Decentralized Finance (DeFi)
Decentralized Finance
Hello again crypto friends.
Rob, here and today I bring you another crypto blog this time I will be discussing the rising industry of DeFi and what it all means (to the best of my understanding and knowledge).
For those of you who don’t know me I have been in the Crypto world for just over 4 years and I class myself as a simple guy, that’s why I try to adopt the “KISS” method (Keep it simple stupid) as much as possible so that I can first simplify things in my head then I can share my simplistic version with you guys.
In my opinion the crypto world is still a very complexed and emerging industry, for any crypto related industry to be successful it’s going to have to gain mass adoption among the general population. Currently it’s no good having all these new crypto services and industries available if the average person does not understand how they are used, what they do and how are they could be beneficial.
Within my blog I will try and explain these new services and industries using multiple different comparisons which I hope at the end of this blog you will all have a better understand.
So, let’s get started,
What is DeFi?
Lending money, borrowing money and earning interest on money are all forms of a financial service. The word DeFi stands for “Decentralized Finance” and the answer is within the name itself. It is simply any financial service or financial sector which works for its customers in a decentralized way. DeFi means that there is no one central entity that controls the financial service, the service is controlled by the computer algorithm or a smart contract in which it is written.
What are smart contracts:
Vitalik Buterin the CEO of Ethereum and his team created the Ethereum blockchain in 2015. This blockchain is open source meaning that it is open to anybody with programming skills who wants to write any applications on top of the Ethereum blockchain, these applications can also be called “smart contracts”. Much the same as Microsoft Word runs on top of the Windows operating system of a PC or the game "Angry Birds" an application running on top of the Apple IOS operating system.
It must be noted that smart contracts are not a new idea as they were first proposed back in 1994. However, what is a new idea is running a smart contract on a blockchain platform. In Vitalik’s own words he describes a “smart contract” as being like a vending machine in the real world. You insert your money into the vending machine and a soda drink comes out because that’s what the vending machine is designed to do, that is the protocol in which it is running. So, a vending machine can be seen as a physical device that executes a smart contract when it is told to do so and does not deviate away from that contract. However, in the real world a vending machine can malfunction, and it can break down. By digitalizing this concept and running the smart contract on a cryptography blockchain such as the Ethereum blockchain it makes these smart contracts far more secure, reliable and powerful. It must be noted that the vast majority of all DeFi services and projects are currently running on top of the Ethereum blockchain.
Peer to peer (p2p):
One of the most exciting concepts of a smart contract is the removal of the “middleman” during any financial matter and promoting the idea of “peer to peer” services. Currently if I wanted to buy a house from my friend Bob we would both have to run the process through a real estate and then through a lawyer to make sure that the process has complied with the local law, these two services would take their commission fee before the final settlement of the property which can be as high as 6% of the sale price! A peer to peer service would work in both myself and Bob’s favour by removing the real estate and lawyer from the process thus saving us both the 6% commission fee. A peer to peer” service would be much more cost effective to the consumer than the current system and much faster because the real estate and lawyer’s paperwork jargon are all compressed all within the smart contract itself. Once the smart contact is signed off by myself and Bob the smart contract excuses itself (Think of the vending machine and the soda drink coming out once money has be deposited). Now think more border, using this same peer to peer method of buying a house there would be nothing stopping you from purchasing a house oversea in the Bahamas and avoid paying the other fees. While you are not living in the house you could complete a rental agreement with another person, the agreement would be on the blockchain as a smart contract where by you know that you will always be paid rental funds while your new property is occupied.
Centralized Finance:
An example of a centralized financial institution would be a bank. A bank is run by a CEO whose job is to look after their customers and run the business of the bank to make a profit. Within Australia, we have many banks all running independently from each other. Above the banks is the Bank of Australia (RBA), it is the RBA that sets the official interest rates for the rest of the banks to follow. Other countries around the world have a similar banking structure. But the point is that the RBA is controlled by a single centralized entity, at the end of every month a meeting will be called, and the centralized entities will discuss whether to raise or lower interest rates.
In the DeFi world there is no centralized entity making these decisions and most importantly there is no 3rd parties involved. The decisions are made by the market itself and the main purpose of the DeFi industry is to remove the need for the 3rd party and create the new peer-to-peer financial system.
DeFi within the Crypto industry:
An example of DeFi within the crypto industry would be a DEX (Decentralized Exchange). Currently the majority of crypto exchanges today are still centralized, so this means when you buy any cryptocurrency using these centralized exchanges the exchange will take a trading fee much the same way how a broker takes a fee whenever you buy or sell shares using their platform. Also, this centralized exchange is going to have in place a KYC (Know your customer) protocol whereby a customer’s identity and their financial activities will all have to be disclosed to the exchange. One centralized exchange (whose name I will not mention) will block customers who are located in the USA and simply will not allow them to use their exchange at all, putting them at a clear disadvantage than others.
What is Uniswap:
The most popular DEX right now is the Uniswap platform. Uniswap is simply a crypto exchange platform running on the Ethereum blockchain. But the major difference is that this exchange is decentralized (DEX) meaning that there is no customer support or any single entity running the exchange. It must be noted that when a customer uses the Uniswap exchange they are only able to buy ERC20 tokens. This means these are tokens that only run on the Ethereum blockchain and you must use ETH to buy these ERC20 tokens. A person cannot buy Link (which is an ERC20 token) using Bitcoin because Bitcoin runs on its own blockchain which is completely separate and different to that of Ethereum’s blockchain, the two are not interchangeable.
What is an NFT?
Now stepping away from DEX’s and talking about NFT’s
The word NFT stands for “Non-Fungible Token”. So, let’s break this down and understand what the word “Fungible” actually means.
The word "Fungible" has the same terminology as the word "Asset", this can be a real-world asset such as a car or a house or a digital asset such as a Bitcoin or ETH.
Fungible:
When something is “Fungible” it means that it has the same value as another fungible token of its kind and it is interchangeable with that other token, but it is NOT exactly the same.
Totally confused right? Let me explain.
Example 1: If I swapped my $10 note with my friend Bob, and Bob gave me back his $10 note then we would have both received the same amount of value back in both back our pockets. However, the two $10 notes that we just swapped with each other would not be exactly the same, meaning that they would not have the same security codes written on the back, so they are called “fungible” tokens, in the sense that they are interchangeable or fungible.
Example 2: If I swap a 1kg rock with Bob and Bob gave me back his 1kg rock both the rocks that we just swapped are not exactly the same but still we have exchanged our rocks and we both agree that both our rocks hold the same amount of value as each other, they are interchangeable or fungible.
Example 3: If I swap my pet camel with Bob’s pet camel, we would both be getting different camel’s back in return, but we have both accepted that both our camels hold the same amount of value, they are interchangeable or fungible.
The bottom line is that anything that is “Fungible” means that this fungible asset can be exchanged for another asset for the same amount of value and there are many of those assets available. I hope that makes sense.
Non fungible:
A “Non fungible” asset as you guessed it would be the complete opposite of a “fungible” asset. It is something that is very unique or rare and it is not interchangeable because it has its own unique value.
Example 1: Would be the Mona Lisa painting designed by the one and only artist Leonardo Da Vinci. To the best of my knowledge this painting is priceless and it could never be swapped or interchanged with another painting of its kind, there is only one Mona Lisa painting. Copies could be made of the Mona Lisa, but those copies would never hold the same priceless value of the true original painting, It is a Non fungible asset.
Example 2: A Ford and a BWM are both cars, but they are not the same make and model of car. A BMW is generally worth a lot more than a Ford so if I tried to swap my 1980s Ford with my friend Bob for his 2020 BWM then I would generally be getting myself a better deal. Bob would be crazy to go through with the swap and so it is cancelled, and his BMW is Non fungible.
Example 3: A first-class plane ticket on a private jet to Dubai is very different to an economy cattle class ticket to Sydney. Yes, both tickets will get you on board a plane but they are both very different to each other and worth vastly different amounts. Bob would not swap me his private jet ticket for my economy class, so these tickets are Non fungible.
Non-fungible tokens in Crypto:
In the crypto world when we talk about NFT’s it is a digital asset that moves on a blockchain and as all of the examples above state it is not interchangeable with any other token of its kind.
A digital NFT is basically a digital asset that cannot be copied or replicated. It would be better to think of a NFT as a digital collectible item. Once you own an NFT no one can take it from you because you will be the owner of the private key. So, try and apply that same thinking as if you own a bitcoin no one can take the bitcoin from you if you are the owner of the private key.
So what could a NFT be?
At the end of 2020 the video gaming industry was worth an estimated $90 billion and one of the most popular online games was Fortnite. The current problem with gaming is that once a gamer progresses to a new level or they are able to complete the game they are often rewarded with a digital item such as a sword, a shield, a certificate, etc. But those digital rewards are always kept within the game. The gamer cannot take their reward out of the game then use that reward in another unrelated game or put the reward in their bank account. So, image this what if you’re playing a game and you managed to progress to the next level, and you are rewarded with a digital sword. This sword could be in the form of a digital NFT, its completely unique no one else throughout the game has one and you are the sole owner of that one and only sword. You could then be able to remove the sword completely out of the game and put it up for sale using a DEX in which you could sell the sword for Bitcoin, Ethereum or any another digital asset? Life achievements. Let’s say that you have completed a degree at university, and you scored the highest marks in the class. Your degree could become an NFT because its unique with the highest marks. Unique digital collectibles such as digital artwork are expected to become a huge market within the NFT world where a person sell their unique art work on an exchange to any potential buyer.
Miscellaneous Terminology:
Fiat currency:
Any form of government issued currency that is not backed up by a valuable commodity such as gold or silver to give it is real value. An example would be the Australian dollar, at the end of the day its nothing but a piece of plastic which the government tells you that you must hand this plastic over when you want to buy anything such as a car, a house or shopping. You hand over plastic paper. Lol
Bull Market:
Basically, means that the market is gaining value, and everybody is making money with positive inflow of volume and buyers. Bull markets are confirmed by higher troughs and higher peaks on a graph.
Bear Market:
Is the opposite to a Bull market, the market is losing its value and people maybe selling off their stocks or assets. [Opposite of above]
Liquidity:
The word Liquidity means the total volume of money that has flowed into an asset and how quickly the asset can be turned back into fiat currency. So, a house during a bear market would be considered low liquidity because during a downturn in the housing market very few people would be buying houses, there would not be much money flowing into the housing market and it could take up to a year or longer to sell a house and turn the asset into fiat currency.
I hope that this all make sense. Let me know what you all think.
Rob 😊