The core functions of finance can be summarized as:

• Allowing individuals to smooth consumption across different life stages.
  Example: Saving while young → Spending after retirement.

• Allowing enterprises to borrow money today for investment and return value to society in the future.

"State" refers to uncertain future scenarios, such as:

• Economic Boom vs. Recession

• War vs. Peace

• House Fire vs. Safety

Financial instruments allow people to:

• Transfer risk (e.g., Insurance).

• Convert uncertain returns into more stable returns.

What people pursue is not "money itself," but the satisfaction derived from wealth.
Risk-averse individuals are willing to pay a cost to reduce risk.

The modern financial system relies on Intermediaries + Regulation to maintain stable operations.

• Banks

• Brokers

• Asset Management Companies

• Mutual Funds / Pension Funds

• Insurance Companies

Reasons for the existence of intermediaries:

1. Lowering Transaction Costs

2. Handling Information Asymmetry

3. Reducing Risk (Economies of Scale)

Objectives of regulation:

Assuming retail investors are vulnerable, requirements include:

• Disclosure rules

• Fraud prevention

• Risk warnings

• AML (Anti-Money Laundering)

• KYC (Know Your Customer)

Preventing the "Domino Effect" from causing the collapse of the entire financial system.

Financial activities must not harm innocent third parties.

Three major categories of instruments used in the financial system:

• IOUs (I Owe You)

• Promise to pay interest + principal in the future

• Lower risk, lower return

Suitable for:

• Conservative investors

• Pension funds

• Capital preservation needs

• Corporate ownership

• Residual Claim → Debts are paid first; shareholders get what is left.

• Returns come from:

  • Dividends

  • Capital Appreciation (Stock price increase)

High risk, uncertain returns.

Contracts derived from the value of an underlying asset.

• The buyer pays a Premium.

• Gains the Right (but not the obligation) to buy (Call) or sell (Put) at a fixed price.

• Both parties promise to trade at a fixed price in the future.

• An Obligation, not a right.

• Borrowing money to magnify gains, but also magnifies risks.

• Lack sufficient financial knowledge.

• Face high fees.

• Tend to trade too frequently.

• Portfolios are often inefficient.

Such as:

• Hedge Funds

• Large Asset Managers

• Pension Funds

• Proprietary Trading Desks (Banks)

Characteristics:

• Well-informed.

• Complex strategies.

• Ability to use leverage and derivatives.

• Strong execution capabilities.

Retail investors cannot access stock exchanges directly and must go through brokers.

If a broker has matching buy/sell orders internally, they do not need to send them to the exchange → they earn the Spread.

• Provides liquidity.

• Places a limit order and waits for execution.

• Consumes liquidity.

• Uses a market order for immediate execution, paying the spread.

The central ledger for the US stock market.

• Acts as the seller to every buyer.

• Acts as the buyer to every seller.
  Reduces counterparty default risk.

Extreme volatility → CCP required Robinhood to post additional margin (collateral) → Robinhood faced a liquidity crunch → Restricted buying.

Demonstrates:

• TradFi settlement lag (T+2).

• Massive capital pressure.

• High degree of centralization.

• SWIFT cross-border payments are expensive.

• Slow settlement (1–5 days).

• Layered fees by intermediary banks.

• Lack of transparency.

1. Store of Value

2. Unit of Account

3. Medium of Exchange

Banks do not keep 100% of deposits in the vault:

• Keep a small fraction as reserves.

• Lend out the rest.

• Thus, Commercial Banks create money (M1, M2).

This lecture provides Web3 learners with the underlying logic of traditional finance necessary to understand DeFi, covering:

1. The fundamental purpose of finance: Resource allocation across time and states.

2. The necessity of banks, brokers, and regulation.

3. The uses and risks of traditional financial instruments.

4. Behavioral characteristics of market participants.

5. How order books, clearing, and settlement systems operate.

6. The structure of monetary systems and pain points in payments.

7. Final comparison with DeFi:

   • TradFi: Opaque, Slow, Expensive.

   • DeFi: Transparent, Fast, Low Cost.

The core functions of finance can be summarized as:

• Allowing individuals to smooth consumption across different life stages.
  Example: Saving while young → Spending after retirement.

• Allowing enterprises to borrow money today for investment and return value to society in the future.

"State" refers to uncertain future scenarios, such as:

• Economic Boom vs. Recession

• War vs. Peace

• House Fire vs. Safety

Financial instruments allow people to:

• Transfer risk (e.g., Insurance).

• Convert uncertain returns into more stable returns.

What people pursue is not "money itself," but the satisfaction derived from wealth.
Risk-averse individuals are willing to pay a cost to reduce risk.

The modern financial system relies on Intermediaries + Regulation to maintain stable operations.

• Banks

• Brokers

• Asset Management Companies

• Mutual Funds / Pension Funds

• Insurance Companies

Reasons for the existence of intermediaries:

1. Lowering Transaction Costs

2. Handling Information Asymmetry

3. Reducing Risk (Economies of Scale)

Objectives of regulation:

Assuming retail investors are vulnerable, requirements include:

• Disclosure rules

• Fraud prevention

• Risk warnings

• AML (Anti-Money Laundering)

• KYC (Know Your Customer)

Preventing the "Domino Effect" from causing the collapse of the entire financial system.

Financial activities must not harm innocent third parties.

Three major categories of instruments used in the financial system:

• IOUs (I Owe You)

• Promise to pay interest + principal in the future

• Lower risk, lower return

Suitable for:

• Conservative investors

• Pension funds

• Capital preservation needs

• Corporate ownership

• Residual Claim → Debts are paid first; shareholders get what is left.

• Returns come from:

  • Dividends

  • Capital Appreciation (Stock price increase)

High risk, uncertain returns.

Contracts derived from the value of an underlying asset.

• The buyer pays a Premium.

• Gains the Right (but not the obligation) to buy (Call) or sell (Put) at a fixed price.

• Both parties promise to trade at a fixed price in the future.

• An Obligation, not a right.

• Borrowing money to magnify gains, but also magnifies risks.

• Lack sufficient financial knowledge.

• Face high fees.

• Tend to trade too frequently.

• Portfolios are often inefficient.

Such as:

• Hedge Funds

• Large Asset Managers

• Pension Funds

• Proprietary Trading Desks (Banks)

Characteristics:

• Well-informed.

• Complex strategies.

• Ability to use leverage and derivatives.

• Strong execution capabilities.

Retail investors cannot access stock exchanges directly and must go through brokers.

If a broker has matching buy/sell orders internally, they do not need to send them to the exchange → they earn the Spread.

• Provides liquidity.

• Places a limit order and waits for execution.

• Consumes liquidity.

• Uses a market order for immediate execution, paying the spread.

The central ledger for the US stock market.

• Acts as the seller to every buyer.

• Acts as the buyer to every seller.
  Reduces counterparty default risk.

Extreme volatility → CCP required Robinhood to post additional margin (collateral) → Robinhood faced a liquidity crunch → Restricted buying.

Demonstrates:

• TradFi settlement lag (T+2).

• Massive capital pressure.

• High degree of centralization.

• SWIFT cross-border payments are expensive.

• Slow settlement (1–5 days).

• Layered fees by intermediary banks.

• Lack of transparency.

1. Store of Value

2. Unit of Account

3. Medium of Exchange

Banks do not keep 100% of deposits in the vault:

• Keep a small fraction as reserves.

• Lend out the rest.

• Thus, Commercial Banks create money (M1, M2).

This lecture provides Web3 learners with the underlying logic of traditional finance necessary to understand DeFi, covering:

1. The fundamental purpose of finance: Resource allocation across time and states.

2. The necessity of banks, brokers, and regulation.

3. The uses and risks of traditional financial instruments.

4. Behavioral characteristics of market participants.

5. How order books, clearing, and settlement systems operate.

6. The structure of monetary systems and pain points in payments.

7. Final comparison with DeFi:

   • TradFi: Opaque, Slow, Expensive.

   • DeFi: Transparent, Fast, Low Cost.