#1 An introduction to de-fi

Gm anon, 

Welcome to the first edition of defined, the de-fi newsletter which will take you from 1 to 100. This edition aims to break down what is de-fi, the landscape and the lingo you’ve probably been seeing everywhere. In further editions we'll dive deep on the need for de-fi and how we got here. 

Imagine every financial transaction or service you’ve availed. 

You’ve probably done most of it through a bank or some financial intermediary. Bought a stock on a centralized stock exchange, borrowed loans from a bank or even put your money in one of them. 

Intermediaries require blind trust- instances like the 2008 financial crisis show that this trust could be misused. Your money is not in your custody, but of the intermediary you choose to trust. Intermediaries gate-keep financial services, deciding who gets a loan and who gets to participate. 

What if you never had to go through an intermediary again? 

That’s where de-fi comes in. 

Decentralized finance or de-fi seeks to do away with financial intermediaries like banks or exchanges and instead replace it with code known as smart contracts. 

With de-fi anyone with money and a wallet can participate in the system. Your money is in your custody. Trust is placed in code, which is audited multiple times over instead of people. 

Now coming to the space itself; It might be difficult to navigate yourself in a string of protocols that are floating around. So thought we’d go deep into the few major types and protocols in those. 

1. Lending and Borrowing Protocols

These form the majority of the protocols that you see around in de-fi. The core idea is that you can borrow and lend crypto tokens. It’s simple really why they’re so popular among developers- lending in crypto is over-collateralized (meaning you put in more than you borrow)- this makes it relatively safe for the de-fi protocol giving you the funds as long as they manage their risk properly. 

Aave, Compound and Maker are the major de-fi lending protocols, with billions of dollars of value locked up in their smart contracts. All of these are protocols based on ethereum. No other chain has the robust de-fi ecosystem that ethereum does. We’ll dive deeper on each of these protocols in later editions. 

2. Decentralized Exchanges (DEXes) 

Apart from lending and borrowing protocols, the other major component of de-fi is decentralized exchanges- essentially an exchange where you don’t need to go through a main party. These are automated market makers- meaning you don’t need to have another person to trade with; you are trading with a pool of the crypto pair (say BTC/USD) which has been set aside by the liquidity providers (people who put money in the pool and expect to earn rewards). 

Major among this is Uniswap which at a time processed more volume of transactions than Coinbase, the second largest centralized exchange. 

Another major player in this space is 1inch, which aggregates all these dexes and offers you the best price across them. 

Uniswap eclipses other DEXes, doing almost half a billion dollars in volume every day

3. Decentralized stable-coins

Decentralized stable coins refer to the ones whose peg to the asset which it is backed by is done through a complex self-sustaining algorithm. Unlike traditional stablecoins such as USDT, there does not need to be a central entity (like Tether) which ensures that the coin is backed by actual money. Most popular among these decentralized stablecoins is DAI.

DAI is created by locking collateral in MakerDAO’s smart contract, known as a collateralized debt position (CDP). The value of this collateral needs to always exceed 150% of the value of the DAI it is used to generate. If it becomes undercollateralized, the assets in the contract get sold to pay off for the DAI it was used to generate. 

4. Synthetic derivatives

Synthetic derivatives are those that are created to follow the cash flow of a certain security- say a stock like TSLA. Synthetix is an example of a popular derivatives platform that allows people to trade derivative products on Bitcoin, Ethereum and so on; basically they can gain exposure to the asset without owning the asset itself. 

For synthetic assets there is WBTC which is wrapped BTC (bitcoin) which is typically used when bridging bitcoin to other chains. Wrapped synthetic assets are the catalysts for a world where we will live by not one chain, but multiple. 

There are other players in the space who do not really conform to these categories but these are broad ones which you as a beginner to de-fi should be aware of. 

Yield farming

A use case to come out of these protocols is yield farming- a way for crypto investors to earn high yields (rate of returns) by giving their crypto to a pool of funds which would be invested in a smart contract. 

Let me break it down further. For example, say you want to trade your ETH for USDT on a decentralized exchange- your trade will be enabled by a pool of ETH/USDT funds kept in the smart contract. This pool comes from users who put their money. These users will then earn a yield on these assets- in this case a part of the fees the protocol earns on the trades.

One thing to note is that yield farming is risky, and could entail complete loss of funds so do proceed with caution. We’ll dive into this deeper in later editions.

Before we wind up this newsletter, here’s a few common terms which will help you go further in the space. 

Annual Percentage Return (APR) = Annual Rate for earning or borrowing money, without any compounding added into the mix. Example: 1% interest each month would be 1x12 = 12%

Annual Percentage Yield (APY) = Takes into account compounding. The same 1% monthly rate would be 12.68% because it compounds: ((1.01^12)-1) = 12.68%.

Fully Diluted Market Cap: Similar to market cap but assumes all tokens are issued and are circulating in the market. For example, Bitcoin has a supply cap of 21 M but there are less than that number currently mined, so fully diluted would be 21M x supply. 

Liquidity Provider(LP) – Users who add to a DEX liquidity pool (basically the funds using which a trade in DEX is executed).

LP Tokens – Tokens issued to liquidity providers that represent the assets they have provided to the pool.

Staking – Pledging your assets to a crypto protocol to earn rewards and benefits.

Total Value Locked (TVL) – Value of assets currently staked. This metric is very useful to identify which de-fi protocols have a lot of traction- higher the TVL, higher the traction.