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).
Addressing Confusion!
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.
Given that BTC is finite, does this mean that eventually one person will just own the entire network with compound interest?
What makes you think the whole network will participate?
1 btc can be divided into 100k units (satoshis). So it is far more abundant (liquid) than you think.
Fractional reserve and levered lending in Bitcoin? What could possibly go wrong
Yeah that’s not it at all.
Fixed bottom of post.
You’ve got it backwards.
In DeFi, it’s *full-reserve lending*.
There’s always more collateral/deposits than loans outstanding.
You know… it took me a couple of seconds to understand what you meant. And now I get it. It looks like finance is going to experience some major disruption.
Every young person reading this right now, LEARN TECH OR BUST!!!!
Depends what you mean by ‘learn tech’. If you mean learn code, that is just too ineffective especially if there is zero experience. WSPs previously said, just learn how the shit works and invest in it.
But you are right in general
After fooling around with DeFi over the last few months, it’s glaringly obvious that this system is going to, at the very least, exist as a parallel financial system alongside the current model.
It may eventually dominate them altogether, but I imagine that even in the worst case scenario for banks, there will likely still be institutions and services that will go on to charge consumers for hand-holding fees and custody around these assets.
The current state of the UX for conducting transactions and managing your own digital assets could be better but isn’t all that complicated once you’re up and running with a digital wallet.
Worth reiterating that nearly ALL this DeFi is happening in various projects on the Ethereum network, by the way… There’s 25x more Bitcoin parked on Ethereum as wrapped Bitcoin (wBTC) than there is on Bitcoin’s Lightning Network.
It’s so blindingly obvious that ETH has a brighter future than BTC, as adoption of these dapps snowballs and as ETH remains the reserve asset for collateral within the system. Just checkout Uniswap, MakerDao’s DAI stablecoin, Aave, and Compound Finance to have your mind blown. They all are hitting milestoens toward decentralization and all of them are permissionless.
The big roadblocks right now are scalability and the transition to Eth 2.0
The network is congested and the cost of interacting with these dapps and executing smart contracts for transactions is currently fucking expensive. It makes little sense for most unless you’re moving major amounts.
Ethereum is also moving to a version 2.0 w/ a new consensus model (proof of stake) and improvements for scaleability. Progress has been slow, but with all the money + assets on the network, they have to get it right.
Sounds like CLO MBS abacus tranches from Goldman Sachs, who’s doing the credit rating on the collateral?
Again missing point we have updated the post. Please read last paragraph.
If you allow questions, how does the borrower of the Bitcoin make money to pay the interest if they can’t spend the bitcoin?
If they can spend the Bitcoin how can you, the lender, get it back if the borrower defaults since the Bitcoin is spent?
Thanks for the insightful overview
Again please re-read. You put up a BTC worth $10K. You borrow $2K against it. Of course you cannot borrow the full $10K because that would mean there is no colalteral.
If price drops or you don’t pay and interest keeps going up you get liquidated and automatically the BTC sent to them.
***we updated the post so its clear as day at bottom***
Wow this is insane, the potential is crazy
Thanks for clarifying
How do you evaluate risk in DeFi?
For example: Pool A offers a return of 10% and Pool B offers a return of 20%.
You wouldn’t choose Pool B if Pool A has a 10% chance of default (9% expected return) and Pool B is six times more likely to default (8% expected return).
In fact, depending on your risk tolerance, you might not choose Pool B even if it has a higher return than Pool A.
A few key metrics
+ How long has the pool been running and how decentralized is the project from the founders?
+ Has the code been audited (by Openzeppelin for example)?
+ Does the project that put forth the pool have bug bounties?
+ How much are the tokens farmed from the pool likely to be worth in the future?
It’s collateralized. Your risk is not default your risk is btc or eth price dropping
“ 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).”
How do I enforce this loan? What my recourse as a loaner?
Financial institutions are able to get collateral by force and/or lower your creditworthiness. I don’t see that being possible here(?)
Re-read it, if you put up $10K in collateral and you drop to say $2K because you don’t pay or the price drops you get liquidated
If you put up collateral to get a loan of course you cannot borrow $10K
***we updated the post so its clear as day at bottom***
Like the idea conceptually as it turns crypto into a productive asset.
Couple of q’s:
– “credit worthiness is a dead concept because you two agreed upon the rates”
It’s not a dead concept, it’s just that the assessment of credit risk now lies with the individual? Is that right?
– Surely the long term returns will just tend towards current P2P debt lending returns (perhaps slightly higher due to lower transaction costs). Free market interest rates are dependant on the IRR of available investment projects regardless of whether the currency is USD / BTC etc?
Is this a short to medium term opp to make higher returns via early inefficiency?
We’ll hold a Q&A later this month
Peer to peer lending is not a new or revolutionary concept and it’s not exclusive to bitcoin. Agreed that it’ll work better with the decentralized nature of crypto but without an institution in the middle you’re expecting individual bitcoin holders to properly price risk? More likely institutions will run the pools of cash, just like with current “peer-to-peer” lender lending club.
Agree it’s a cool concept but completely don’t understand how this means careers in finance are dead.
If you don’t see how this will be devastating for parts of finance if it works we can’t help you
As someone that’s been following this space since July…
$YFI is something you should seriously look at. It’s a smart contract that automates the top yields for farming… if you want to farm the yield farmers.
Andre the founder is a wizard with how quickly he’s pushing out new releases.
The other blue chips will be $LEND and $SNX
I just saved you lots of hours of research finding the gems
What are your thoughts about the SAPS/criminal case number posted on Andre’s sites? True or hacked maliciously?
Your analysis concerns me around the future need for governments, central banks and its impact on social stability.
At least there is no real spending market for crypto yet and it requires fiat as settlement and a central bank. When that day comes please give us a heads up as to which bunker to hole up in for a while.
Does not require fiat as settlement and central bank re-read the bottom
It’s a HELOC with no liquidation costs upon default. A higher volatility in the underlying collateral
Expanding. It’s like a no cost HELOC (positive for borrower) that has no liquidation aggravation upon default (positive for loaner). A frictionless transaction that doesn’t need middlemen and breaks the back of a support market of surrounding “facilitators”. Im simply a brick mason by trade forgive me if my terms are a little clumsy! Thanks guys for your insights
Low level way of looking at it – interest rates on loans will all be embedded in code through technology/cryptocurrencies, therefore banking/finance goes bust in the future.
Banks still win this war because they have access to nearly free unlimited money. They can arb for smaller profits because their costs are so low.
If this ever takes off, the goldman’s will issue their own crypos and take over the space.
This makes absolutely no sense and shows you haven’t read anything about the space. While your comments on stocks and investing for traditional markets have been useful this comment showcases that you don’t understand how it works at all. If you read up on it for a few days you’ll realize why goldman can’t issue their own crypto to change the industry.
If you borrow an amount less than your collateral and have to pay positive interest rate on it, then there is no value gained by the borrower. The lender gets free money without providing any value so nobody would borrow. The borrower could just spend his collateral without having to pay interest.
Situation A: with loan
Borrower gets to spend an amount less than his assets, but has to pay interest to the lender.
Situation B: without loan:
Borrower gets to spend an amount less than (or equal to) his assets, and does not need to pay interest.
Therefore nobody would borrow.
oops nevermind i get it, the value of the transaction is being able to avoid the transaction cost of converting between currencies, by borrowing and paying back in a set currency, while using the bitcoin as a separate collateral currency. its value proposition is that, bitcoin is a deflationary currency that continuously gains value in the long term, so there is an expected fee when you turn bitcoin into cash, so you might as well borrow cash and whatever interest you pay on the cash borrowing is strictly less than the transaction fee of converting bitcoin to cash. something like that
Stop leaking alpha bro
DeFi is so obviously gonna revolutionize the traditional financial system. These normie fintech companies are so dumb. Like, have fun waiting 4 days for a bank wire with your shiny new user interface.
I know it’s not a Q&A but —
Is there an easy way – especially as a New Yorker where for example, BlockFi BTC interest accounts are not feasible – to participate in this as a crypto holder?
Will ask again in the upcoming Q&A, thanks for the article WSP.