What is "DeFi"?
What is Defi? Well, it stands for Decentralized Finance. In that past, we have always used Centralized finance, where there is a central authority that controls the flow of money. The government and the banks control it. They don’t really say they do, but they do.
They can print more of it if they want to, they can stop you from borrowing if they don’t want you to, they can even keep you from having a bank account. If they wanted to, at any time, they have your money, so they could change it and you couldn’t really argue against it. I mean you could, but how would you prove it? You gave your money to them.
Also, if you are running a business, they can limit what you do. For example, right now if you have a little magical tree business that may be medicinal… they can tell you not to bring in any money from the business to a bank… which means you can’t deposit it or invest it or keep it safe.
One more thing, traditional finance is quite expensive. Payday loans go up to 500%, Credit cards can average 25%, even personal loans can cost you 18% of your value. These are high rates, but you pay them if you need to, because that’s what you got.
The alternative is decentralized finance, where there are no banks, instead there are pieces of code that run and act as a bank. They are open to anyone, they don’t require you to trust them (because they are literally code just running a program - you can read through it and verify it won’t scam you), they are also censorship resistant and lastly, they are much much cheaper than traditional, centralized finance.
Decentralized finance is built on 3 main things:
If you don’t know what these are, we highly recommend you to check out our other videos on these topics where we break down the topics so simply using stories and analogies that even your grandfather could understand them. This is going to be a bit of a longer video, but it’s a very broad and growing topic.
Okay, so I have a friend who traveled to London a few years ago from the US. Of course, in London, the standard currency is Pound, while over here in the US, it’s Dollars. So naturally, he had to visit a foreign exchange booth and trade out his dollars for Pounds. Unfortunately for him, the fee was like 15%, so he immediately lost 15% of his money because that’s what foreign exchange traders do, tourists don’t know any better and they need local money, so some people are taken advantage of. Well, when it comes to Decentralized Finance, instead of a foreign exchange trader, we have decentralized exchanges where you can exchange your coins and tokens for other coins and tokens. The fees are usually very small, like less than half a percent, which is huge for anyone who regularly wants to trade their crypto assets.
Most popular decentralized exchanges, or Dexes, work in a manner where investors pool their money together and then traders can trade that money. The fee for each trade goes to the investors. It’s also all written in code, so it can’t change. A government can’t step in and say “You cant buy bitcoin anymore”. The fees are locked too, so they don’t change and rise to crazy prices like 15%.
Decentralized Exchanges open the world up to a whole new variety of tokens and coins. For example, Coinbase, the first centralized exchange to go public only allows you to buy and sell 32 cryptocurrencies. Since they are regulated by the government and have to abide by certain regulations, they closely analyze each coin before adding it. The most popular decentralized exchange, Uniswap, has literally hundreds of tokens that you can trade, and they aren’t regulated by anyone. That’s the decentralized part, there are billions of dollars locked up in these liquidity pools so traders can trade, but nobody can control these billions of dollars… they are just following a program that someone wrote. In fact, only investors could be the ones to pull their money out of the pool, but then lending rates would rise and new investors would come along. The code can’t be changed either, it is immutable, so in the crypto space, we like to say “code is the law”. Uniswap is one of the major exchanges on the Ethereum network and it has billions of dollars in it’s pools. PancakeSwap is another exchange on the Binance Smart Chain network that also has a few billion dollars of liquidity.
Another important pillar of defi is lending and borrowing. In fact, a huge part of our current financial situation in the world is based on lending and borrowing money, so it would make sense that the blockchain could do it better.
One of the reasons we can reliably lend and borrow with banks is because if we put down 20% for a down payment and never pay the full loan back, our government can come after us and throw us in jail. In short, there are legal consequences for not paying a loan back.
With crypto, this is a problem because one of the pros of crypto is anonymity. You could put 20% down and run away with the rest of the loan never to be seen again. We have to find a way to solve this. In fact, with the use of smart contracts, we can actually allow others to use our funds, while still keeping custody of them.
Here’s an example, Person A wants to earn interest on his coins, while Person B wants to borrow some coins. So Person A goes to Compound or Aave, which are two platforms that allow crypto borrowing and lending, and deposits his coins into a smart contract. Smart Contracts are just code that runs a particular function. In turn, he gets what are called CTokens, or ATokens, that are a representation of his original coin, plus interest. When we wants to, he just turns his ATokens or CTokens into the smart contract and they spit out his original deposit plus interest. The smart contract is created this way, so there’s no human being to do the calculation or have to do the transaction. It’s all automatic, by code. So that solves Person A wanting to earn interest by lending in a traditional way.
In the borrowing portion, Person B must do something called overcollateralize his loan. This means if he wants to borrow $100, he must put up $120. So if he runs away and never pays back his loan, the smart contract is written in a way that can pay back person A their coins plus interest.
What’s the point of taking a loan… if you already have the money?
Well, you’re probably thinking in United States Dollars. Say you have 10 Ethereum worth $1000, because they are $100 each, but you don’t want to sell them. So you put them up as collateral, and borrow $800 worth of Tether, which is a stable coin pegged to the USD. You trade that $800 around, make some, lose some, make some again, and now it’s time to pay your loan back. So you have $850 tether and you pay back the $800 loan to get your 10 eth back. Well, you already made $50 from the little trades you did and got lucky, but it has been a few months, and ethereum shot up, now they are worth $150 each, so now you have 10 eth at $150 each, so $1500 plus the $50 you made trading. Basically, if you believe in eth, have it, don’t want to sell it, but want to use the value of it, you can take a loan out on it knowing it will be worth more when you cash it out. However, if you traded, lost, gained, and lost, and had $750 USD… you would have 2 options. Option A is to front the extra $50 to pay back the full loan. Option B is to keep your $750 and you lose your 10 eth, which could be worth a lot.
Real quick, there is a second type of loan in crypto called a Flash Loan, which is a loan that lasts for like 10 seconds. If you could buy ethereum for $10 on Coinbase, but sell it for $11 on Gemini… you could make a dollar, and so you can use a flash loan to literally borrow millions of dollars. You write the flash loan to borrow $10,000,000, buy ethereum for $10, sell it for $11, and then pay back the original $10,000,000 in one small little smart contract that gets run in 10 seconds. You made $1,000,000 minus the fees you had to pay for borrowing, but they are small because the lender knew you would pay them back and it was for a very short period of time. This is a more advanced technique, but you could never perform this type of arbitrage in traditional finance.
3) Margin + Synthetics
Margin trading is a whole new beast. Let me explain margin trading in the traditional world real quick, then I’ll explain it in the decentralized world. Okay, so you want to buy the Apple stock, and right now it is at $100. Essentially what margin is, is a loan that will automatically sell your stock if it goes below your down payment. So to buy that $100 stock, you need a $100 loan, and the bank agrees to give you a $100 loan if you can give them a $20 down payment and a small fee of 5% a year. So here’s 2 scenarios that could happen.
The stock goes from $100 to $150. You decide to sell the stock, so you get $150, pay back only $80 of your loan - because the bank already had your other $20 as a down payment, and keep the rest, which is a profit of $70. Essentially you made $70 by only spending $20. This means you more than tripled your money. This is the power of margin, you use it when you think something is going to increase in value to multiply your own money.
Now, this is the second scenario, and it’s if the stock drops to $50. Well, with margin… you actually have to sell as soon as the value of what you bought can’t pay back your loan. So the stock starts at $100, then drops to 90, then 85, then once it hits $80… boom, the bank FORCES you to sell your 1 stock of Apple at $80, so you can pay them back the $80 you borrowed. So the $80 you made from selling the stock plus the $20 you gave them as the down payment equalizes the loan, the bank has their $100 they originally gave you. Now you have paid your loan back… but you didn’t profit anything. In fact, you lost your original $20.
In Centralized Finance, to trade on margin you usually need to be able to prove who you are, along with have a minimum of a few thousand dollars to have access to margin trading. The fees are also much higher than 5% usually.
In Decentralized Finance, Margin trading can be a lot quicker, open to anyone with money, and safer as well.
4) Yield Farming
Insurance is really easy to explain. For example, with car insurance, you pay $100 a month to protect your new Tesla. However, one day while using the autopilot feature, another car causes the autopilot to glitch and you drive into a ditch, unharmed… but totally wreck the car. Well, since you paid insurance, the insurance company pays you what the Tesla was worth so you can go buy a new one. They use statistics to predict how many of their drivers will crash their cars, and use this data to predict how much they would have to pay out each year to determine what the monthly price of the insurance is (which is also called the premium).
Well, with decentralized finance, the insurance company can be code. Let’s say a farmer wants to buy crop insurance, so if his crops die, he still has income for planting them and taking that risk. We could write a piece of code on the Ethereum network that says “If there’s any days this summer that are 95 degrees or hotter 4 days in a row, pay out Farmer Joe $100,000. However, he has to pay $2000 to initiate this contract”. So Farmer Joe can buy his crop insurance through what is called a smart contract, which is just code that sees if the conditions are met to pay him.
You might have 2 questions. 1) How does the code know if it is 95 degrees and 2) Where does the $100,000 come from?
Well, to connect the real world to the blockchain, we have to use something called oracles, which are trusted sources that become a bridge. We can create an oracle in our city that reads the temperature and is verified by a few people to make sure it can’t be frauded. Then the smart contract can reliably use it as a data source to decide if insurance requirements are met.
Secondly, the $100,000 comes from other people buying insurance that bought their premiums, but did not pay out because the requirements were not met. Just like an insurance company makes profit, people who provide liquidity to any decentralized finance platform may be incentivized with an interest rate to earn on their deposit.
First off, we need to understand the bridge of decentralized finance, and that is cryptocurrency that is matched to a real world asset. For example, DAI, Tether, and USD Coin are all what we call “Stable coins”. This is because their price is tied to the US dollar. Think of it like this, when you buy one for $1, a new USD Coin is minted. When you withdraw one, a a USD Coin is burned. So the coin is always worth 1 united states dollar. The purpose of this is to have a reliable way to buy and sell certain coins without having to buy and sell them - instead we can just trade them. Here’s a quick example of why this is beneficial.
Let’s say you bought 1 ethereum at $500. It is now $1000, and you want to sell because you think it is high. Without stablecoins, you have to sell your ethereum at your centralized exchange like Coinbase or Binance, and they’ll give you USD for it. Now, of course, they are going to take a cut of that transaction, they want a fee and they’ll take it. Also, the IRS makes you pay tax on any gains you make from trading or selling, too. Coinbase or Gemini will be snitching that you made it, so don’t try to get out of it. Then you can withdrawal from them to your bank account because you don’t want them controlling your money. A month later, ETH drops to $250 and you want to buy more, so you deposit your $1000 back into Coinbase, wait a few days for the transaction to clear, then buy 4 ETH and hold them. ETH rises again to $500, and you decide to sell, so you sell them to your exchange, bite the fee, and then wait a few more days for it to hit your bank account. That’s a lot of fees, taxes, and waiting.
Now, let’s say we utilized a stablecoin like USDC. You bought 1 ethereum at $500, and it raises to $1000. Instead of going through all that headache, you trade your 1 ethereum for 1000 USDC. A month later, it drops to 250, and you trade your 1000 USDC for 4 Ethereum. Then it raises to 500, and within 5 minutes you sell your 4 ethereum for 2000 USDC. The fees were less than 1% because you used a decentralized exchange to trade, which we will explain later, and you were able to trade almost instantly. Plus, the USDC was secure, and you trusted it because it’s code - it doesn’t change, unlike Coinbase or Binance or Gemini, which are controlled by the government and more importantly, PEOPLE. They have been hacked before.
Anyways, we are getting off topics, so that’s the purpose of stablecoins. You can be in the cryptosphere without actually using your government-owned bank. We take it for granted in places like US, but some countries are really limiting in how much money you can move around, or what currency you can buy from them. In fact, in the US, every transaction over $10,000 has to be vetted and approved. Meanwhile, using USDC, you can move $10,000,000 from one address to another address, without anyone blinking an eye and for like a $5 fee at the moment.