almost 3 years ago • 8 mins
Decentralized finance – or Defi – is definitely having a moment. Interest in the digital tokens at the heart of a growing ecosystem of blockchain-based financial tools is exploding. And while some are drawn to the promise of a Utopian future where the fat-cat middle-men are removed from the financial system, plenty of others are attracted by the frankly crazy price swings many of these tokens go through – enabling huge sums to be won or lost in a matter of days.
To address this exciting segment of the financial world, our guest on this edition of Insights is Camila Russo, founder of The Defiant, a news service for decentralized finance and the author of The Infinite Machine, a history of the Ethereum blockchain.
Finimize analyst Andrew Rummer started by asking her to outline her personal take on decentralised finance.
Camila Russo: Decentralised finance is the ecosystem of financial applications that is being built on top of open blockchains like Ethereum.
It is an entire financial system that includes payments, it includes savings, lending, borrowing – every use case that you can imagine. And traditional finance is being recreated, taking out financial institutions from the middle, and having people interact directly with smart contracts and computer code.
Andrew Rummer: How does the concept of Defi relate to cryptocurrencies like bitcoin?
Camila: Bitcoin was a very first blockchain and cryptocurrency but it is designed very simply as a way to send money in a peer-to-peer way or send value in a peer-to-peer way. Its architecture is basically a distributed network of nodes that are spread out globally. And these nodes are basically a computer running the bitcoin software. And the way that people are incentivized to be part of this network is because they earn the cryptocurrency of the network – in this case, bitcoin – to confirm transactions. As you may know, the way to confirm transactions is rushing to solve a cryptographic problem, which requires a lot of energy. That's proof of work. The issue with bitcoin is that these nodes are meant to transact just value, but they can't really process anything more complex than that. That's where ethereum comes in. Ethereum was built on the same architecture. It's a distributed network of nodes running on proof-of-work consensus. And it has its native cryptocurrency, ether, which incentivizes participation on the network. But the difference is that these nodes in the network can actually process computer code – any program that you throw at these nodes, they can process it and execute it. So this has allowed developers to build more complex financial applications on ethereum and on other blockchains that are being built with these capabilities too.
Andrew: What’s so wrong with the current financial industry? What’s the problem these Defi developers are trying to solve?
Camila: Unlike the traditional financial system, it's a global system. And it's open so it allows anyone to participate wherever they are in the world – both by participating in the network, but also building and also using these applications. In traditional finance, each country has its own system, and the systems are blocked from anyone else using them. So for example, you have people in countries with depreciating currencies and capital controls who cannot access other currencies because they're locked in their financial system. Or, for example, people outside of the US who might want to buy US stocks.
Each financial system is restricted to its own geography. If I wanted to send you a payment from the US and you're in the UK, that's gonna take days and like really high fees, and via a whole hassle of SWIFT codes and bank account numbers. That just goes away when you're using a global system like Defi.
Andrew: There's hundreds of these Defi projects out there, each with their own token. How does someone like me as a small investor go about choosing between these different projects or tokens?
Camila: What's cool about this, this kind of progression in blockchain and crypto history is that, right now, it's not just about picking up a token – it's about you actually using these applications.
Defi Pulse is a good resource where there's a list of Defi applications on there. And it's ranked by assets held in these applications. So I think a safer bet is to go with the applications that are holding the most assets, because, you know, they've been trusted by more people, and they've been around for longer. So you can just go down that list and see what you can do on these protocols. Like maybe what's interesting to you is opening a US dollar-based savings account and earn 10% yield on a dollar-based account. And you can do that in Defi. Maybe you want to trade a Tesla – like a synthetic Tesla stock – from the UK, or buy Coinbase stock after-hours. You can do that in a synthetic trading platform.
I think it's just better to start using this stuff and just like experiencing it for yourself, you know. Buy some ether on a centralized exchange like Coinbase, then download MetaMask, which is a web3 wallet allowed to interact with all these Defi applications. Transfer ETH from your centralized exchange to your noncustodial. Noncustodial means that you are actually holding your private keys and you're not delegating that to a centralized exchange. So you transfer your ETH from the centralized exchange to the non-custodial wallet and with that you're ready to start you know playing around with these new Defi applications
I think that's kind of a good way to explore, you know, actually using these applications or not just investing in or like buying a token and watching it go up and down, which isn't very inspiring.
Andrew: But plenty of people out there do want to speculate on the value of these Defi tokens. Do you have any advice for them?
Camila: If you want to buy the token, of course, many people are doing that. And, again, I would just recommend looking at the fundamentals if you can of these projects: like, which are holding the most assets, which have the most volume, the most users? I think that's a good gauge. Or, as always – like in the traditional market – buying an index of tokens. I think it's a better way to go instead of trying to stock pick and pick a single token.
Andrew: Just like with traditional finance, it’s possible to earn interest on deposits in the Defi space, right? So how does that work?
Camila: So I talked about proof of work earlier. There's a different consensus mechanism for a blockchain that's called proof-of-stake. And what it does is, instead of relying on the energy that's put towards securing the network or confirming transactions, instead of energy, the nodes of the network put towards the network deposits of the tokens of the network. So they put up a stake of the network.
And by putting a stake down or deposit down, you also earn interest – you earn more of those tokens as a reward for participating in the security of the network.
Andrew: Earlier you mentioned the possibility of earning a 10% interest rate on a token tied to the value of the US dollar, if I understood that right. How can a service pay an interest rate that high? Obviously, that’s much higher than any western bank is offering at the moment or what you could get on a safe bond anywhere. So where does that come from?
Camila: It comes from the other side, who is taking a loan, that's using those deposits of stable coins to borrow them, and then go basically trade with them and speculate. So right now borrowers of crypto are paying really high rates to borrow, because they expect to earn more money than the rates that they're paying. I think it's obviously a temporary thing, but you can earn these rates, and they do fluctuate. Sometimes demand to borrow crypto isn't as high and rates will go down, sometimes it's higher, and rates will increase. So it's certainly a volatile thing, the rates that you get for deposits. But I do think that in general, the rates for Defi should be higher than rates in traditional finance just because of the risk that you're taking. So I think that's that's always something to keep in mind like this. This system is definitely riskier than the legacy financial system.
These interest rates that you're getting should probably decline over time as the overall system is more liquid. And maybe we're not in such a bullish crypto market where there's a lot of demand to own crypto, maybe rates will come down. But, because it is a riskier system, I think you should always expect there to be some spread between traditional banks. And so people should be aware that there is some risk and that you shouldn't put all of your money in Defi right away.
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