Crypto Investing Made Simple.
DeFi, or Decentralized Finance, is a set of protocols which utilize the blockchain to replicate traditional banking services in a programmatic way. Rather than a company or entity making decisions on which services can be provided to whom as in traditional finance (TradFi), these decisions are built into code and executed programmatically. In order to understand why these decentralized financial services are so unique, it’s useful to review how decisions are often made in traditional financial services. Borrowing and lending provides a simple example.
Let’s pretend Joe lives in Smalltown, USA and deposits money in his local bank, Main Street Financial. Joe deposits $10,000 along with 1,000 other people in his town. Main Street now has $10,000,000 on their balance sheet to provide financial products with. Main Street will use this capital to lend to people in the community - for mortgages, student loans, car loans, etc - or businesses who will pay varying levels of interest based on the type of loan and their credit score. This could be somewhere around 3% for a mortgage to a homebuyer with a good credit score to a 30+% for different loan types and people with lower credit scores.
Before the loan is approved, some type of credit manager or credit committee at the bank will review the loan application and make a decision. Much of this review has become automated or assisted by software, but the application is typically signed off by a human. The bank earns revenue as people repay the loans (i.e. 3%) and pay the bank depositors (~0.5%) who keep their money at the bank. The difference between the borrowing and lending (2.5% in this example) is how the bank makes money, along with fees.
Additionally, banks may package a bunch of these loans together and sell them as collateralized debt obligations (CDO’s), which are sort of like a bond but for different asset classes. They may also sell mortgage obligations to Fannie Mae or Freddie Mac. In this way, the default risk is passed off from the individual bank to another institution. To review, a bank takes depositor's money and decides who to lend out to. They make money on the spread between borrower and depositor interest rates or by selling securities. The same concept applies to other financial services as well. A market maker buys and sells stocks and keeps the spread between the bid (buy price) and ask (seller price). An insurance provider collects money from premium payers (think recurring depositors), and pays money out to people filing an insurance claim.
In DeFi, all of this is done without any central entity making decisions on any individual transaction. The parameters to connect depositors and borrowers, buyers and sellers, etc are written into code instead. The goal of any DeFi app is to provide financial services without the need for centralized actors to be making decisions regarding individual financial transactions.
Unsurprisingly, DeFi protocols share common principles with the broader cryptocurrency ecosystem. These include:
The first step in building an open financial system is to enable secure transactions that are guaranteed to be legitimate and accurate. This is the specific breakthrough that cryptocurrencies like Bitcoin or Ethereum enable. Different blockchains use different consensus mechanisms to validate transactions. Proof-of-work on Bitcoin and Proof-of-stake with Ethereum 2.0 are the most well-known examples, but others exist as well. While the mechanics vary between different consensus mechanisms, the intention is the same. Entities across the rest of the network - i.e. miners or stakers - are rewarded for verifying that every other transaction on the network is legitimate and accurate.
Validators are incentivized with financial rewards from the network to maintain the accuracy of all transactions on that network. In this way, they can be thought of as the “security force” of the network against potential bad actors. Whereas a typical financial transaction routes through a central entity like the Fed Clearinghouse to ensure all parties have the appropriate funds, with crypto this is all done programmatically and validated decentrally. This additional security and efficiency is what unlocks new possibilities for Decentralized Finance like in lending and market making.
Like a bank or a credit union, DeFi apps like Aave and Compound allow people to lend their crypto assets to a common pool which others can then borrow from. These projects will pay depositors an interest rate for leaving their asset there, and charge a different interest rate to borrowers.
Below are current rates on Aave for deposits, and both fixed and variable interest rates for borrowing USDC. Depositors can earn 5.26% for lending, and borrowers can do so at either 13.42% or 6.42% for fixed or variable rate loans.
Instead of assessing credit scores and reviewing a credit application for borrowers, Aave uses overcollateralized loans to hedge against the risk of default. This means that borrowers must stake $100 worth of ETH in a smart contract in order to borrow $75 of USDC from Aave, for example.
If this loan-to-value (LTV) ratio of 0.75 moves above some other predetermined amount, the borrower’s ETH may then be sold and converted to USDC to repay the loan.
Some types of loans work like this in TradFi, such as margin loans from a stock broker like Charles Schwab or Robinhood. With others, like mortgages, the bank waits until you stop making payments before foreclosing (repossessing) and selling the house to cover their loss. In both these TradFi cases, you would have first submitted an application to gain access to these loans. In Aave, the only thing that matters about you is what the LTV of your loan currently is. Everything else is handled programmatically.
On a traditional stock exchange like the NYSE, market makers help facilitate liquidity by maintaining inventory of a large number of stocks. They use this to provide buy or sell support in the market when there is a trade imbalance. If everyone is selling, they will step in and buy, or vice versa. They purchase and hold stocks at a Bid price and sell them at an Ask price in the market, collecting the difference. Thus, they act a bit like financial wholesalers - buying in bulk at a lower price and selling that inventory in the market at a higher price. As buyers and sellers enter orders, the trade is facilitated through an order book, which aims to match buyers with the closest possible price from a seller.
DeFi apps like Uniswap and Sushiswap have automated market making by using liquidity pools instead of order books. For any asset pair (i.e. USDC : ETH) the asset is priced algorithmically based on the amount of each asset staked in the pair. Users are incentivized to provide ETH and USDC to the pool as they are rewarded with liquidity tokens which entitle them to a pro-rata share of the trading fees earned on that asset.
The more liquidity there is in a pool, the more gradual the price will rise or fall, just as in regular markets if there are a lot of buyers and sellers. The less liquidity, the more the price can move on any given trade. The main advantage for Automated Market Makers using liquidity pools is the lack of sophisticated infrastructure and complex algorithms required by market makers in traditional finance.
While DeFi is open and permissionless, today it still requires an onramp from a TradFi institution to buy cryptocurrencies like Ethereum that can be used on DeFi projects. The typical user does this by creating an account on a crypto exchange like Coinbase or Kraken and then transferring funds from their traditional bank (i.e. Wells Fargo). Entities like Coinbase are often referred to as CeFi (Centralized Finance) and banks as TradFi (Traditional Finance). CeFi references the fact that while Coinbase or Kraken are helping users buy decentralized coins like BTC or ETH, they are still centrally executing all trades on their customer's behalf. Additionally, they also custody these assets on a user's behalf like a traditional broker.
Also like traditional banks, the major crypto exchanges all perform Know Your Customer (KYC) when onboarding users. Thus, they are similar to TradFi institutions in this sense, but are digitally native and focused on digital assets. You won't find a local Coinbase branch you can call to execute trades, as some people still might do with their Charles Schwab account in TradFi.
Once you’ve bought crypto, you can transfer these funds to a wallet which can be easily connected to a DeFi protocol. After connecting your wallet, you’re free to begin using the protocol. That’s it, no onboarding, forms to complete, or anything else required.
A common misconception is that cryptocurrencies are completely anonymous and thus used by criminals. Keep in mind that your crypto purchases and transfer to your own wallet for self-custody are all publicly visible on the blockchain. This is fundamental to all blockchains as its security relies on the rest of the network observing all the transactions.
Nothing is attached to a username, but like bank wires, you could theoretically trace the money to an individual if you knew their associated account numbers. In crypto, the same applies to your 26 alphanumeric “public address” which show up in each transaction. Think of these like a PO Box for your funds on the global network that is a cryptocurrency network.
DeFi has become a cornerstone of the crypto landscape, and the Web 3.0 ecosystem more broadly. Just as Amazon and e-commerce provided new ways for how we shop in Web 2.0, DeFi is unlocking new ways that we can invest and earn money in the Web 3.0 world. The analogy to shopping provides a useful example of the type of transformation we are beginning to see in Finance. For a long time we could only buy goods if we physically went to a store. Stores like Walmart would purchase inventory from suppliers, stock their shelves with these goods, then sell them to customers in person. With the invention of the internet came the rise of e-commerce. Now companies like Amazon could buy inventory themselves or sell other people’s inventory online through their FBA (Fulfilled by Amazon) offering. Instead of stores, Amazon only had fulfillment centers and shipped orders directly to customers instead.
Finally came companies like Craigslist and EBay who didn’t hold any inventory at all. They enabled their users to sell directly from one person to another. Although these companies were not decentralized (i.e. they could still ban certain users or products from selling on their sites), the commerce was.
Thus, the trend in shopping we’ve seen looks like this.
Walmart > Amazon > Craigslist
The same thing is now happening in Finance, except cryptocurriency is allowing true decentralization.
Charles Schwab > Coinbase > Uniswap
Just as no one could have predicted how Amazon, Ebay, or Shopify have changed the way we shop, it’s hard to predict how DeFi will change the way we use financial products. The one thing we likely can predict is that DeFi new technology will create new financial products and uses we’ve never thought of before.
Below is a current chart of DeFi projects and the type of financial product they are providing: