcoin has yet to see any major rollout of DeFi services. Part of this is how the code is designed, while part has to do with Bitcoin's more conservative community. A few projects such as RSK and Money of Chain are developing DeFi projects, but the vast majority of new projects are released on Ethereum.

Developers on Ethereum tend to be more open to developing experimental code that either will thrive or spectacularly fail. Ethereum smart contracts are notorious for their security weaknesses. In its infancy, the DAO project was the first major project to fail, when hackers stole $50 million of ETH. Even recently, MakerDAO discovered a security flaw that would have let a hacker steal all of the Ethereum in the smart contract.

DeFi is still in its infancy stage, even with the total amount of ETH locked topping $750 million USD. It's only been two years since the launch of MakerDAO and the ecosystem is rapidly changing. A new world of banking is appearing, but it is important to understand how it took so long to manifest.

History of DeFi

Twenty-twenty marks the 11th year since the launch of the Bitcoin network. For all of its insane price growth, DeFi services have failed to appear for the grandaddy of crypto. Some of this has to do with the Bitcoin code, but the main reason has to do with its inherent lack of stability.

Bitcoin by itself is limited in what it can do. It can be sent from address to address, and some information can be included in each block. But you can't do much else with it. You just have to hang on the wild price movements and hope the price ends up higher than when you bought it.

Bitcoin is extremely volatile and prices exploded over the past several years netting 1000's of percent returns for investors. Massive returns can't exist without high volatility, the amount of variance in price over a certain time.

Ask yourself this, would you want to take a loan in Bitcoin? Of course not! Price volatility makes it a poor asset to accurately plan any finance around. Scaleable finance requires stable, low volatility assets for long term planning.

Bitcoin's primary use is as a speculative asset, not as a means of payment. Marcus Swanepoel, CEO of cryptocurrency exchange Luno told Coindesk that "Roughly 90% I would put into the category of investments slash speculations, [while] 10% would be transactions." Bitcoin's greatest strength is also a weakness, the network boats incredible security, but it achieves this by sacrificing use of its blockspace, the data contained within each block.  

DeFi only appeared with the launch of Ethereum, a Turing complete blockchain that increased its available blockspace. With these changes developers could add  "smart contracts." A definition of a smart contract is:

A self-enforcing piece of software that is managed by a P2P network of computers. Smart contracts are efficient rights management tools that provide a coordination and enforcement framework for agreements between network participants, without the need of traditional legal contracts. They can be used to formalize simple agreements between two parties, the bylaws of an organization, or to create tokens. - Author Shermin Voshmgir is his book Token Economy

The idea of smart contracts has existed since 1994 when Nick Szabo first coined the term. It wasn't until the launch of Ethereum that smart contracts could be used without the need for trusted intermediaries. Smart contracts on a blockchain synthesized beneficial properties, creating unalterable, trustless, permissionless software.

Today, we understand how novel this idea was, but after the launch of the Ethereum network in 2015, it took a few years for projects to figure what to do with smart contracts outside of minting shitcoin tokens and P2P trading.

It wasn't until the later part of 2017 that the first building block of DeFi emerged, DAI.

Tether'd

For all of the massive returns in cryptocurrencies, the dollar is and will still continue to be King. In countries with high inflation, like Venezuela, Turkey and Argentina, the dollar is the first currency people desire.

The greenback might be losing 1-2% a year, but in the aforementioned countries inflation can run as high 1,698,488% a year! Dollars are stable, their value is extremely predictable and their risk of collapse is near zero (at this point).

During the 2017 bull run, using Bitcoin for payments was the most logical choice, as its price was increasing everyday. Post-peak, when volatility returned and prices resumed two-directional trading movements, merchants switched to Tether, a dollar pegged stablecoin.

Tether derives its value from different types of collateral; "reserves, which include traditional currency and cash equivalents and, from time to time, may include other assets and receivables from loans made by Tether to third parties, which may include affiliated entities," as per their website.

Tether is the lifeblood of the crypto economy, with more than $26 billion dollars of trade volume in just the last 24 hours, the highest for ALL crypto currencies! No matter what you think, dollars or dollar equivalents are highly in demand.

Today, Tether still remains the most popular stablecoin, even as information emerged $800 million USD of collateral had been frozen by authorities in connection with money laundering and an investigation brought by the New York District Attorney. It's entirely possible Tether loses their case, receives an injunction to stop operating and shuts down in the near future.

American authorities have in the past pursued digital dollar issuers with rampant force.

E-gold was a digital gold currency launched 10 years before Bitcoin, that allowed users to open an account on their web site denominated in grams of gold  and make instant transfers of value to other e-gold customers. The digital currency attracted more than 5 million people and was processing $2 billion USD volume daily before it was shut down and its founders tried and found guilty of operating an unlicensed money transmitter business.

Tether has been able to evade US authorities for several years now, but their business is still under threat and by the time you are reading this it may have suffered the same fate as E-gold.

DAI = Decentralized Dollars

DeFi today is defined by DAI, a fully decentralized stablecoin pegged to the dollar. The key solution MakerDAO, creator of DAI, introduced was to use Ethereum as collateral for the issuance of DAI. There are no accounts with collateral that can be seized, companies shut down or founders to be thrown in prison.

Any person with Ethereum could interact with the smart contract to create DAI. The newly minted stablecoin is backed solely by the value of the ETH collateral.

DAI is a fully decentralized, censorship resistant, permissionless dollar pegged currency that derives it value from ETH, another fully decentralized asset.

Isn't that cool?

Minting DAI is similar to taking a loan on the equity of your house. The value of the house is the collateral for the loan. If the value of the house falls below the loan capitalization rate, a margin call is issued and part or all of the loan must be repaid.

DAI must always be over-collateralized by ETH at a rate of 150%. If the price of ETH falls significantly, the DAI smart contract will automatically liquidate a portion of the ETH to protect the value of the smart contract issued stablecoin..

DAI is special because its value is derived solely from Ethereum, a trustless asset. This makes DAI also trustless, as its value is derived from the underlying asset. Unlike other stablecoins (Tether, USDC, etc.), no one can seize, freeze or destroy your DAI.

Its value has stayed relatively stable since 2018. The price of Ethereum went from $1200 to $88, but the price of DAI has not strayed from $1. This stability creates opportunities for investment, borrowing and lending.

At the end of 2019, MakerDAO launched multi-collateral DAI. Users can now use BAT to collateralize and create DAI. Single collateral DAI was renamed SAI.

Compound = Decentralized Savings Account

The first "killer" app for DeFi was Compound, a borrowing/lending product that leveraged the stability of DAI for high-interest loans. Compound Finance is a decentralized lending platform that pools user collateral instead of facilitating direct loans.

Unlike traditional platforms, such as Bitfinex and BlockFi, lenders retain custody of the value of their collateral, plus they automatically get interest payments.

Interest rates are higher for DAI and other stablecoins (USDC) than traditional bank accounts. In Summer 2019, DAI lending rates topped out at 13.38% on Compound. This incredible figure was slowly arbitraged down to 5.88%.

Interest rates are a function of the total liquidity for each market pair. Higher liquidity lowers interest rates, and when it becomes scarce interest rates rise, incentivizing more lending into the protocol.

When you lend DAI into compound, cDAI is added to your wallet. cDAI is a tokenized interest bearing collateral obligation. cDAI can be traded, sent to accounts and is compostable with other DeFi products.

DeFi = Better Banking

In 2020, one my goals is to convert a large portion of my dollar holdings into DAI and then lend it out on Compound, Uniswap, Fulcrum or any of the myriad of DeFi interest bearing apps. DeFi's high interest rate is better than any bank at the moment. Obviously there are increased risks associated with the higher rate, however, its a risk I'm willing to take.

More than $1 billion USD are held in DeFi products and services in 2020. It satisfies an actual use case crypto enthusiasts have demanded since the launch of Bitcoin.

DeFi checks the boxes on the type of bank I want: transparent, open source, permissionless and trustless. It's the decentralized banking future we deserve.

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