Decentralized Finance — in a nut shell
No Financial Advice — This content is solely for educational and informational purposes. Any investment decision you make should not be based on the information offered here. Make sure to Do Your Own Research!!!
A View from Value Investor
If someone had approached me six months ago and suggested that I should invest in crypto currency, I would have refused to listen. I’ve never encountered any easy money in my entire investment journey. When I find investments that appear to be too good to be true, I always ask questions.
I’ve heard the boom and bust of several bitcoin cycles over the last decade, but I’ve paid little attention because I’m still profiting from stock investments. However, this time is different since this cryptocurrency market has entered a bear market in mid April 2021. So many folks in my immediate vicinity are bemoaning their losses. I began to see that many of them were placing excessive bets on these assets.
The first thought that came to me was why do so many individuals spend their lives saving for an intangible asset that they could lose all of their money on? And that was the beginning of my journey!!! I spent weeks after that diving deep to learn the essence behind the buzzword “crypto currency”.
Following the creation of Bitcoin, there have been other crypto assets (i.e. Alt coin) that have risen and fallen in value over the last decade. In the beginning, Bitcoin dominated the market, accounting for 90 percent of total market capitalization. Until recently, the increase of Alt Coin supremacy caused by a paradigm shift in the financial industry due to encryption technology and smart contract philosophy. This shift refers to the introduction of Decentralized Finance (DeFi).
In a nutshell, DeFi is a financial system that eliminates the middleman, such as a bank, broker, asset management, insurance provider... Some of the crypto assets’ potential to provide economic value rather than merely being just a store of wealth. These digital assets are analogous to the traditional finance that people with my age 👨 are familiar with…
Many investors believe that Bitcoin ($BTC) is similar to gold in many ways, including scarcity, fungibility, durability, verifiability, and decentralization. Ether ($ETH) can be thought of as a commodity (similar to utility gas) that is necessary to run a business. Lending platforms (AAVE, Compound, Maker) can be thought of as a bank that manages deposits and loans. Making analogs to the traditional assets made my life simpler when I sought to value assets. That’s right, valuation is what separates speculators from investors.
The mega trend
Let’s stand back and look at the big picture. Blockchain technology has the potential to drive adoption and innovation in a variety of fields. Digital Assets aren’t the only use case. In fact, the Blockchain can be used in supply chains, health care data, and smart contracts. The trend for overall spending on Blockchain will be growing 48% CAGR (2020–2024). While the Blockchain is more than just digital assets, the pie chart below from Global X shows that the use cases in financial category might account for 35 percent of all expenditure in the next four years.
In code we trust
Smart contracts…some people don’t think it is smart!!!…simply because it is a set of predetermined logics (if/when/then) for automating contract execution. But it is seem trustworthy, since code will not lie or breach the contract. The smart contract themselves can range from simple exchanges to more sophisticated arrangements such as mortgages. Consider traffic severance combined with machine learning on a chain as the ultimate use case. In terms of penalties, autonomous law enforcement can be applied to traffic violators in real time…
As a result, code is extremely important. Especially when it comes to using a smart contract with money. The code will inform you whether your money is in the Secure Asset Fund for Users (SAFU) or not. Similar to the financial statement, which needed an auditor to determine whether the company was financially sound. Code auditors are in charge of checking for exploitability in DeFi.
The value chain
When looking at Blockchain technology from layer perspective, it can be visualized as a set of building blocks stacked on top of each other as shown in diagram below from Fabian Schär. The Settlement layer is the foundation blockchain such as Ethereum, Binance Smart Chain, Solana, Terra, etc. Native protocol assets ($ETH), tokens, and non-fungible tokens (NFT) are examples of asset layers constructed on top of blockchain.
In traditional finance, the protocol layer is comparable to different types of financial institutions. In dealing with financial services, different protocols will engage in different businesses. The lending protocol, for example, can be compared to a commercial bank in traditional finance. Because a commercial bank can have multiple companies, the same principle applies to the Lending Decentralised Application (DApp).
The final layer, or Aggregator, is a platform similar to Lazada (which sells goods without owning them), Uber (which provides rides without owning a car), and Airbnb (provide accommodation without own room). DEX Aggregators, for example, provide “Best Rate” Decentralized Exchanging for assets that do not have their own Liquidity Pool.
The early adoption
The usage of smart contracts in Decentralized Finance has exploded in recent years. It can be seen from the Total Value Locked (TVL)below from “THE BLOCK”, the fund flow into the Ethereum DeFi since September 2020. It’s not difficult to figure out why. On a snapshot of September 9th, the TVL was highest at $ 93.4b. The most value locked are in Lending and Decentralized Exchange (DEX).
Note that Ethereum is the smart contract platform with the highest percentage of Value Locked, accounting for 70% of DeFi.
However, when comparing the market capitalization of digital assets ($2.12 trillion / $BTC 0.86 trillion) to that of gold ($11.35 trillion), the digital asset is still small. Crypto adoption and the rise of DeFi may follow the internet adoption rate in terms of active users. Today’s DeFi adoption is similar to that of the internet in 2000, with plenty of room for expansion. With proper risk management and a keen eye, you may be able to meet the DeFi industry’s next AMAZON.
