For one reason or another, we’re getting a lot of questions about decentralized finance. Typically when a new industry is created, it is quite difficult to explain as most people are not involved. For example, the number of people who know the difference between bitcoin and ethereum is likely small. For fun we’ll go ahead and explain what it does and that will then explain why we recommend going into tech instead of finance if you have the choice. Again. M&A is still around but we’d encourage you to avoid moving into capital raising activities.
Reminder of Basics: In simple terms, we’ve found a way to make digital money that cannot be replicated. There is a lot more to this but that is one of the main ideas. Before, if you got a digital item it was easy to copy/pirate and send around. Photos, videos, music etc. While many will disagree and say it won’t work, we have to go ahead and assume it does work. Otherwise the next step will not make a lot of sense. So we’re going to assume that these crypto items (Bitcoin, Ethereum etc.) are worth something and can be used as money. If you believe they are worthless, then simply put that view aside for a second and read on.
If We Have Digital Money, What Does this Do? If we have digital currencies that are secure, we could in theory let people borrow them. So if you own a single bitcoin but don’t need to use it any time soon, you could lend this bitcoin to someone else and charge them an interest rate. We’re not going to explain how all this stuff works since it’s a headache. Just imagine you’re holding onto one bitcoin and you don’t need to spend it for the next year or two.
So instead of spending it, you create a loan with someone else who needs the bitcoin. Again. Assume that there is a small economy where bitcoin is accepted as a form of payment.
What you do is simply create a loan that says “I will give you 1 bitcoin if you give me 1.02 bitcoins back in the future”. A easier and more intuitive example is a collateral based loan. So you borrow $1,000 US dollars and you let the person hold onto your 1 bitcoin until you pay them $1,050. If you don’t pay them, and the loan balance keeps going up $1,100 to $1,150 etc. the person is able to officially take your 1 bitcoin (the person defaulted on the loan).
Assume This Works: Now we can move onto the next set of implications here. If we can agree that a bitcoin/ether etc. has value and isn’t worth nothing, this means we now have a peer-to-peer loan market (Uber but for loans). So you can run around this network and find the best interest rates and make a return.
So if you have one bitcoin and want to make a return on it, you can loan it to person A for 10%, Person B for 6% or Person C for 8%. Well all else equal you’re going to loan it to person A so you can generate a higher return for yourself. You get to keep your crypto and earn a return on it as the coin is returned to you if the person fails to make a payment.
Since this is a peer to peer market, you can see how demand will change for certain coins/currencies. If the demand for Bitcoin is extremely high then you can probably get a high rate of return by lending it out. If there is high demand for ethers, you will get a higher rate of return for ethers. Now for those that are actually following the space you’ll recognize that this isn’t exactly what happened or how it works but we’re really attempting to bring it down to the basics/high level concepts.
Yield Farming: This part is extremely complicated for those that are not involved in the space. In short there are pools of money. So if you want to lend out your bitcoin you would actually put it up in a large pool of money that has bitcoins, ethers, etc. This pool is accessible by people who want to borrow the assets. In addition, a lot of the pools then issues tokens that paid people for holding their crypto assets within the pool. Hate repeating ourselves, but this isn’t exactly how everything works in perfect detail, but the concept is the same.
So if you have different pools of money with different return profiles and each pool incentivizes people to leave their money there, you can see how the returns will be volatile. If you know Pool A offers a return of 10% and Pool B offers a return of 20% you’re going to choose Pool B. That is level one thinking. Level two is that you could then in theory borrow from pool A and lend to Pool B. Since you have to pay 10% interest to borrow but can collect 20% in Pool B that’s a 10% return on “borrowed money”.
One Big Elephant in the Room: Well this all sounds good but who in the world is executing all of these loans/contracts? That is the point. It is done by code. Before, you had to go to an intermediary that would set all of this up based on a set of rules/laws. The rules/laws for liquidations and payments are all made with lines of code. We’ll let the reader decide what this means for a lot of services we have today.
Explanation with Correct Wording: Right now the vast majority of all loans are made using the Ethereum blockchain. Individuals send their bitcoin/ether etc into a pool of money to earn a higher return. By having it in that pool they may earn additional rewards for using that system. Since the space is new there are extremely high rates of returns. If you move money around in the system aggressively you can see yields upwards of 100%.
To be clear here, the higher yields usually involve a ton of risk and that is no different here. If you decide to borrow from one pool and put it into another pool, if the price goes down/collapses you could get liquidated in a matter of seconds. Any time you see extremely high returns you should acknowledge that risk is typically high as well.
For Those That Need Direction: Straight to the point: if this works you are the bank. You don’t need legacy banking services if crypto assets are able to function as currencies. You get to decide if you want to make loans (letting people borrow) and you can even decide on the interest rate. If you are asking for too much you won’t get any interest, if you offer an interest rate that is extremely low someone will take the offer quickly (worldwide).
In basic terms how this works. You put up $10K in bitcoin as collateral. You don’t want to sell your BTC but you need cash to pay for something (the cash is really USDC/Tether etc. but just imagine physical cash so its easier to think about).
Well you cannot borrow $10K. Why? Because if the price drops the person who lets you borrow $10K loses money.
So you can borrow say $2K at an interest rate you two agree upon. Therefore the contract held on the internet holds your $10K and you have to pay $2K back plus interest to get your bitcoin back. If you don’t pay and you owe *close* to what bitcoin is worth, you get liquidated and the person who loaned you the cash gets your bitcoin.
This is done automatically without an intermediary, credit worthiness is a dead concept because you two agreed upon the rates. You decided to take the loan at X% and he decided to give the loan at X%. If you fail to pay you lose your Bitcoin to him and if you do pay, you get your bitcoin back and never had to sell it.