Intro to DeFi
This is a contributing article from Yitaek Hwang, Sr. Software Engineer at Axoni, writing about cloud, DevOps, and SRE topics.
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Why the $GME mania is a giant endorsement of decentralized finance and the underlying blockchain technology to replace the current settlement systems.
The wild rally of Gamestop stock and other meme stocks stole the headlines in January, formulating various narratives on the social class divide (the masses — r/WallStreetBets vs. the establishment —hedge funds, Wall Street). The frenzy exploded when Robinhood and other brokerages placed temporary limitations on trading activity, spurring up conspiracy theories regarding Robinhood’s relationship with Citadel (who also bailed out Melvin Capital due to the GME short squeeze). Conspiracy theories aside (which is already drawing regulatory scrutiny from Washington), this situation highlighted the complicated plumbing underneath the stock settlement process. For those interested, @compound248 on Twitter gave a detailed primer on the entire process:
DeFi: Decentralized Finance
So how does this relate to DeFi?
DeFi — or decentralized finance — is an ecosystem of distributed financial applications built on blockchain, which means that there is no single governing authority. This addresses both problems exposed by the Gamestop rally. First, blockchain technology can reduce the current T+2 settlement time via smart contracts to seconds from days. Secondly, due to the distributed nature of blockchain systems, no entity can singlehandedly block trades or close positions like various brokerages did to mitigate their risk during the meme stock frenzy.
Besides the problems highlighted by the current situation, centralized financial systems also share some flaws:
- Payment networks are slow and expensive: We now know about the T+2 settlement time in stock markets, but also in retail operations, sending money to different countries is not only slow but riddled with fees. Despite its name, the current infrastructure based on the SWIFT payment system (international wires) take days to settle.
- Not everyone has access to strong financial systems: According to the World Bank, about 1.7 billion adults remain unbanked as of 2017. Even for those with a bank account, if the country’s economy is struggling (e.g. hyperinflation in Venezuela), banks or other financial institutions cannot provide the same functions as those in developed countries.
- Centralized systems lack transparency: Despite regulation and laws regarding transparency, for most retail investors, there’s no way to fully know what happens behinds the scenes at these financial institutions. The 2008 financial crisis, where Lehman Brothers and other banks masked high-risk subprime loans as safe investments, underpins this risk.
DeFi aims to address these flaws and make financial applications accessible to more people around the world. Since the DeFi ecosystem is still in its nascency, many projects are still in experimental states or changing rapidly. In this post, we’ll categorize some major applications of DeFi as a brief introduction.
Note: Most DeFi applications are currently built on Ethereum. Technical explanation of Ethereum is beyond the scope of this article. For those interested, you can check out this excellent overview by Preethi Kasireddy: “How does Ethereum work, anyway?”
A crypto wallet is a physical device or an application that interfaces with the blockchain network and manages the private keys to your crypto assets. Like a traditional wallet or a bank account, a crypto wallet allows you to store and send/receive crypto assets.
There are two types of wallets:
- Custodial (e.g. Binance, Kraken): a third-party manages the private key on your behalf. These entities reduce the burden of keeping the private keys to your crypto assets safely but also expose you to the risk of losing control of your coins when they are hacked (e.g. Mt. Gox).
- Noncustodial (e.g. Trezor, Argent, Metamask): user-controlled wallet where the user is responsible for the security and storage of the private keys.
Amongst the crypto community, the mantra is “not your keys, not your coin.” Hardware-based wallets like Trezor and Ledger are the most secure, but new DeFi users may opt for a more polished user experience that mobile-based wallets like Argent or a browser-extension like Metamask provide.
It no secret that the price of cryptocurrencies is extremely volatile. This makes assets like Bitcoin and Ethereum a poor store of value compared to fiat currencies. Stablecoins mitigate this problem by algorithmically pegging their value to other stable assets (e.g. fiat currencies like USD). According to the Block Data Dashboard, $1 trillion worth of volume was transacted with stablecoins and their usage is steadily growing.
There are two types of stablecoins:
- Fiat-collateralized coins (e.g. Tether, USDC): these stablecoins maintain reserves of equivalent value per minted coin (i.e. to mint a new Tether coin, Tether must keep $1 in their reserves).
- Crypto-collateralized coins (e.g. DAI): the value of these stablecoins are pegged via smart protocols voted by DAOs (decentralized autonomous organizations). For example, Maker token holders can vote on the collateral ratio of various crypto assets to algorithmically peg the value of DAI to $1. If the collateral ratio of Ether is 200%, it means that to mint $100 of DAI, $200 worth of Ether must be deposited.
Lending & Borrowing
Unlike traditional financial institutions that have stringent regulatory policies (e.g. know-your-customer guidelines in anti-money laundering laws), DeFi lenders only require users to provide crypto collateral to take out a loan. On the other hand, users can also earn interest on the crypto assets they supply.
While popular centralized exchanges like Coinbase and Binance provide liquidity to facilitate crypto trades, users risk their assets being stolen while the trade is held on the exchange wallet, not to mention their personal information being leaked via hacks. Decentralized exchanges (DEX) bypass these intermediaries and use smart contracts to carry out trades on the blockchain network.
- Book-based (e.g. dYdX): buy and sell orders executed by the order book (similar to the mechanism on centralized exchanges)
- Liquidity pool-based (e.g. Uniswap, Kyber Network): reserves of crypto assets pooled together for higher liquidity and faster trade execution
2020 saw wider institutional adoption of crypto, reigniting interest in a bitcoin ETF. DeFi users don’t have to wait for regulators to clear such ETFs. Decentralized fund management that algorithmically tracks the performance of various cryptocurrencies or DeFi assets are already available. One example is TokenSets. TokenSets allows users to invest in Robo Sets that automatically trades crypto assets based on underlying metrics (similar to quant funds) or Social Sets that are handcrafted by featured traders (similar to hedge funds).
DeFi ecosystem continues to evolve and bring over traditional financial vehicles onto blockchain:
- Derivatives (e.g. Synthetix, bZx, opyn)
- Lottery (e.g. PoolTogether)
- Insurance (e.g. Nexus Mutual)
- Payments (e.g. Flexa, Matic Network)
Future of DeFi
Although the size of the DeFi ecosystem is small compared to the traditional financial markets, recent events from the unprecedented fiscal policies to respond to the pandemic to the ongoing Gamestop frenzy have shown how current systems may be improved with DeFi. To quote Thomas Jefferson, “Paper money is liable to be abused, has been, is, and forever will be abused, in every country in which it is permitted.” The rise of digital assets is going to continue in the future, and the question with DeFi is not if but when.
Disclaimer: This post is not investment or financial advice. All views expressed here are my own.