Momentum 6 Financial Literacy Guide (Lite)

The words you don’t know can cost you

TL;DR

• Clever money guys can make up big words to obfuscate the reality of their financial actions because they know most people won’t get past this TL;DR section.
• We won't understand why it fails if we don’t know the words.
• DeFi is creating a “level playing field” by building a suite of financial tools that are adequately fair, private, censorship-resistant, and globally accessible. They can’t be ready soon enough.
• We owe it to ourselves to understand how to use these new tools. We need to get informed, stay current, and keep learning the latest lingo.

Intro

Humans have argued about economic and monetary policy since we learned to reason. It’s hard to design a fair system that can’t be gamed or censored. It’s even harder to resist the temptation to make a little extra for yourself if you happen to find yourself being the sole issuer of a major currency. We’ve adapted by building clunky economic systems that usually fail on top of imperfect currencies that also usually fail. We can do better.

There are a lot of smart people in DeFi that have been working together to speed-run humankind’s entire history of financial experimentation. The industry is getting to a point where almost every monetary scheme ever existed was re-visited, attempted, restructured, and then forked at least a dozen times. DeFi builders have already discovered and built some of the best monetary mechanisms and governance models the world has ever seen. They’ll continue to test and experiment with the latest versions of their techno-modernized monetary policy and tokenomics to create previously unimagined economic concepts, then iterating, experimenting, and trying to break them. Technology’s seemingly endless exponential adoption means there are probably more people working to solve these age-old problems today than the rest of history combined, so I figure we can expect to have this whole currency issue wrapped up in the next 2 or 3 years max. To be more specific, we will at least know the best ways to structure universally acceptable, permissionless, censorship-resistant, and private methods of exchanging and storing value.

The pace of the world’s collective financial understanding is accelerating, and we think it’s a good idea to try and keep up. As for myself, I started this whole crypto thing with practically zero financial literacy beyond some basic understanding of interest, risk-to-reward ratios, and the most straightforward concept of supply and demand. One day, I caught a significant enough upswing while playing me. I was forced to start caring and learning portfolio management and capital allocation or watch my newfound fortune get chopped up and diluted. I spent 2… maybe 3 minutes researching “best resources to gain financial literacy” before writing this. This isn’t going to help you find the best way to structure a SEP IRA or figure out the long-term compound interest on your index fund. It’s just a collection of the resources I stumbled across as I began building a new financial vocabulary and some of the more interesting words I learned.

People Smarter Than Me

• The Calculator guy @phtevenstrong — Steven is basically a public good in the DeFi space. He analyzes new DeFi products, often building custom calculators to confirm or refute their claims. He has strong foundational skills and a rapidly growing knowledge base that can explain how the ed DeFi products function. He has everything from excellent beginner content to staking calculators for rebasing tokens and breakdowns of the actual cost of yield aggregators.
• Taiki Maeda @TaikiMaeda2 — This guy is responsible for at least 50% of my yield farming and liquidity mining knowledge. Very humble and always giving his honest opinions, Taiki does a great job explaining his assessment of current farming opportunities in the DeFi world and has plenty of older videos that are an excellent resource for those lacking that #FinLit knowledge. Max out the playback speed and make up for the lost time. Full disclosure: I’m a bit biased because, like me, he’s an ex-online-poker player who switched careers when he realized the opportunities in DeFi. We use similar probability-based risk assessments that are habits left over from grinding thousands of poker tournaments. I also recently wrote a little story about how studying poker taught me a bunch of things that have been useful in my new crypto career:

Pocket Apes: How my poker skills have helped me navigate the calamitous landscape of crypto…

• Captain Rational @noahseidman — He talks like he knows, but he does, so I put up with it. His insistence that you approach your own market participation from a carefully constructed long-term view shouldn’t be ignored. Among many things, He’s taught me a lot about differentiating between ‘growth’ and ‘value’ investments, how to find reasonably valued companies and protocols that generate revenue, and to understand how they do it.

This is just a starting point, but even if you only speed run a few lessons from each of these guys, you’ll get a much better sense of what else you need to learn.

Glossary

Here are some new words I picked up along the way. None of this is Literary Advice. These are my own (somewhat) peer-reviewed definitions; always consult a professional dictionary before making decisions with financial words.

• Rehypothecation — the re-use of collateral held for a loan to finance additional loans. A practice where financial institutions like brokers and banks reuse the assets posted as collateral by their clients to secure their borrowings. Clients are rewarded with a “lesser cost of borrowing”. They use customers’ deposits as collateral to borrow extra money for themselves. It’s a fancy word that was made excessively long and challenging to obscure its definition. This strategy isn’t necessarily a ticking time bomb, but it must be used responsibly and have appropriate trust guarantees.
• Looping — it’s kind of like self-directed rehypothecation. This is when you deposit assets on a lending platform, borrow against your assets, then deposit the borrowed money right back into the platform to earn additional APY on money that’s not yours. simplified example: Put 2 million bucks on your favorite lending platform (Aave, Banker Joe); it’s earning 10% APY. ($20k) borrow 50% of this deposit that will cost you 15% interest. (it will cost you $15k to borrow another million) Deposit your borrowed money ($1M) that will also earn 10% APY ($10k). Total Interest earned: $30k. Cost to borrow: $15k.
  Congratulations, you made money. But in this example, you underperformed versus just not borrowing at all. It could be a much more rewarding situation if you’re lucky enough to find a reputable lending platform offering some decent liquidity mining incentives. These protocols compete for TVL and users, so they’re often willing to subsidize new users’ ‘cost-to-borrow’ by rewarding them with their native tokens for borrowing assets. Polygon launched an extensive incentive campaign when Aave was first established on the network. This glorious period was when lots of us Degens were getting paid quite well to borrow money. An added bonus was that the MATIC token wasn’t quite done mooning, so those courageous or reckless enough to keep accumulating MATIC tokens were paid way more than the advertised APY for re-supplying our borrowed money. Most new and competing lending platforms soon adopted similar strategies to attract new users, and it’s become a standard practice in the crypto-lending industry. The challenge is to keep up with the rotations as the incentives programs start and stop on so many different chains and platforms.
• Liquidation — the process of closing a leveraged position when there’s not enough collateral backing the loan. When traders borrow money to bet on stocks or coins, they’re required to deposit a healthy value of collateral relative to how much they’re borrowing. If the value of your collateral falls below their threshold, they take your coins to cover your debt. This could be 100% of your collateral if you’re mashing buttons. If you’re leveraged, you’re trading with their money, not yours.
• Usury — yeah, I said it. We have to go back this far to really get a glimpse of how this particular financial language was formed. I found the most straightforward definition was “an act of economic injustice caused by collecting [excessive] interest on loans.” Save your opinions for a moment. We need to face the basic idea to make sense of the words they invented next. What’s most interesting to me is regardless of how you feel about that quoted definition, crypto has created the tools that allow all interested people to participate on both sides of this lender-borrower relationship, including letting you borrow from yourself. So what’s important is to focus on the impact that monetary policy and economic incentive mechanisms have on the likelihood that a lending platform starts leaning more towards the “excessive” or “financial crisis” end of what we could call the “fair amount of interest” spectrum.
• APR vs. APY — APR is the rate your money is earning interest (this equals the fraction of your annual yield that’s equal to the APR period length). Example: you have $1k in a turbo degen farm earning 365% daily APR. (good for you). This means you’re earning 1% of your deposit each day. In this case, that’s $10. After 30 days, you’ve made a 30% ROI on your investment. If you deposited your daily yield right into the same farm every day, and the farm can keep providing this return for an entire year, the compounded total is way more than 365% annually. More like 3,678% for a total of $36,780. That’s almost 15% of your next Lambo.
• Algorithmic Stablecoin — a(usually) dollar-pegged stablecoin that’s not backed by collateral assets. Instead, these rely on secondary token mechanisms that burn or mint new tokens to maintain the desired peg.
• Rebasing — adjusting the supply of a currency relative to its market capitalization or another currency or asset. It’s like if the U.S. government added 40% to every dollar their citizens had in their bank accounts and under their mattresses to compensate for the loss of purchasing power that occurred when they printed such a massive percentage of the total circulating supply of dollars. This would be hard to do in real life, much easier with crypto. It’s an excellent example of using economic incentives to help a currency maintain a peg. A good analogy is a stock split. Rebasing allows the necessary percentage of the newly created or burned supply to be distributed to or removed from current holders while their share of the total supply remains unchanged.
• Loan-to-Value (LTV) — the maximum amount of money you can borrow based on the value of the collateral you are supplying. This number can vary depending on the type of collateral you supply (how volatile it is) and your platform.
• Open Interest — another noteworthy word. Open interest is fundamentally a measure of liquidity. The number of options contracts are currently open or outstanding. A relatively high amount of open interest and volume means options traders have a friendly, liquid market. (volume is tracking the number of traded options per time horizon-daily, weekly, etc.)
• De-Leveraging (unwinding) — reducing debt. Usually by selling assets or collateral. This one makes the list because it’s fun to describe this process in DeFi. You need to reverse the process that got you looped in this deep. Luckily many platforms have this function streamlined for your convenience. You send your request to the contract, and it will withdraw some of your super-pumped collateral, use that to repay part of your loan, allowing you to withdraw another chunk of collateral that you borrowed from yourself, repay more of your loan, and repeat this process 3 or 5 or 20 times until you’re entirely unwound.
• Cascading Liquidations — a chain reaction of liquidations. In addition to the utterly spectacular swings crypto makes all by itself, bigger macro-market events also cause occasional massive moves. These events often cause cascading liquidations. When a crash is significant, people are forced to sell some assets to supplement margin accounts or restore their LTV ratios on any borrowed. This pushes the price down further. If it moves hard enough, it creates a new class of forced-sellers that weren’t expecting such a dramatic drop. This can keep going until everyone’s margin accounts and collateralization ratios are back in an acceptable range. I’ve often heard this referred to as flushing out the leverage in the system. In the 2008 crisis, the deleveraging that needed to happen ended with an epic saga of unexpected plot twists and meandering corn mazes of fiduciary alchemy. We learned some brutal lessons. DeFi tools are becoming available to prevent that kind of opacity. We can still over-leverage and blow up our accounts if we want. But it’ll be much easier to know with very high certainty whether a DeFi protocol is solvent and where everyone’s assets are at any given moment.
• Delta Neutral — a strategy for minimizing exposure to any specific asset’s volatility. You balance short and long positions to negate any movements in price. Why? So you can yield farm with an insane amount of a highly volatile asset and get some crazy yields without being exposed to the dumping price, and because lending protocols like to sometimes incentivize users to borrow.
• Liquidity Mining — using your capital to provide liquidity for a pair of tokens traded on a decentralized exchange and being rewarded native (or a 3rd party’s) tokens. This is subject to a risk of ‘Impermanent Loss’ that needs to be considered versus the projected value of the reward tokens you’ll receive.
• Impermanent Loss — the potential to miss out on upside or lose a percentage of your initial capital when providing liquidity to a pool for a trading pair. As a liquidity provider, you are exposed to the relative volatility of the two tokens in the pair. If one token goes way up in value and the other stays flat, the impermanent loss is the upside you didn’t get because the liquidity pool traded some of your mooning tokens for more of the boring token. Over-simplified example: you provide $200 of liquidity for the MoonCoin and DollarCoin pair. They both cost $1 when you enter the pool, so your ‘pool share’ is 100 of each token. 5 minutes later, MoonCoin doubles in value. For this to happen, people will have traded lots of DollarCoins to get some MoonCoins, so the liquidity pool will now be a different ratio. In this instance, you would now have 150 DollarCoins and 50 MoonCoins. You still have all your capital, but if you hadn’t provided liquidity, you would still have 100 of each token, and your MoonCoins would bring the current value to $300. You missed out. This is not exactly how the math works, but it helps grasp the concept. The important part is that your IL is relative to the expected result of just holding bare assets. So why do it? Liquidity providers are rewarded with a percentage of the fees collected from each swap transaction; a combination of this and additional incentives offered to LPs can often outperform the IL risk. Also, if you’re providing liquidity for a pair of equally volatile assets and both of them start mooning, it paints a much prettier picture for the LPs. See our Tweet on IL:

• Risk-to-Reward Ratio — how much upside is possible versus how much downside is possible. If you think your favorite meme coin can only go down 10% from where it currently is, and its previous all-time-high is a 10x from here, you have an excellent R:R.
• Capitulation — when market sentiment becomes very bad and excessively hopeless and too many people are panic selling. The overall market becomes unreasonably undervalued. You usually don’t want to try to catch falling knives, but it's like a rubber band if you can recognize when this event is happening. The further it stretches down, the more likely it will snap back. Look for signs like extreme pessimism, lots of bickering on Crypto-Twitter, and new record-breaking quality memes.

Advanced Section

Determining the value of a project is hard if you don’t understand the metrics. Here are a few of the more common terms you’ll hear when discussing fundamental values. This is another dictionary-worthy topic; I just picked out the ones I’ve found the most useful.

• Market Cap Dominance — the percentage of a market sector controlled by a specific protocol (or company). Understanding this metric helps us understand the size and total addressable market and can help us decide how much market share a competitor can potentially steal.

• Price-to-Earnings ratio — the value of a company’s (or protocol’s) current stock/token price relative to their projected income minus expenses. This shows what investors are willing to pay for a company’s projected returns.
• Fully Diluted Valuation — a method of calculating the potential future market cap of a project by considering all future token emissions and unlocks. Max possible supply multiplied by the current market price.
• Risk-Free Value — the fraction of a protocol’s market cap backed by assets that have real value. This number is determined by taking the current value of a project’s market cap minus the value of the assets managed by that protocol’s treasury.
• Trading Volume-to-Market Cap Ratio- This is a metric for determining the fees earned by a protocol relative to its market cap. This is useful for gauging the current value of a DEX versus its earnings.

Fundamental Analysis is worthy of its own article; we’ll probably slap together something soon.

Literally Finished

This got a lot longer than I planned. I hope it clarifies some concepts for those still trying to piece everything together. One of the significant advantages of permissionless protocols and open source software is that we can all work together as a global team to watch out for suspicious over-complicated financial language, analyze and understand it, and then share the details with the whole world in an instant. This way, we can keep hyper-crowdsourcing the answers to some fairly complicated monetary policy questions and finally finish building something humankind has never seen: A universally fair financial system.

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