What’s the Deal with DeFi?
Synthetix, Curve, Sushi, Compound, Balancer, Uniswap are pushing the envelope of DeFi with explosive yields and innovation like liquidity pool, yield farming, rebasing, automated market making. This article will explain some of the new terms and demystify DeFi.
Disclaimer: The article is meant solely for educational purposes only and is not intended for use as an investment directive. By viewing any material or using the information within this page you agree that this is general education material and you will not hold any person or entity responsible for loss or damages resulting from the content.
The familiar, unmistakable, clacking sound of tiles reverberates throughout countless neighborhoods from Havana to New York to Hong Kong. Wherever four or more Chinese are together, constituting a quorum of 4 “legs”, an unyielding force compels them to “open a table”, parlance for starting a mahjong game.
Mahjong, a 4-player, rummy-like game of strategy, psychology, probability calculation, and luck, is the national pastime of the Chinese although they are not the sole purveyors of mahjong. As witnessed in an episode of Seinfeld, George’s mother is playing with her other three Jewish table mates. Visit any Catskill resort, colloquially known as the Jewish Alps or the Borsht Belt, and mahjong tables are as common as a pastrami on rye.
I have yet to witness participants in both groups sharing a table of mahjong together. The Jews innovate and dominate finance, while Chinese food is their de facto cuisine on Christmas. It’s a recipe for a good financial hotpot.
Mahjong is the Abacus Edition of DeFi
But what does mahjong have to do with DeFi? Just as the simple abacus was a precursor to the slide rule and now calculator, the basic tenets of DeFi, such as the lack of central authority, have been around for a long time. This supports the notion that DeFi, based on technology, has a good chance of gaining serious traction.
Back to our mahjong game, say that Player A has a string of bad luck and is out of chips early in the game. One option would be simply to end the game and cash out. There’s no fun in that.
But if everyone agrees unanimously, as per the governance of this table, they’ll dole out another round of chips (tokens) to add liquidity, which is sorely needed by Player A. Decentralized quantitative easing! Problem solved; game continues.
By the way, the terms protocol, project, and platform are used interchangeably. Project refers to the whole thing, from the concept inception to the execution of the governance rules, tokens and technology. Protocol refers to the governance model and rules of the idea, while platform refers to specifically to the physical implementation what users interact with.
These rules govern what actions are triggered by specific events. In the DeFi jurisdiction the codes of a smart contract is law, and the administration is executed programatically. If certain conditions are met, then the smart contract will execute some code. There is no manual intervention whatsoever which is considered a good thing due to its efficient automation and impartialness. The smart contracts subscribe to specific data feeds, such as prices, known as oracles.
However, the oracles and its dissemination is now considered a potential security weak link. Imagine a nefarious source falsifies oracle data, triggering a panic selloff which then gives the attacker a steep discount. Chainlink is the dominant source of oracle data to most of the platforms.
Using the mahjong example, new (additional) tokens are minted for distribution. The specific details of each DeFi protocols’ rules — the how, what, and when, determine the usefulness and popularity of the DeFi platform.
Liquidity, Liquidity, Liquidity
The Ampleforth platform rebases daily to either expand or contract the token supply (if needed). No matter which way the platform adapts, your percentage of the pool stays fixed. Say you have exactly 1% of the pool’s supply of the AMPL tokens, while a runup on demand causes a price rise. So far this is just old-fashioned supply and demand mechanics.
Ampleforth calculates the actual price deviation of AMPL from its target price and mints more whenever the actual price > target. Conversely it may burn AMPL if the price goes the other. The adjustments are triggered only after it eclipse from a certain range.
After the adjustment, it then adjusts the amount of EVERY wallet holding AMPLs proportionally such that each wallet’s quantity retains the same percentage of the pool prior to the rebasing.
AMPL is referred to as adaptive money and the technique used is known as supply smoothing can provide much liquidity when needed without creating inflationary concerns, or vice versa. It’s enough to make the Fed chairchief question their job stability and polish their resume.
Liquidity is the grease for without which hampers economic growth. But like all things, moderation is key, as too much expansion of the money supply leads to inflation.
A platform needs liquidity in order to attract users. If there is no one to play with, the platform will naturally shrink. Build liquidity, and the platform will become more useful and gain further efficiencies. Likewise it will boost the value of the tokens normally granted to its participants, which attracts more users.
Liquidity Pool, Staking, Yield Farming
AMPL is not a stablecoin, although it self-gravitates towards a specific price target without any asset backing, unlike Tether (USDT) which is backed one-to-one with the US dollar. Participants are known as liquidity providers (LP) who are staking into the pool. The LP’s deposits crypto assets into a pool and receives governance token of that specific pool. Borrowers are often rewarded as well.
The two most popular DeFi use cases, borrowing/lending, and crypto exchange, both crave liquidity in order to operate efficiently. The fees and interest returns generated are somewhat modest, but not insignificant, especially when compared to traditional asset class debt.
However, there is an additional wild card at play. Many of the protocols, such as Compound and Ampleforth will try to incentivize liquidity participation by granting governance tokens. These tokens give you a seat at the table for potential governance votes. Mind you that the governance tokens have NO inherent value but if protocol becomes popular, their value can skyrocket.
You can also use these tokens as collateral to further leverage your position. It is these tokens that may supercharge your return. Some do, some do not.
It’s really a self-prophesying arrangement to attract liquidity. Once the total asset value (TVL) starts rising then the associated governance token will follow suit, which attracts more attention and liquidity to further push the token price.
Besides borrowing and lending, liquidity pools are also used to support decentralized exchanges or DEX. They differ from the more traditional exchanges like Binance in that they do hold your keys and its fully automated p2p exchanges. Instead of the order-book process commonly used by centralized exchanges to match up trades, Curve (love that retro DOS look) uses an algorithmic approach for price discovery which minimizes manipulation and offers lower slippages.
Slippage is the difference between expected price and executed price in a trade. Illiquidity is one of the primary causes for slippage. Prior to the recent introduction of new DeFi projects like Curve, many of the DEX’s were not as liquid to their CEX counterparts. But the incentivizing governance tokens really did its job to pump up the platform’s TVL, although its CRV token is down to $0.69 at the time of writing. Down from its all-time high of $54 less than 2-months ago.
Before I go into the risks, one can also juice up the yields by leveraging. Instadapp is a powerful UI tool that will calculate and configure a complete complex staking transaction which will leverage your crypto assets. Say you have to start with 100 Dai, a popular stablecoin by MakerDao that is pegged 1-for-1 with the USD. First you deposit your 100 Dai with Compound. Those 100 Dai’s are now earning their interest and service fees mentioned above. Compound will also issue you COMP tokens, which are the governance tokens from above. Hey they are worth a lot, so why not use the COMP’s as collateral as lend out more money. Depending on the desired degree of leveraging, and thereby risks, it’s possible to push total yields into the 50–80% range. Prior to Instadapp, one would have to look through many charts and decide on the appropriate complex trade and then manually step-by-step complete each leg of the trade. When it’s time to unwind your position, again, it’s a step-by-step process.
Before I list out the many risks, I need assert again that DeFi is a nascent industry and there are a lot of unknowns. First there are black swan events. Unforeseen runup on liquidity, or network bottlenecks that can cause a cascade of disasters. All at the worst possible time. In March of 2020, Dai had such an event, when ether, which is used to collateralize and mint Dai fell drastically by 50% in a day due to the pandemic. This in turn caused a cascade of liquidation of the underlying ether. But there was not enough liquidity to support the liquidation auctions causing Ether to fall further, and thereby triggering more liquidation. Maker, which is the protocol behind Dai had an emergency governance meeting and they decided to make good to those adversely effected.
The other risks are smart contract bugs which are transparently available on all the platforms. Some will have the code audited by an independent third-party to assess for potential defects. Yam, an unaudited project, had a spectacular runup in practically no time until a bug was discovered causing its top price of $40 a token to suddenly collapse to single digits. It is now trading at under $1.
Additionally, there are the potential for admin key lost, honeypot hacks, and other systemic risks, that being the unpredictability of the market.
Where is DeFi Headed
No one knows. DeFi is based on a lot of technological and financial innovation. In the past when you were assessing a technology play, you can judge what the potential size of the market, the competition, the value proposition, its technical prowess. These frameworks simply don’t apply to DeFi because it’s a brand new game.
It is wise to listen and learn, especially if you are interested in financial theories. If you simply want to participate in DeFi, as a learning exercise, then invest only in what you can completely afford to lose. Look for projects that serve the masses and solve real business problems rather than coins serving simply as rebates and rewards
You can also start off with simple, unleveraged staking which is relatively safe. When leveraging your assets, remember that the higher leverage, the greater the risk as there is less room for error if the price goes against your position and triggers a liquidation. The keyword is relatively.
If you really believe in DeFi and want to participate but would prefer to have professionals invest for you instead of trying to figure out all the current and upcoming protocols, Novum Capital’s DeFi Dominator product is a fully managed service that uses proprietary machine learning algorithms to perform a liquidity pool risk-to-yield index. While their DeFi product is new, Novum has a long and solid history of quantitative crypto trading.
While its tempting to participate in triple digit APY’s, it is very difficult to gauge the technical and financial hypotheses that new projects are devising and promoting everyday. Their governance token may spike up for a day, only to see finicky participants abandon it for the next hottest platform and wipes the feet from under the once hot token.
Here is a very simplified summary of how DeFi works:
- Come up with an “innovative” idea on how money works. Ampleforth came up with the idea of elastic adaptive money.
- Determine your governance rules, e.g., every holder of your token will get x tokens for y deposits, or z borrowing.
- Codify the details and implement the smart contract.
- Create the tokens, and build the platform which will be on a blockchain.
- Issue and list the token on an exchange.
- Attract liquidity, which increases popularity, which in turn boosts token value.
The investor would evaluate the pools based on which one is going to go up. Choosing the right one will generate enormous yields. The wrong one will be deflating. There is also the element of timing. Get in and get out at the right time is just as important. But there is no need to gamble.
DeFi’s premise is to remove the intermediary, by shifting the trust to technology, the blockchain, and the principles of game theory. Some view that DeFi will completely taking over and replace CeFi in an all or nothing struggle. While I admire their principles, I think it’s is just an added flavor or style of finance, and that the two will co-exist with synergies between them. The banking system can be reconstructed by a balance which takes advantage of the innovations and efficiencies characterized by DeFi along with the safeguards and central governance that are CeFi-centric.
As the industry matures and settles, DeFi can make further inroads by collaborating with institutional players who can further simplify, or water down some of the more complex protocols in an asset management advisory role or by creating investment products which invests in DeFi. Also they can provide tremendous liquidity.
DeFi is a radical shift in the control of money, and thus will reverberate effects which are too complex to predict. In a completely self-regulated system devoid of any governance, monopolies will still arise. DeFi represents a shift in that paradigm while improving efficiencies.
Money is a powerful tool as witnessed by its use by the US since the end of WW II. Will the Chinese’s digital yuan make forays against the dollar? The complex balance and its effects are impossible to model and predict. That is progress for you in the long run. And if you are reading this, then chances are that already ahead of the other 99 percentile.
Stay well everyone.