defi finance

Why DeFi will win

What if every bank worked together to improve finance for all, instead of competing to extract maximum revenue from every customer? This is happening, today, with Decentralized Finance (DeFi). Its most underrated innovation – Permissionless Composability – is causing an explosion of growth which will lead it to completely dominate global finance this decade.

Composability allows apps to easily integrate with each other. In traditional finance (TradFi) if firms wish to cooperate, they must hold meetings, negotiate a contract, figure out the API, build the integration, have staff on call to keep the API from breaking or going offline. They must write code to handle errors, latency and unexpected results. Then, after all that work either firm may decide they don’t want to cooperate any more, or maintain their API, and shut off access, wasting all that time and effort.

In DeFi these complications disappear. It’s open source and permissionless, you can look at how any app works and build an integration immediately. If you think you can do a better job you can fork them and build your own version. Uptime and latency is handled by the blockchain so you don’t need to worry about services going offline or not returning data quickly. Code is immutable so no one can change their API unexpectedly.

These innovations seem small in isolation, but when combined you can see how this system is a massive improvement over anything we’ve had before. Instead of fragmented, hostile companies writing the same code over and over, not working with each other, and needing many people to maintain this system, you have immutable, stable, open protocols that cooperate with each other. It’s no wonder DeFi has already replicated much of TradFi in under 2 years, and is far exceeding their rate of improvement.

The Curve Composability Wars

What does this look like in reality? An interesting example is the symbiotic relationship between Curve, Convex, and Votium.

  • Curve is an exchange focused around stablecoins (US Dollars, Euros etc). If you want to trade a LOT of one stablecoin for another it’s the best place to go because it has the most liquidity. These stablecoins are in pools of 2 – 4 coins, and when you trade you send the coin you don’t want to the pool and it sends you the coin you do want.
  • Curve has a token CRV. To incentivize people to use Curve, they give bonus CRV to anyone who provides liquidity to certain pools.
  • If you have CRV and lock it up you become a Curve governor and get to vote on what pools get those bonus CRV tokens.
  • If you have little CRV it’s hard to influence the protocol, and it’s unlikely you’d want to pay the gas cost of locking your CRV tokens for little influence.
  • Convex, a new app made by a different group, solves this problem by allowing you to lock your CRV in their smart contract, and get cvxCRV in return, which is a 1:1 equivalent to CRV but not locked, and gives bonus CVX tokens. Convex wants all the CRV tokens so that they can direct liquidity to pools of their choice.
  • Convex is a decentralized app run by CVX token holders, if you hold the CVX token you’ll be able to vote on where the CRV rewards from Convex go. All the additional CRV Convex earns is also given to CVX token-holders.
  • New stablecoin tokens such as Frax, Fei and UST are constantly being created, and these tokens want lots of liquidity so they are useful and other DeFi apps integrate with them.
  • Curve is where most people go to trade stablecoins, so these projects want to have large pools of tokens available for people to trade with.
  • To incentivize their pools to grow, via people adding liquidity, these stablecoin projects want CRV rewards to be given to pools involving their token.
  • They could do this in 3 different ways:
    • Beg Curve governors to allocate them tokens (unlikely to work).
    • Buy CRV themselves and direct CRV emissions to their own pools (long term effective, but could be costly).
    • Bribe Curve governors to direct CRV emissions to their pool (cheap and effective!)
  • These stablecoins now want to find Curve governors and bribe them to receive CRV emissions for their pools so they get more liquidity. How do they do this?
  • Enter Votium – an app that works with Convex allowing protocols to give bribes. It does the math, revealing the protocol giving the most profitable bribes, and allows CVX holders to vote for them. This makes it extremely profitable to be a CVX holder, as you not only receive CRV and CVX rewards, but bribe rewards as well!
  • What if you don’t have time to explore the different bribes each week and figure out who you want to support? Enter the Llama Airforce Union an app that works with Votium to automatically calculate what apps are giving the best bribes, allocate your votes to them, harvests the rewards, and auto-compound those rewards week after week.

In this tiny slice of DeFi there are 7+ different apps, made by different companies, working together in a cohesive ecosystem to benefit every participant. All these apps cooperate with each other, are open source, permissionless and immutable, and as an investor you are always in control of your funds. As long as there are no un-forseen bugs, you can invest and be certain none of these protocols will change or break for potentially hundreds of years. Your grandkids could still be receiving commissions and bribes from new protocols launching in 2070.

None of this existed even 2 years ago. Curve is 18 months old, Convex is 12 months old, Votium is 6 months old and Llama Airforce is 3 months old. The pace of innovation is continuing to accelerate and new alternatives that enhance this system are launched every day.

Now that curves tokenomics has been proven successful other companies like Frax and Balancer are adding a similar token their products, using the same smart contracts, so that Convex or similar can easily integrate with them too.

Curve itself is still innovating, and many more innovations will continue to be built on top of it. Some basic ideas:

  • A Wise like app where you can send money anywhere in any currency and it automatically uses Curve in the background to convert to your chosen currency at the best rate possible.
  • A Forex trading app that allows traders to get 10 – 100x leverage by borrowing tokens and swapping them on curve for the tokens they want. The liquidity required for borrowing could be provided by users in a curve like model too.
  • Smaller banks can provide cheap currency swaps and use curve in the background instead of having to keep large floats of every currency.

If anyone wants to build these apps they don’t need to go to curve and ask for permission, they don’t need to worry about being blocked or have the API break or change on them – they simply build.

Exponential Growth

Non-composable systems grow linearly, everyone builds unique solutions to each problem. Composable systems grow exponentially. When companies can build on each other problems only need to be solved once, companies can become building blocks for ever greater companies, and creativity flourishes. When you enter a non-composable space you must start from the beginning, building from scratch with little help from existing players. When you enter a composable space you start from the current state of the art, and can easily innovate from there.

How long do you think it would have taken traditional companies to build something like the Curve / Convex / Votium / Llama Airforce relationship? It may happen inside one company, but it’s unlikely it would ever happen across many companies. Why? The risk of things breaking down – what if TradFi Convex decided it doesn’t like bribes any more? Or Curve decides to get rid of CRV voting. All apps downstream of them would be screwed. In DeFi – code is immutable, once a smart contract is deployed it stays there forever, for everyone to build on top of.

We’ve never seen anything like this in finance. It’s a new paradigm and it’s super exciting to be a part of it. The rate of innovation is only going to accelerate, there are many apps building Curve like tokenomics with voting and bribing, and there are many apps trying to muscle their way into the curve wars, all of which grow the profit and usefulness of the system. This curve war is only a tiny slice of what’s happening in DeFi right now, there is so much going on that even working full time in this space I can’t keep up. It’s become fairly obvious that this is finance 2.0 and it’s only a matter of time until the rest of the world realizes that too.

defi finance

Decentralized Finance – Crypto’s Killer App

I recently discovered Decentralized Finance (DeFi) and believe it’s the killer app for cryptocurrencies that will propel them into mainstream use. DeFi is going to disrupt finance as much as the internet disrupted newspapers, and eventually it will change the world.

DeFi is financial services devoid of middlemen handling your trades. Instead of fail-able humans, you use an app that interacts directly with smart contracts on Ethereum, a decentralized worldwide computer that nobody controls.

Decentralized Lending and Borrowing

The simplest DeFi apps are lending and borrowing platforms such as Aave. On these you can deposit Ethereum based tokens (known as ERC-20 Tokens) and earn interest on them. Instead of your token going into a vault managed by humans, it goes into a smart contract, and you are the only user who can withdraw your money back out.

Where does this interest come from? Other users can borrow those tokens, and pay interest on them. They don’t borrow your tokens directly, but instead borrow from a pool of all the tokens everyone has deposited.

The interest rate for saving and borrowing are calculated automatically based on the ratio of deposits to loans for each coin. If you have tokens in high demand you could earn upwards of 10% interest on them! Current interest rates are 3 – 5% for stablecoins (Coins worth $1 USD or with little value fluctuation), which is better than any traditional savings account, and you can deposit and withdraw at any time.

What if the borrower disappears with your money? On these platforms all loans are over-collateralized, for anyone to borrow they must deposit some other tokens of equal or greater value. If their loan ever matches their collateral in value, they are automatically liquidated and their collateral is sold to pay off the loan.

Why would you use this if you have to deposit more than you borrow? Let’s say you believe Ethereum is going to go up in value, but need cash now. Instead of selling your Ethereum, you can deposit it, borrow USDC, and use it for your expenses. If Ethereum rises in value, you can sell some to pay off the loan. If it drops below the loan amount, it will be automatically sold to pay off your loan.

Decentralized Exchanges

Decentralized Exchanges (DEX’s) are applications which allow you to trade any ERC-20 token for any other. The most well known DEX is Uniswap. Uniswap runs 24/7 with no human managers, it’s all code. How does it do this? With a concept known as liquidity pools.

Imagine you go to your bank to trade US Dollars for Euros. Your bank has large supplies of both US Dollars and Euros available so they can swap them almost instantly, but they charge you a fee to do so, sometimes as high as 10%! Wouldn’t it be cool if you didn’t have to pay this? Wouldn’t it be even cooler if you were the one collecting the fees? This is one of my favorite parts of DeFi.

Uniswap isn’t a bank, it doesn’t have every token in storage waiting for you to make a trade with it. Instead other users provide those tokens. Lets say you have some USDC and LINK tokens you’re saving for the long term which are sitting in your wallet doing nothing. You could deposit these into a Uniswap liquidity pool, then when anyone wants to trade their USDC for LINK, or vice versa, you get a cut of the fees! You get to rake in the profits banks have been making for years!

Decentralized Stablecoins

Stablecoins are another fascinating innovation in DeFi. If you’d rather not hold Ethereum, Bitcoin or other volatile cryptocurrencies, you can opt to use a token called DAI. One DAI token is always worth 1 US Dollar, and keeps this value through some very clever algorithms. You can get DAI by either trading for it on a DEX, or creating it out of thin air by depositing ERC-20 tokens as collateral in a MakerDAO vault and minting new DAI. Like Aave if your collateral value drops below your DAI value it is liquidated and used to pay off your DAI loan.

With DAI you can participate in the DeFi ecosystem without worrying about the crypto market crashing and taking your profits with it.

Why is DeFi better than existing finance?

Do you know where your money goes when you deposit it in your bank account? When you buy shares do you know where they come from? Do you know how many rent-seeking companies front-run and take a cut of your trades?

Modern financial systems are extremely opaque, and firms like it this way. Being secretive and having powerful friends is useful in finance. You’re able to bend the rules and make risky bets, then bribe anyone who’s allowed to look behind the curtain. As an added bonus, if you make a mistake and lose it all, the government is there to bail you out.

This is in stark opposition to DeFi. In DeFi everything is transparent, you can see the code of the smart contracts you’re putting money into and all trades happening between everyone. Platforms cannot block your trades because they don’t like you or what you’re doing, and bad traders lose their money instead of being bailed out by their powerful friends with money printers.

DeFi is finance made open, transparent, permission-less, and fair. DeFi doesn’t care about your Nationality, Sex, Skin Color or Power. Everyone is on an equal playing field with equal ability to trade, earn income and make a mark on the world.

Remember what happened with Robinhood and Gamestop in January 2021? When the big players started losing money on bad trades they decided to manipulate the system to their advantage using their power. The firm Robinhood used to purchase shares decided they didn’t like retail investors buying Gamestop, because their purchases were hurting their hedge funds friends, so they turned off the tap and stopped retail being able to buy, manipulating markets to their advantage. This is blatantly illegal but they realized they can probably get away with it with a few bribes, I mean campaign donations. This kind of market manipulation isn’t possible in DeFi.

The risks of Decentralized Finance

DeFi is an unregulated, un-policed market. It’s like the wild west, both exciting and risky. There are scammers, rug pulls, buggy code and plain stupidity out there. You could lose what you put in. If you pay attention and take your time to understand what you’re doing you’ll be able to avoid most of it.

The biggest risk right now is what’s known as a rug pull. It’s where a developer will create a DeFi product, such as a decentralized exchange, yield farming opportunity, or loan system. But buried deep in their code is a backdoor, a way for the developer to steal everyone’s funds and ride off into the sunset. This has happened dozens of times and will probably happen again and again. You can avoid these by sticking to only the most well known, audited pieces of software. A great place to start is DefiPulse which lists the top apps by total value locked, most products at the top of this list will be fairly safe against rug pulls, especially if they’ve been audited.

Never put your money into a product less than a month old, no matter how good the returns are is, because some companies will promise the moon in returns only to take your money and run after they’ve accrued a few million dollars.  

Should you dive in now and start playing with DeFi with all the risks it contains? Maybe, but I definitely wouldn’t put your life savings in yet, or any money you’ll need in the next few years.

The biggest rewards go to the early adopters, but they’re also exposed to the most risk.  The more you learn the more success you’ll have as you’ll be able to tell good deals from bad and earn much higher returns than ever before, without the risk of being a day trader.

Even if you don’t invest anything it’s a super fascinating world to explore, especially if you love technology and finance and have an independent streak (which I imagine is true of most readers of this site). There are some brilliant financial tools being developed in this space, what I’ve described above is barely scratching the surface.

DeFi may not eat the financial system for another decade, but it will eventually. In the same way the internet crushed newspapers and TV, DeFi will crush traditional finance. When consumers have a plethora of choice, it’s unlikely they’ll stick with the legacy financial firms. You can’t stop permission-less, decentralized, open systems, and this is going to revolutionize the world.