The Golden Nine in DeFi
“Decentralization of finance is really the democratization of finance. It’s about eradicating barriers,” said Ethan Buchman, co-founder of the Cosmos Network.
Decentralized Finance or DeFi was just an idea 7 years ago when Ethereum’s founder Vitalik Buterin was discussing the possibility of stablecoins tracking the USD, tokenizing stocks on the blockchain and scripting financial derivatives into self executing code in his Ethereum Whitepaper. It wasn’t until MakerDao proved to be the first decentralized application (dApp) that built the first automated market making protocol (AMM). It allows for anonymous borrowers to collateralize their ETH (Ethereum’s native token) for Maker’s synthetic stablecoin DAI and for lenders to earn interest on their idle digital assets.
Today, DeFi might be the fastest and most exciting technology happening on the planet. The total DeFi market cap is over $13B doing about $3B in daily trading volume with over $10B of value locked in these protocols. Most of this activity is happening on Ethereum’s blockchain, however it’s low hanging fruit for competing layer 1 blockchains and dApps.
In Alex Tapscott’s book, Financial Services Revolution they broke down the financial industry into 9 components that will be changed and reimagined via blockchain technology.
- Authenticating Identity & Value
- Storing Value
- Moving Value
- Lending Value
- Funding & Investing
- Exchanging Value
- Insuring Value & Managing Risk
- Analyzing Financial Data
- Accounting for Value
Authenticating Identity & Value
While verifiable and cryptographically secured identities will be ensure “Know Your Customer (KYC) and Anti-Money Laundering (AML) compliance laws, I think the biggest opportunity is around authenticating value and the permissionless nature of decentralized finance. Our financial system is built on fractional reserving banking and the rehypothecation of assets used and reused as collateral. This obviously increases credit counter party risk and most likely inflates our boom and bust cycles, but it also slows down the velocity of money with delayed or trapped settlement times. Programmable digital assets like stablecoins have proven to increase the velocity of money and free up capital with nearly instantaneous settlement and finalization. At the end of the day, it’s the verification of value that matters when initializing and clearing transactions. When you add on the global and permissionless nature of public blockchains, we open up finance to more people and more capital in hopes of creating a more efficient digital economy.
Bitcoin has already proven to be one of the best stores of value technologies ever created. It’s artificial capped supply at 21 million and it’s deflationary monetary policy guarantees that there will be less available bitcoin tomorrow than today. And, given our current debt based financial system, there should be more demand for inflation hedge assets tomorrow than today. We’re now seeing more bitcoin moved onto Ethereum for DeFi. Projects like REN and Synthetix are “wrapping” bitcoin into a smart contract and tokenizing the reserve asset increasing bitcoin’s utility, privacy and transaction times.
Our current financial system is incredibly inefficient. We have a patchwork of different financial firms, companies and institutions, each using different analog technologies and operating in their own data silos. Nothing is actually connected allowing for real time secure data sharing and value transfer. Not to mention most transactions require human intervention to request permission, process paperwork, and take cut of the action in the form of a fee. Settlement times can take anywhere between 3–7 business days with ability for 90 day reversals and claw-backs. For international high value transfers, over 11k financial institutions and more than 200 countries us the SWIFT network or the Society for Worldwide Interbank Financial Telecommunications. SWIFT was created in 1977 and updated IP infrastructure in 2005. There’s not much to this system. It’s essentially a permissioned shared and secured messaging network. Firms exchange pay orders with one another where actual transactions are cleared and settled with the different correspondent banking relationships. Over the last decade, SWIFT has come under pressure from abroad as a tool to implement US Government foreign policy and sanctions against countries like Iran. Without going any further, moving value in our current system is obviously in need of a technology overhaul.
Blockchain and self executing smart contracts used in decentralized finance flip the current system on it’s head. Anyone can interact with these value transfer protocols without speaking to a single human being. Transactions are cleared and settled almost instantaneously. And, the value is actually being transferred and moving from one account to the other. This is all verified on the network and as each network begins to mesh with other networks, these value transfer protocols will enable seamless movement of assets across all networks. This is network interoperability.
Technically speaking, when our cash is sitting in a checking and savings account we are actually lending our deposits for interest. However, that interest is barely recognizable and we have no idea where our money is being lent and who is profiting.
This is fractional reserving banking in action. We deposit our money. Banks keep it safe and they used to generate a return. Now, we deposit our money. Banks technically keep it safe via Federal Deposit Insurance Corporation (FDIC), but only up to $250k. Banks lend it out and basically pocket our returns. Plus, we most likely pay service fees and other hidden taxes. Not anymore.
Lending was one of the first applications built on Ethereum, but now there’s many and they’re all striving for the best yield or interest on our deposits. Imagine that. Actually having our money work for us. Aave is a decentralized non-custodial (you never lose control of your assets) money market protocol. Essentially, you can deposit a number of different assets to lend for a return. The annual percentage yield (APY) varies from time to time and for different assets, but it’s much higher than our traditional banks, and can be even higher if you dial up the risk using Yield Farming protocols such as YFI and Cream.
Funding & Investing
In 2017, we had the initial coin offering boom (ICO). Projects would create their own tokens on Ethereum and do something similar to an initial public offering (IPO). Startups raised about $5.6B via this new mechanism. Yes, there were a lot of scams and yes, many of the projects have failed, fluttered or have yet to release a product. But, entrepreneurs and developers who had an idea and perhaps didn’t have the time, resources or network to raise enough funds could now bootstrap their projects and attract capital with this new platform. ICOs attracted a lot of attention and provided new investment vehicles for speculators. Life changing amounts of money were made for those who picked the right projects. The “Average Joe” now had their opportunity at exclusive venture capital like returns. However, ICOs also attracted the attention of SEC who’s laid a heavy hand on these projects in order to project investor from risky projects.
Some might say the SEC went too far, stifled innovation and pushed the innovation over seas to countries that have less restrictions or more advanced regulatory guidelines. But, the show never stopped as the DeFi ecosystem evolved and decentralized exchanges (DEXs) started becoming more popular. Now, projects can create their own token and rather do an ICO through a centralized exchange, tokens can be listed on a DEX like Uniswap where users can swap their ETH for that specific currency. No listing fees and less restrictions. The show goes on.
Creating, sending and exchanging value has never been easier, which is a good thing. It’s a symptom of technological advancement and productivity, which is a symptom of human engineering. Humans have been exchanging value ever since we needed something that someone else had. This was barter in the absence of money. Then as we evolved and trade began to dominate the human experience, the phenomenon of money came into existence from a problem called coincidence of wants. In order for barter to function, two parties must want the thing that the other party has. This was inefficient for obvious reasons and then we created money. A medium of exchange, a store of value and an unit of account. While money has had many names and has worn many hats, money is taking on a new form of programmability which may lead us back to similar times of barter. Except this time it’s the idea of Hyper Barter. In DeFi, we have a many different currencies, some more valuable than others for a variety of reasons, but each is programmed on a network tracking it’s data and price. Now, through decentralized exchanges (DEXs) anyone can trade almost any asset for another asset. For example, if I only have Venezuelan bolivars that are quickly depreciating in value and I want to to exchange them for US dollars, rather than go to a bank to get cash if even possible, I can swap my bolivar for bitcoin or ether and then swap for the USDC or DAI stablecoins. This is seamless and doesn’t involve any exclusive access, just a smart phone and an application. Taking this a step further and adding AI and other protocols. You can have your digital assets being swapped through multiple protocols and smart contracts. This could be via a trading bot executing a particular trading strategy for a target yield or via a shopping bot keeping track of online deals looking for the best vacation spots. This will all be happening in the background using self executing smart contracts and a variety of digital currencies exchanging value for value.
Insuring Value & Managing Risk
Insurance is coming to the blockchain and risk is now a shared across the ecosystem without the need for insurance company. Insurance has always been about financially coordinating people, pooling money together and figuring out how to deploy that capital in the form of a insurance claim payment. Nexus Mutual is a project that’s using Ethereum’s blockchain as financial coordination mechanism to pool capital in the form of tokens and allow token holders to vote on whether to cover a claim or not. Their whitepaper states that roughly 35% of insurance premiums are lost due to frictional costs in the system. Only 65% of premiums are returned to customers via claims, the rest is lost in distribution, operational expenses (including regulatory), capital costs and profit. Blockchain technology and smart contracts will strip out these inefficiencies and bring trust back the mutual system. No longer is trust in institutions necessary as it’s moved into the codebase. Nexus Mutal is in their early days and will start by providing an insurance framework for DeFi applications and faulty code execution that can be proven via on-chain data. They have plans to provide additional products such as Earthquake insurance down the road.
Analyzing Financial Data & Accounting For Value
The next and final two components of the financial services sector that are being transformed by blockchain are analyzing financial data and accounting for value. Blockchain is simply a tamper proof data structure that is shared by it’s network participants. All transaction data is readily available in real time. This allows for a continuous transparent data flow of information that dramatically improves capacity of regulators to scrutinize financial actions, for financial services to manage risk and for companies to take advantage of improved efficiencies.
Conclusion: A Quote from Chief Strategy Officer at CoinShares, Meltem Demirors
“If you abstract out the need for an identity and centralized intermediary, we suddenly create an open world marketplace that is defined by a completely new set of criteria, where everything that is programmable and tradable can be traded 24/7. The realm of possibilities of what you can now do — market, assets structure — all start to change.”
**This is not financial advice. Investing in bitcoin and cryptocurrency is extremely risky. Please do your own research. The ideas and news presented in this newsletter are my personal opinions and meant for informational and entertainment purposes only.