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What is DeFi?

What is DeFi?

Like most of crypto, the answer is simple and complex.

DeFi stands for decentralized finance. It’s based on the idea that the centralized financial system is vulnerable to failure. In contrast, crypto, with its DLT, peer-to-peer math-guided issuance, and clearing, is considered a viable alternative.

These are all the elements that started with Bitcoin and evolved into Ethereum.

DeFi is essentially crypto’s financial sandbox ecosystem. This is where you participate in a developing parallel financial system. The place where projects are floated, tested and traded.

The vision of DeFi is evolving daily.

But the basic principles of DeFi are constant. A vision of finance guided by incentives, smart contracts and math.

DeFi is primarily taking place on the Ethereum blockchain. However, there are several additional blockchains designed to support smart contract applications today.

The flexibility, programmability and borderless scale are unique attributes of this evolving financial system.

And the players in DeFi remind me of a contest involving a marshmallow.

Messari’s DeFi protocol screen including prices, market caps and details for Aave, Uniswap, Compound and Maker.
DeFi Asset Screener courtesy of Messari.io

DeFi is for adventurers

What would you do with twenty pieces of raw spaghetti, a yard of tape, a yard of string and a marshmallow?

And you’ve got 18 minutes and three other teammates.

That’s what designer and engineer Peter Skillman was curious about when he created the contest.

The goal is to build the tallest freestanding structure possible.

After testing numerous teams of four, he discovered something surprising.

The teams with the fewest preconceived notions and that were more open to play did better.

They weren’t constrained by status, planning or potential for failure.

The winning teams got to work fast and iterated continuously.

They were open to new ideas.

And after 18 minutes, they crushed their competition. Every time.

These kindergarten students showed the difference between being open and unbounded by extraneous rules. They were a contrast to the teams of MBAs who performed poorly. But they also beat teams of lawyers and CEOs as well.

This isn’t about dunking on professionals. But to create a new financial system, you have to be able to explore beyond what’s there already.

DeFi is open and discovery rich. It’s new ideas and new visions of what might be possible.

And much of it would be impossible if it was coming out of the highly regulated, traditional financial system.

DeFi and smart contracts

DeFi is best thought of as a virtual marketplace of services. An almost independent virtual world built primarily on the foundation of the Ethereum platform.

The code in most of DeFi is open-source, allowing for new iterations of existing platforms. Each new iteration builds on the success of the previous one while attempting to overcome its shortcomings.

DeFi also relies heavily on smart contracts.

Nick Szabo, a legendary Cypherpunk, first explored the concept of smart contracts..

Smart contracts are software programs that automate specific tasks, actions or responses.

DeFi is, in essence, a series of smart contracts that operate as moderators between different users. The purpose of each smart contract is defined by the service provided.

The contracts are designed to operate without human intervention. But they operate in response to human interaction.

So a trader exchanging one stablecoin for another on Curve will interact with a smart contract. The smart contract is tied to a pool of assets and acts automatically. Providing rewards, enforcing agreements, making adjustments are all executed automatically through smart contracts.

The DeFi system is often explained in contrast to the typical centralized exchange marketplace system. That’s where DEXs come in.

Decentralized Exchanges

Decentralized Exchanges (DEXs) are often presented as an alternative to centralized exchanges. The idea is that they are more secure because they are decentralized.

In a DEX, there are typically no traditional order books. You don’t have to give up as much information. Smart contracts dominate execution, and security is theoretically better.

DEXs provide a series of solutions designed to serve crypto, token and altcoin holders and developers. Getting new tokens and altcoins listed on loosely regulated centralized exchanges is difficult. Criteria are often strict for listing, and a certain level of activity and liquidity is expected.

DEXs, therefore, provide a place for a variety of experimental projects to get exposure. They can build crucial communities, and battle test their protocols.

There are DEXs for stablecoins, token pairs, multi-asset combinations, synthetic assets and prediction markets. Uniswap, Ox, Curve and Kyber Network are examples of DEXs.

Access to DEXs and the vast majority of DeFi is primarily through using ETH cryptocurrency.

The execution of smart contracts is done through algorithms known as Automated Market Makers.

Automated Market Makers

Market makers are present in almost any market. They are considered essential to assist in maintaining orderly market activity. In traditional markets, automated High-Frequency Traders (HFT) dominate different forms of market making. This is the wheelhouse of companies like Citadel.

In DeFi, market makers have been reimagined as smart contracts in a series of liquidity pools.

These are called automated market makers.

Liquidity pools in crypto are crypto, token or altcoin pairs defined by a specific ratio. These pools are where you can swap one token or crypto asset for another. The ratio and the smart contracts help maintain a stable pricing environment between the assets in the pool.

Hodlers of various crypto assets stake the pools with liquidity. In exchange, they receive a portion of the trading fee, yields and the potential to earn governance tokens.

Curve focuses on stablecoins, where Uniswap covers many different token or crypto asset pairs. Balancer allows for a Libra like multi-asset token pool model with up to eight different tokens.

The token or altcoin pairs are matched and don’t typically fluctuate dynamically in response to the outside market. So you will read about impermanent losses on some DEX protocols.

Impermanent losses are when the underlying asset in the pool doesn’t track the asset price on centralized exchanges. It opens up the potential for arbitragers to exploit the mispricing at the expense of the staker.

DEX’s are working out how to address this problem through iteration and various processes.

Fungible and non-fungible tokens 

Various types of tokens help define the DeFi space.

These include fungible ERC20 tokens and non-fungible ERC721 tokens (NFTs). There are other tokens, including governance tokens.

Governance tokens are granted to users and supporters of a given protocol. The tokens provide hodlers with the right to vote and provide guidance on the direction of the protocol.

Several protocols have issued governance tokens like UNI for Uniswap and Comp for Compound.

NFTs are another hot area in the DeFi space. These have been in development on the Ethereum blockchain for a few years. The first big example was CryptoKitties.

The technology underneath every NFT marketplace is Alchemy. Alchemy sits between Ethereum and NFT marketplace companies like OpenSea.

Canada’s Dapper Labs builds their applications on top of their Flow blockchain. This is where you will find NBA TopShot.

Wrapping Bitcoin, virtual banking and yield farming

Wrapped Bitcoin is another token.

Bitcoin is chain-specific. That means that it can operate exclusively on the Bitcoin blockchain. Or put another way, it lacks interoperability.

Because Bitcoin is the equivalent of the blue-chip in the space, creating interoperability was important.

So to get BTC on the Ethereum blockchain, a stablecoin architecture is used.

Wrapped Bitcoin is a token backed by BTC. Like the stablecoin minting process, BTC is deposited in exchange for WBTC. When the holder wants to redeem it, they send it back to the treasury to be burned. And the BTC is returned.

WBTC works on Ethereum like any other ERC 20 token.

WBTC allows BTC hodlers to take advantage of various staking, lending and borrowing opportunities in DeFi. Other projects are working on creating more DeFi opportunities for BTC.

The DeFi landscape allows you to participate, use and contribute to various financial products.

If you want to lend your crypto to a virtual bank-like structure, there’s Aave or SushiSwap.

You can earn yield without converting out of your assets. Or you can borrow using your crypto or token assets as collateral.

If you want to create, buy, sell and trade tokenized derivative assets, there is Synthetix. Or you can trade perpetuals on dYdX.

I would recommend Messari’s excellent resource for detailed information on specific DeFi protocols.

DeFi is a value exploration world

DeFi is a virtual, borderless, experimental financial system. It is creating numerous ways to discover value.

You can lend, stake, borrow, trade, and create.

You can stake some or all of your holdings on a DEX to earn a portion of trading fees. You can farm for liquidy or yield. You can change your loan arrangements without closing out loans. You can move in and out of highly speculative assets with ease.

And to participate in DeFi, all you need is some ETH.

But it’s not risk-free.

Sometimes code blows up, and protocols like Yam get creamed. There are some scammers. It’s an evolving experiment, and it’s a buyer-beware environment. But despite this, DeFi is growing.

DeFi has US$45-50 billion sloshing around in liquidity pools, lending products and various swaps. And the space has continued to attract talent, money and development.

US$50 billion doesn’t sound like much these days. But consider this, Bitcoin had a market cap of US$50 billion in the third quarter of 2017 and again in 2019.

Now it’s US$1.2 trillion.

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