Chapter 6:

DeFi

A closer look into what permissionless Systems enable.

Chapter 5

Permissionless Systems

Chapter 7

NFTs & DAOs

ZacharyZachary
26 May 2022
May 2022

DeFi ecosystems are not just an assortment of financial services, but rather an interconnected web of permission-less systems. The essence of these applications is token utility and interoperability which is what we’re going to focus on in this chapter.

The idea of a crypto renaissance will come back at the end of the course but first, let’s clear the air on what the difference between coins and tokens is.

Today’s Agenda

Coins

Coins refer to the fee-paying currency that blockchains require to finalize transactions.

On the Ethereum blockchain, you pay transaction fees with ETH, its native coin. On the Solana blockchain, you pay transaction fees with SOL, its native coin. Bitcoin – BTC; Avalanche – AVAX; Algorand – ALGO; etc.

Tokens

Tokens are smart contracts that are deployed on top of a blockchain. They refer to both fungible and non-fungible tokens which can be confusing, especially considering that they function differently than coins. Smart contracts are self-operating assortments of code that can run on blockchains without any human interaction. Everything described below is possible because of smart contracts. A token’s programmable nature gives it qualities that have not existed before and they can serve all sorts of new purposes.

Smart Contracts

The fungibility and non-fungibility of any token are encoded into a smart contract, which again is simply a program deployed on a blockchain. There’ve been various software standards implemented that classify tokens and their functions such as ERC20 for fungible Ethereum tokens and the SPL standards for Solana tokens. These standards make it easy to create new tokens and DEXes make it easy to trade them.

If you can encode the fungible and non-fungible nature of a token into its program, what else can you encode? Well, this is where it gets interesting.

Tokenomics

An entire field of crypto has sprouted alongside the development of cryptocurrencies. This field, known as Tokenomics, is the study of the economic feasibility and utility of a cryptocurrency.

Investors will research a token’s tokenomics in order to see if there are any events they should be wary of such as team vesting schedules or community airdrops which may affect the value of the individual tokens themselves by putting more of that token into circulation. 

Many founders and entrepreneurs utilize tokenomics from a more experimental point of view where they try to learn from past tokens’ mistakes and implement a framework that leads to a healthy valuation and growth life cycle for whatever they are working on. So be cautious of the tokenomics of any new token you’re looking to invest in.

A cryptocurrency’s tokenomics can change and if you want an idea of how complicated it can get, read this.

Stable Coins

Stablecoins are one of the highest priority issues in the regulatory landscape. They are intended to retain a peg to another asset such as a USD. The biggest stablecoins in the world are USDT and USDC, amounting to roughly $100 billion in combined value. Each of these coins is intended to be worth $1 at all times and enable all the benefits that blockchains have to offer.

There are three primary types of stablecoins.

  1. Asset-backed – USDT and USDC are examples of asset-backed stablecoins where there is a supposed $1 or $1 worth of assets backing every 1 stablecoin.
  2. Over-collateralized – MakerDAO’s DAI is an example of an over-collateralized stablecoin. Users can deposit volatile collateral like BTC on the Maker platform and receive DAI in return. To receive $100 worth of DAI, for example, a user will need to deposit $200 worth of BTC (assuming that the loan-to-value ratio is 2:1). If BTC drops in value to the point where you are unable to trade it back for your DAI (LTV ratios fluctuate based on market supply and demand dynamics so this liquidation point can change).
  3. Algorithmic – Algorithmic coins are inherently more risky than the above types of stablecoins but there are a few out there that seem to work but it is unclear if this model is scalable. Terra Classic was a $60 billion example of an algorithmic stablecoin that did not work and was a predictable culprit of an algorithmic stablecoin death spiral.

There are other types of stable coins out there but the majority fall into one of the above categories and the majority are tied to 1 USD. Sure, you could tie a stablecoin to 2 USD or 1,000,000 USD. You could make a new cryptocurrency, call it PIE, and peg it to $3.1415926535 – although the ticker PIE is already taken.

There are of course stable coins pegged to the EUR, AUD, etc but most of the volume and use cases involve USD-based stablecoins.

DeFi

Decentralized Finance (DeFi) highlights the difference between owning something and possessing it. In traditional finance (TradFi), you are trusting intermediaries to do right by you every step of the way

Here are some examples of that:

  1. Every time you log into your bank account, you’re trusting your bank to tell you your accurate balance as well as give you access to it. The bank also gets to do whatever they want with your money and not tell you. 
  2. Every trade you make on a brokerage, you’re trusting that you’re getting the right price and not being front-run by the exchange that you’re trading with.
  3. Every time you buy something with a funded debit or credit card, you’re trusting that the bank will transfer the money from your account to the vendor’s account accordingly and that the vendor will accept the transfer. 
  4. Every time you attempt to open an account for any financial product or service, you are asking permission to do so. 

In most parts of the world, this trust is taken for granted. In the other parts of the world that have experienced currency failures and uncapped business and banking corruption, this level of trust is too much. Even in developed financial economies, this trust becomes a liability. If dirt ever hit the fan, do you really trust your exchange to let you withdraw your money?

DeFi has a tumultuous and weathered history but is now a massive hundred billion dollar market with room to grow. TradFi markets are worth hundreds of trillions. 

DeFi Llama’s Dashboard

Price Action

Crypto began as a single blockchain and a single currency. As a number of projects like MasterCoin and ColoredCoins popped up, Ethereum became the only one with staying power. 

Ethereum paved the way for decentralized projects to bootstrap their funding rounds by issuing tokens in their 2014 ICO (Initial Coin Offering) and this led to the ICO mania of 2017. Much has been documented about this time period as it was rife with scams and interesting celebrities attempting cash grabs while the price of Ethereum soared to nearly $1500 and Bitcoin to nearly $20,000.

In the following years, Ethereum would crash to less than $100 and Bitcoin would fall to $3200 during the Covid drop in March 2020. Then it was up only, down only, then up only, and now down only again.

Bitcoin’s Price Chart Since 2012

The macroeconomic environment is continually finding itself in an unprecedented territory so it will be interesting to see how Bitcoin’s price and the cryptocurrency market as a whole react to the upcoming decades. Again, crypto is barely a teenager and has many uphill battles to fight.

DeFi Summer & The Standard Stack

As Bitcoin and Ethereum recovered during the remainder of 2020 after the Covid drop in March, something known as DeFi Summer took off. This was a movement being built in the background since 2017. Protocols like Uniswap, MakerDAO, Curve, Yearn, and Aave took off on Ethereum and these protocols enabled the world’s first decentralized markets for lending, borrowing, and trading.

Millions and then billions of dollars poured into these protocols along with other applications. 

This period was rampant with innovation and at the same time speculation. Prices were going up at unsustainable rates and a number of protocols were failing while their tokens were going to zero. DeFi protocols like the ones listed above – that had some staying power – have inspired thousands of blockchain applications to be built across dozens of blockchains. 

There is a group of financial services that DeFi protocols inhabit that are mirrored on one new blockchain after the next. They have become the standard stack. Without the basic DeFi layer, blockchains are considered to be lacking. This is why you’ll see so many protocols that do the same thing on different blockchains. 

Oddly enough, Bitcoin does not have a developed DeFi network. Although it’s possible, the code is not built to foster DeFi and the development community surrounding Bitcoin is not keen on enabling it.

Case Study

To truly have an understanding of crypto, you need to participate in on-chain transactions. 

Let’s compare aspects of the trade process at ETrade, one of the world’s largest centralized exchanges (CEX), vs Jupiter Aggregator, Solana’s most advanced decentralized exchange (DEX). It’s not just a DEX, Jupiter is an aggregator of different DEXes. 

If you submit a trade and Jupiter finds two options for how to do it, you’ll be presented with the option that gives you a better deal. 

Caption: Jupiter Aggregator displaying 2 methods for buying $10 worth of SLRS

ETrade

Even just opening an account at ETrade involves jumping over some hurdles. 

To understand this full breakdown, you need to know what it means to be long and short. It’s weird phrasing if you’re unfamiliar but being short means you make money when the prices go down and being long means you make money when prices go up. 

Here’s the unabridged process for funding an account on a CEX.

  1. You open an account using an email and password. You submit government documents and perhaps a phone bill to verify your address. 
  2. You wait multiple days or weeks for your account to be approved. If there are any delays, it could be months – especially if you are opening an account on a crypto exchange.
  3. Your account is approved but now you have to deposit funds. If you choose to wire funds and pay wiring fees, you’ll usually be able to trade in 24 hours or so but regular bank transfers can take 3-5 business days. 
  4. In order for your deposit to go through, it has to be done during regular business hours which are 8 am to 5 pm. If you decide to deposit funds at 6 pm on Thursday for example – it wouldn’t go through until 8 am Friday and if it’s a bank transfer, you probably won’t have access to your funds until the next Thursday or Friday. 

The above processes are not even taking into account the number of centralized entities involved. The centralized exchange has a centralized custodian who possesses all of the stocks and options that people own. The centralized market makers have a much more in-depth understanding of current market conditions because they are privy to every single order. etc.

Market makers are known to play games. Below is an example of that.

  1. You want to buy 100 shares of Apple so you press the right buttons to do so. 
  2. A market maker receives your order alongside 100 other people’s orders and decides you are a gullible sap. 

The market maker sells you the 100 shares but not before buying 10 puts that represent a 10x exposure of being short to your 1x exposure of being long (a put = exposure to 100 shares of being short Apple). FYI, if they sell you 100 shares of Apple, they are technically short 100 shares, and buying 10 puts makes them long 900 shares. 

  1. The price of Apple goes up for a moment and you are in profit. Then, as the market maker predicted based on having more information than you, the price crashes. The market maker closes their 10 puts and sees that you are trying to sell your 100 shares at a loss. 
  2. The market maker buys back your shares for less than they sold to you after profiting from the collapsing price of Apple. Then Apple rebounds and hits all-time highs.

The centralized exchanges are often selling order flow in a business model called payment for order flow – PFOF, to market makers in exchange for the market makers to make markets. This is counterintuitive as it just makes the information asymmetry already present in finance that much more dramatic. PFOF is the reason you can trade without commissions. As is the case across much of the traditional internet, if you use a free product – it’s actually you who is the product.

Unlike TradFi, there is no default intermediary safeguarding your funds in DeFi and there are no traditional market makers. There are automated market makers (AMMs) which are the blockchain mechanisms that underlay DEXes. 

Jupiter Aggregator

If you want to open an investment account on a blockchain, you would be opening the same account that you need to operate on the blockchain in the first place – a non-custodial digital wallet – like Solflare. Sure, some fintech institutions are beginning to operate like this but it’s not the same thing. These fintech institutions can freeze your funds or delete your account at any time. 

Blockchains can’t do that. The only way you can lose access to your funds is if you lose access to your mnemonic or if you position yourself to be hacked by clicking on fraudulent phishing links or telling someone your mnemonic. 

Let’s open an account on Jupiter. 

  1. Connect your funded wallet.

Boom. Done.

Let’s make a trade on Jupiter. 

  1. Input how much you want to trade and wait for it to be confirmed. 

Boom. Done. 

There is no counterparty dependence. You’re not trusting anything other than the open-source code that is backing the Jupiter Aggregator and the underlying blockchain itself.

This trade would not be sent to a centralized market maker who will play games with you. Instead, it is being sent to an AMM which is utilizing a liquidity pool. In short, liquidity pools are decentralized pools of funds that come from individual Liquidity Providers (LPs). Liquidity providers are traders who lend funds to these pools in exchange for trading fees and potential liquidity incentives.

Conclusion

DeFi is powerful yet it is still only a toddler and there are of course growing pains. There have been dozens if not hundreds of blockchain application exploits and if you want to get involved, you really need to know what you’re doing. The remainder of this course focuses on the media’s favorite buzzwords – NFTs and DAOs. What is important to consider is these sub-industries within crypto are just logical extensions of what DeFi can do. 

Just remember:


We have a new extension