1/5 Demystifying DeFi From Planting Flags to Dow Jones REF
Wait .. what has planting flags got to do with the story of DeFi!
To understand DeFi (Decentralized Finance), we need to get a sense of how DeFi came about to exist and for that, we need to understand how asset classes evolve. And no better way to start than my every parent's favorite asset class - Real Estate.
As early humans settled down to form civilizations, 'real estate' grew as the most valuable asset class after precious metals. The first set of financial transactions that involve any asset class are buying, selling, and hodling. And the most obvious way of showing ownership on your real estate was 'planting of flags' - cheaper than building something fancy.
Remnants have stayed on even today in various forms - remember Neil Armstrong planting a flag on the moon! or Paintball!
And there obviously is the bit around making your real estate more attractive by planting crops on it which led to the first wave of 'differentiated' valuation within the same asset class.
Eventually planting flags got replaced by certificates (from leaf parchments then to digital sale deeds today) from a 'trustworthy' authority to overcome the operational hassles of planting flags.
As the ease of ownership increased, a bunch of rich dudes (investors) realized, “I have so much land and I am long on it, but all I am doing is planting flags .. how can I make passive income on it?” And that led assets moving into the world of complex ownerships, lending/ renting and borrowing, which over time evolved into more mature instruments like REITs and today AirBnBs.
In parallel, a bunch of smart bros (traders) thought, "Do I even need to own anything to make money" and that paved the way for complex instruments like futures/derivatives ala the Dow Jones Real Estate Futures (REFs).
Every asset class has 'broadly' followed a similar journey. Replace planting flags with lockers and planting trees with engraving emerald stones and you have the origin story of Gold.
If you take a step back, Crypto has taken a similar journey.
It skipped Phase 1 given it was inherently a non-physical asset. And the birth of Ethereum and Smart contracts added the first set of incremental "value". For the first few years since its inception, all you could do - was well buy and sell crypto. 2017s saw the rise of BitMex and the first applications at scale for derivatives and leveraged trading. The 2020s saw the rise of DeFi - financial applications on top of crypto.
I can lend and borrow BTC on my exchange. And also leverage trade. So is that DeFi? That is not DeFi - that is just crypto-financial applications managed by a central authority - the exchange in this case.
For the “decentralized” bit, we need to understand who defines the rules of the game and how the world got from Temple Priests to DAO’s
2/5 Demystifying DeFi From Temple Priests to DeFi DAOs: Who defines the rules of the game!
All finance started off as peer-to-peer (P2P).
Flintstones trusted Barney and parked his gold with Barney, who in return gave him rice grains. But as needs expanded, humans realized that you needed to interact (financially) with more than just the people you were friends with.
But hey! Can you trust others that they will return your assets?
So what do you do - you go to the only trustworthy person in your area - Temple Priests.
Temple Priests were the OG bankers and the temple’s the OG vaults. It worked great - every area had a temple, the priests were the educated lot and could be trusted upon. Given places of religious worship functioned as financial centers, you can now make sense of why rulers across civilizations ransacked them during wars.
But they suffered from an inherent inefficiency - they worked only within their city limits.
What do you do if you had to borrow from someone in another city? The Roman empire first established dedicated banking institutions free from the temples that spanned entire geographies and some of these institutions even outlasted the Roman empire. Remember the Knights Templar from Da Vinci!
The 16th and 17th centuries led to the formalization of the concept of Central Banks, where the governments started framing the rules of the game.
And then this nerd, Adam Smith comes along with his pitch, about ‘invisible hand’ and the concept of self-regulated economies. And that led to the rise of private banks and merchant banks, co-existing with government financial institutions.
So from you directly controlling your financial transactions (P2P), we moved to temple priests to the government and private banking service providers. And with that, the concept of never-ending paperwork and preferential treatment came to being. Humans are softies after all.
The ones at a disadvantage were the ones who couldn't take their Relationship manager out for a drink or whose pocket money didn’t have the requisite number of 0’s. And all this complexity - because you cannot trust someone you do not know, and you need an intermediary to do it for you!
And that’s where ‘Code is Law’ comes in. What if all the rules were coded on a code ( ‘smart contract’) that no one owns and couldn’t be tampered with. And who decides what those rules are - DAOs (a community in which you can be part of and vote on those rules). More details on DAOs in a future post.
And that is what DeFi essentially is - financial instruments for crypto built without any intermediary - laws purely determined by a smart contract code. Back to the original world of P2P!
Cool tech haa! .. But what’s in it for me
3/n Demystifying DeFi DeFi sounds like cool tech but why should I care?
There is the overarching philosophical perspective - decentralized applications leading to value accruals to the users and the builders than the central intermediaries, and the ethos of community-driven governance.
But let’s unpeel the layers and look at it from a tactical lens:
Crypto as an asset class has evolved and yet is volatile. Beyond directly investing in the price of an asset, one can diversify now and invest in a lower-risk yield based crypto-financial applications
With no intermediaries & capex, there are no fancy take rates and as such one stands to gain a higher return than traditional finance
With smart contracts in place, the rules are clear, transparent, and immutable. You know what you are going to get (no retrospective hidden fees) and get it quickly (offset days of paperwork)
If one were to go one level deeper, there are a bunch of specific use cases one can think of -
I am long on crypto. Don’t let your BTC and ETH lie idle on exchanges. You can make passive income on them by lending them to DeFi protocols.
I am a passive trader. Park your profits in high yield stablecoin money markets while you wait for the next dip
I am a gangsta trader. Start using DEXes (decentralized exchanges) where you don't have to worry about crazy fees on each trade you make
I love a good night’s sleep but still want to have exposure to crypto. Or it's a bear market and nothing looks good to buy but I want exposure to crypto. Yield generating DeFi is the place for you.
There is a bit for everyone in the DeFi space.
There is also something for the hardcore speculator and the degen leveraged trader but that is a story for another day.
Dang .. am I late to DeFi?
4/n Demystifying DeFi
I must be late to DeFi .. Just like I was to Bitcoin :(
DeFi sounds fascinating and one gets to make better margins so I am guessing a lot of crypto native audiences would already be using it. Right?
DeFi has just scratched the surface. DeFi today makes up ~$250B (less than 10% of the total Crypto market cap) and just 3% of all Crypto users have ever interacted with a DeFi service directly. And DeFi today is less than 1% of the market cap of all Trad-Fi banking market cap.
And that is because it is time-consuming and operationally a lot of hassle. Let's do top-level anatomy of a simple DeFi transaction -
You have some ETH and you want to lend it out on a DeFi platform. (Your exchange gives you ~1% on lending but a DeFi protocol may give you ~5%)
Transfer ETH from your exchange to a ‘private wallet’
From the 240+ DeFi protocols evaluate which one you want to lend to (Returns vs Risk of the specific DeFi protocol failing) by going through 30+ Discord Groups and 20+ Telegram channels
‘Bridge’ your ETH from the Ethereum ‘chain’ to the ‘chain’ on which you want to lend on a ‘bridging platform’
Spend ‘Gas fees’ to do the bridging (which is variable)
Lend your ETH on that protocol website/ app
The next day, you click to redeem your daily interest on the lending. And then repeat the previous steps in reverse to get the interest back in your exchange account.
So for something as simple as lending, you now have to deal with 4 applications (exchange, private wallet, bridging platform, and protocol) and your vocabulary just grew by ‘n’ new terms (private wallet, gas fees, protocol, chain, bridging etc.).
And that is why the user adoption of DeFi hasn’t accelerated at the pace at which buying and selling of crypto has.
DeFi is where exchanges were a decade back.
Back in 2013 when I first bought crypto I had to go through a similar journey of multiple applications - today it is a single click to buy bitcoin on your favorite exchange. Or the best analogy being - when your parents had to go through 8 different clerks to get their loan approved to today it is a single button click on many of the new-age lending platforms.
Okay so I get it .. DeFi is time-consuming.
But what were all those terms that you used and how do I get started?
5/n Demystifying DeFi
How do I get started?
In the last thread, we did the anatomy of simple lending transactions and we realize that to get started one need’s to understand a bunch of new jargon. Let's deconstruct.
Private Wallet: the simplest analogy to think of is your home locker to park your gold. Only you have access to it. That is a private wallet. When you park your gold in a bank locker, both you as well as the bank can technically have access to it. In a decentralized world, you are the sole owner of your wallet
DeFi Protocol: Think of them as a crypto financial institution equivalent albeit codes that drive DeFi activities
Chain: Think of them as the parent platforms 'rails' (potentially built on different technologies) on which protocols exist and transactions happen.
Bridging: Think of it as the process of moving one asset from one chain to another chain while retaining compatibility. An overtly simplistic analogy - Let's say you have a bike in Delhi and you recently transferred to Bangalore. And if you want to continue to use your bike in Bangalore, you need to change the registration from DEL to KA.
Gas Fees: This is the transaction fee that gets paid for transactions and gets passed onto the validators (folks approving the transaction).
All this is great but it sounds like a lot of work.
And I do not have the time to do the research on which protocols are safe and have the best alpha.
What do I do?
We at Pillow.Fund are solving this exact problem. As a user, all you get to do is Deposit and Withdraw while we manage everything else for you!
Keep an eye out. Coming Soon!