DeFi is getting high
DeGen is hyping gains
DeFool is aping pools
At the time of this writing, the Ethereum blockchain hosts an over $55 billion USD worth of ecosystem of decentralized applications. These apps provide a staggering of services previously only available to the savvy and wealthy institutional investors in the traditional world. According to defiprime, there are 233 DeFi projects listed and 216 of them built on Ethereum. So 🔥🔥🔥!
Alot of these services are so novel and innovative that they would require their own separate research and explanation. Due to my limited understanding and for the purpose of keeping this series of blog post simple, easy to understand, I will only try to cover the basic terminologies and concepts (for crypto-virgins if you will).
For more technical and deep understanding of DeFi, as always, please do your own research, you’ll be better rewarded for it.
What is DeFi?
DeFi = Decentralized Finance. In simple terms, it refers to a category of services that are financial related with no central authority. It takes the basic (and sometimes advance and confusing) elements of traditional financial system, allow peer to peer transactions and replace the middlemen (with smart contracts and oracles)
Imagine being able to be your own bank, your own stock broker, your own stock exchange, your own insurance broker, your own lender etc, without a central governing authority.
What are the components of DeFi?
At a high overarching level, the components of DeFi are similar as existing financial systems, requiring and offering things such as:
- Stable currencies aka Stablecoins
- Wide varieties of activities involving crypto currencies such as: payment, lending, borrowing, hedging, speculating, derivatives, insurances, CFDs (Contract for Difference) etc.
At the operating level, these components are created to interact with each other autonomously, without a central third party, all through codes and data feeds.
Money Legos
As long as these components are created in the same blockchain ecosystem (for example: Ethereum), they should be able to combine with each other to form complex DeFi applications to provide the services mentioned above.
These DeFi applications are based on 4 layers.
Let’s use a simple analogy of a Tesla car to explain this. Click here if you fancy a more detailed understanding of the topic
1. Settlement Layer – the electricity that powers the Tesla’s car, from the engine, the software to the mechatronics & electronics. In DeFi, the electricity is Ether denominated in Gwei
2. Protocol Layer – the car software & car physical design that governs the make up of the car. In DeFi, the software protocol is the Ethereum Smart Contract Language, its Blockchain Network and its protocols like ERC-20, ERC-721, ERC-1155, ERC-1159. These protocols operate & enhance functionality of the Etherum ‘tesla car’.
3. Application Layer – the steering wheel, the pedal, the brake to control car movements. In DeFi, think UniSwap, KyberSwap, Balancer, dYdX, 1inch, Aave, Compound etc.
4. Aggregation Layer – the Tesla car dashboard and touchscreen, to control complex movements such as speed-limit, auto driving, GPS route optimization. In DeFi, think Yearn, Synthetix, MetaMask, Argent, Nexus Mutual etc.
What is AMM – Auto Market Makers?
A unique decentralized financial tool to the Ethereum (and other smart contract blockchain). In simple terms, it allows the automated trading between buyer and sellers without using a centralized exchange system like an order book. It achieves this by utilizing the liquidity provided by people staking their cryptos in pools called Liquidity Pools. These pools then facilities the swapping of cryptos based on a mathematical formula that automatically adjust the prices according to fluctuating demand and supply. Gemini has written a great in depth article on this.
What is Staking?
Staking is the general process of locking up your money|cryptos for a period of time for someone else to use on your behalf in exchange for some kind of reward.
See below for the use of staking in Liquidity Mining | Yield Farming
Note: Staking in terms of Proof of Stake is totally different and should be not be confused with Staking for Yield Farming
What is Liquidity Mining or Yield Farming in DeFi?
I use the [ x | y ] to indicate the analogy between real life [ x ] and crypto [ y ]
Farming is essentially like issueing [shares | tokens] by the ABC company, for people to [loan | staking] their [money | cryptos] to provide [funding | liquidity] for their application to function. These people are called liquidity providers
The ABC company then uses that liquidity to provide a financial service such as swap, lend, insure or hedge to other people for a fee, collected in [shares | tokens] upon completion of service, which is then used to pay back the liquidity providers and this process is called farming.
The service users in some cases, have to contribute their crypto-assets as collaterals in order to initative the service. And due to the volatile nature of crypto prices, over-collateralization is required.
The ABC company can also offer [shares | tokens] to borrowers, to incentivize them to use the financial service. Think of this like kickback for using your credit cards.
The ABC company can also incorporate their company governance into a DAOs where the decision making of the company is decided on-chain via voting by those who hold the company’s [shares | tokens]. This is often done to create further value or give the impression of value of their [shares | tokens]
The [shares | tokens] holders can also occasionally receive more tokens via [shares issuance | airdrops] or [gifts | NFTs] as a gesture of thank you for hodl-ing.
These [shares | tokens] can also be traded for other company’s [shares | tokens] if they deem to have value.
Some personal takeaways
The high APY farmed tokens have high probability of being worthless, since they are so easily ‘printed’. 1 billion of nothing is still nothing. Vitalik seems to share this view.
The money locked up in liquidity pools have high probability of being made to disappear/rug-pull. There have been many great stories and lessons on this.
Depending on the code written in the smart contract at the genesis of the X company, unaudited code is a massive risk to the gullible and yield hungry farmer.
It has some similarity of the game of musical chair. So try to be close to a chair, any chair when the music is about to stop.
DeFi is hot and people in it should be ready to be shirtless, in every sense of the word.
All in all however, DeFi represents a sneak peek of the future leveraging blockchain that we all could aspire to, where financial services can be done seamlessly and easily, at low costs, where third parties are not necessarily required to conduct one’s own business, where information, financial services and money merge & flows into infinite possibilities.
What a time to be alive.