DeFi 101: Crypto Utility For Everyone

For many, crypto is nothing but a speculative asset: a colorful logo tied to currency and a chart on coinmarketcap.com with questionable underlying value. The invention of DeFi and NFTs have shown that blockchains are about more than just digital coins.

Bigger than Bitcoin

Let’s start with the basic stuff. “Bitcoin” refers to a cryptocurrency, but also the blockchain network on which that currency exists. Bitcoin as a network has a very simple and efficient purpose: to facilitate the storage and transfer of value via Bitcoin as a currency. Today, however, we have blockchain networks that allow us to do more than just simple money transfer. The largest and most famous of which is the Ethereum network.

Source: Binance Academy — the yellow cubes represent “blocks of transactions” the blue squares represent the network of computers that verify and maintain a record of those transactions.

Then came smart contracts

Vitalik Buterin, one of the creators of Ethereum, was one of the first notable figures to campaign for a broader range of utility in blockchains through the concept of “smart contracts”.

Similar to traditional contracts, a smart contract defines a set of terms and conditions that are programmed on a blockchain network. As long as the terms and conditions are met, the contract is automatically executed (that will make more sense by the end of this article). An easy way to start thinking about smart contracts: “code on a blockchain” that allows you to do more than just simple value transfer like with Bitcoin.

Apps that execute these smart contracts on a blockchain are commonly referred to as decentralized apps or “dApps”. DeFi (decentralized finance) is the first breakout use-case for decentralized apps. It has existed in development since Ethereum was created in 2015 but only began to materialize as an industry in 2020. At the time of this writing, the DeFi industry has a total of $42 billion dollars locked into hundreds of protocols and hundreds of thousands of people using it to execute financial strategies on a daily basis.

What is DeFi?

DeFi stands for Decentralized Finance and represents a specific type of smart contract that takes a new approach to the traditional contractual agreements created by banks and other middle men in the finance industry. Broadly, these financial contracts exist in one of two spaces:

• Lending and Yield generation — Loans and interest. This is what bonds, treasuries and global financial markets do. Connect people who need to borrow money, with people who are willing to lend it for a yield (interest).
• Derivatives — the ability to gain exposure and protection from different types of events and risks. Examples include: options, futures and insurance contracts. These contracts are typically engaged in by more sophisticated investors.

Essentially, DeFi works by putting traditional “centralized” financial contracts in the categories above, into a decentralized technical format.

The devil we know

Traditional finance generally involves going to a bank or some other institution that offers financial products. You purchase a product and you hope that the bank honors that product. The easiest way to think about this is your classic savings account. When you open up a savings account, a contract is created between you and the bank that states that you’ll receive a specific yield (typically around 1%) as long as you hold a specific amount of cash in your saving account.

Oftentimes, people don’t have clarity on what the exact terms of their agreement with a bank is. Sometimes parts of financial agreements are intentionally kept private or vague to keep counter-parties and others out of the loop with what’s really going on. This is basically what happened with the mortgage crisis in 2008. There were a lot of agreements and a lot of assets involved but the financial system worked in such an opaque way that it was difficult to understand what was really going on. This lack of clarity and transparency is, in part, what led to a big boom and then correspondingly to a big bust in 2008. That bust had an impact on everyone even though they didn’t participate in the boom part of the process.

Changing the game

DeFi allows YOU to be the sole authorizer of what can be done with your money by using wallets and smart contracts. This provides three powerful benefits:

1. Complete transparency over what’s going on with your financial product. You can drill down very deeply to understand the condition of the contract. For example: what the collateral is, how much collateral there is, what format it’s in. You can see what’s happening on a second to second or “block to block” basis in the code of the contract or on block explorers. You can see exactly what’s going on in the financial protocol that you have your assets in. Blockchain infrastructure forces that transparency.
2. Control over your assets. Look at what happened with Robinhood or FTX. Everyone thought they understood that they could trade, and then suddenly, centralized forces decided what people could do with their deposits and holdings. In the case of Robinhood, trading was halted. In The more nefarious case of FTX, centralized actors used customer deposits to make risky bets and blew the money all away.
   With DeFi, you control your assets. Not a bank, not a broker, not a third party. You hold all your coins/tokens inside of a self-custodial wallet and decide what to do with them from there. You can send them to a financial protocol of your choice for borrowing, lending, trading, etc. If you don’t like how things are going in a particular protocol, you can remove it and put it toward another protocol. In most cases the protocols do exactly what they set out to do.
3. Global Yield — Right now if you go to a bank with USD you get 1% or less. If you go to DeFi with the USD equivalent stablecoin, you can often get much more. The reason for this is because DeFi protocols don’t have the overhead that banks do and can allocate liquidity more effectively through code. Think about how this is important at this moment in history, with the trillions of dollars of cash the US has printed likely to create inflation down the road.

Given these three benefits, it seems the only reason DeFi isn’t more popular is because enough people haven’t heard of it or taken the time to learn how it works. Even those who have been in crypto for a long time have made the mistake of holding their assets in centralized exchanges like Binance and FTX. At the very least, I think it’s worth limiting the risks of holding coins on these exchanges by setting up a self-custodial wallet like MetaMask or keeping it on a “hard” wallet like a Ledger. This way, only you are responsible for your coins. Self custodial wallets are the first step in understanding this nascent world of money without middlemen.

DeFi isn’t perfect. Lots of the tech is still maturing and if you’re not savvy you can expose yourself to financial security risks. That said, recent events have shown us why it’s worth building up an understanding of what crypto can offer through DeFi. Everyone thinks they’re in this version of the world where everything works reliably and transparently but they’re not. Things like the FTX insolvency or the Robinhood trading halts during the GameStop saga make it painfully clear that that’s not how the world works. There’s a better way and it has the potential to kick off the next great financial revolution.

Summary of what this post covered:

• Blockchains as a layer of value exchange
• The introduction of smart contracts allowing us to do fancier things with value exchange, namely DeFi
• The advantages of using DeFi over traditional finance and core differences between them
• The value of being in control of your own assets.

I may do a more practical post around setting up self-custody wallets, and selecting and using the right protocols. I’m learning to but if you have any questions feel free to hit me up @josh_maldonado