The True Power of DeFi: Composability
Why an open financial platform like DeFi will create a new world of finance that we’ve never seen before
As always, this article is made for educational purposes. This does not constitute financial advice nor trading advice. Past performance does not indicate future results.
Do not invest more than you can afford to lose. This is not financial advice; always do you own research :)
Poll 100 crypto enthusiasts what is the most interesting and compelling part about DeFi, and you’ll get a slew of answers.
Some will say decentralized — duh. We’re reimagining the financial system without any intermediaries, freeing ourselves of relying on third-parties to own our data and our money.
Some will say its global nature. Because of the lack of intermediaries, we’re free to send money to and receive money from anyone in the world — creating a truly global economy that the Internet imagined nearly 50 years ago.
For me, the most interesting thing is the composability of decentralized finance apps.
Composability. I’ve mentioned that word a ton on several of my blog posts. Now it’s time to dedicate some time to digging into what it means.
It’s definition from Wikipedia:
Composability is a system design principle that deals with the inter-relationships of components. A highly composable system provides components that can be selected and assembled in various combinations to satisfy specific user requirements.
A bit dense in technical language, but a composable system is one that is formed by parts that can interoperate with one another.
Another big word sorry — parts that can openly communicate with one another across different systems, and thus can be swapped in and out.
So essentially Legos.
Composability, in DeFi, is the ability for applications and protocols to interact with one another in a permissionless way — meaning they are constantly talking to one another and leveraging each other’s code, and therefore each other’s utility.
As a result of the open source nature of DeFi, these apps are leveraging one another to create a synergistic effect.
Apps can combine and form new forms of financial services never thought possible.
Building on our Legos analogy, DeFi apps are essentially Money Legos.
You can pick and choose which DeFi app to combine together to form a brand new financial product.
Because of this, Ethereum is often called the Infinite Machine — because it’s a blank canvas with infinite possibilities because of the composability of DeFi apps.
The Power of Open
Before we dive straight into DeFi’s composability, I want to briefly talk about why being open is so powerful.
Think of the world we live in now, which for the most part is built by Web2 companies with a ‘walled garden’ mindset.
These companies — the Googles, Facebooks, PayPals— fight hard for your attention. They pour billions of dollars to get you to sign up on their platform, so they’re not going to let you go so easily.
They built a whole ecosystem of applications to keep you in their network.
You want to send money? Use Venmo— all your friends are on here. Oh by the way, you can’t send money to people outside of our closed network, so no Cash Apps or Zelles. Just tell your friends to join PayPal! And by the way, here are a slew of other services that we offer you too.
You want to share a meme? It’s so easy to do on Instagram — just DM your friend! If they’re not Instagram, just tell them to join. Otherwise, you’ll have to screenshot this meme and send it them somewhere else.
Every new social media platform is a brand new social graph. You can’t bring your followers and connections to another app.
Every new marketplace is a new cold start problem of finding critical mass of buyers and sellers.
It’s because things are closed off. No one wants to share their users.
Now imagine if things were open. You can send TikToks to your Instagram friends. You can pay people on whatever wallet they choose, in whatever currency, through whatever network.
Zooming outside of software, imagine — instead of Uber and Lyft having separate drivers, and DoorDash and Postmates having separate delivery folk — there was a global pool of people going from point A to point B, and apps could place products that moved from A to B on this global pool of transportation, bidding for the best price.
This worked to an extent in the early days of Web2 social media platforms.
We played games like Words with Friends and Farmville, and all of our Facebook friends were there. You could share moments of these games onto Twitter, and you could even natively share Instagram photos on Twitter.
A global feed of content and friends that could interoperate anywhere.
Then Facebook realized that they were better off making money through ads to a captive user base, and shut off their API — preventing other apps from leveraging its rich social graph.
Let’s frame it another way. Imagine if an open network like GPS was built by private Web2 companies. You get GPS with your iPhone from Apple satellites but its coverage is different based on your monthly cellphone plan. Each company had their own GPS that only worked with their own products.
DeFi is Open Finance
The beauty of DeFi is the new crop of insane apps that leverage multiple apps into a brand new, never-before-seen financial product.
For example, Yearn.
Yearn is an auto investment product. People park their money in Yearn for yield. In the back-end, Yearn uses this portfolio and places them into other DeFi protocols to generate that yield.
Yearn places money into lending protocols like Compound, liquidity pools like Sushiswap or Curve. It essentially abstracts the investment and optimal rebalancing of these other financial products.
Alchemix builds on top of Yearn. It places money into Yearn to earn a yield, and while the capital is earning yield, Alchemix allows people to take a loan out against the allocated capital as collateral, and instead of paying off the loan, Alchemix uses the yield from Yearn to pay off the principal + interest.
How about Ribbon Finance?
Its Theta Vault runs a covered call strategy. Typically in a covered call, you have to hold the underlying asset — not doing much with it other than holding.
With Ribbon, its vault can also lend out the underlying collateral on another protocol like Compound and generate a yield. So you’re writing calls AND generating lending yield on the underlying asset 🤯🤯
So DOUBLE the yield for the same asset. No wonder why DeFi can generate up to 100%+ p.a. in yields.
There’s so many more instances of absurdly awesome strategies that can be done with DeFi — because of composability.
Staking tokens and then using that collateral to take out a loan. Adding liquidity to a DEX and using that liquidity to stake into another protocol to earn a yield.
Lending out a token and taking out the same token as a loan, basically multiplying the access to capital that you have.
Multiplicative yield from the same underlying asset. Pretty insane stuff.
And more and more use cases popping up every day. That’s the power of composability — infinite access to innovation from thousands of insanely smart developers.
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