Opportunities & Dangers of DeFi

Here is Part 1 of a beginner-friendly, eye-opening post where I try to demystify the complex world of DeFi.

This is Part 1 of a longer post. Hopefully worth the read whether you are completely new to the decentralized finance (DeFi) concept, or already have a decent understanding of how the sector works.  

In Part 1, I will sell you the idea of DeFi by pointing to some of the conventionally mentioned advantages DeFi holds over traditional finance (TradFi). Then I will add in my philosophical inputs. Towards the end, I will offer my take on a Crypto Investing 101 course to prepare you for an in-depth view of how DeFi is used to generate income in Part 2.

Motivation

My motivation for writing this and giving out, what I believe to be, an insane amount of value for free, is tied to my own interest in gaining more knowledge about DeFi. I am by no means an expert, but have been studying DeFi intensely over the last couple of weeks and months and found that trustworthy, accurate, and adequate information is hard to identify.

I sincerely believe there should be more university courses dedicated to the topic of DeFi across academic disciplines such as law, economics, business, computer science, IT engineering, mathematics, philosophy, social science, and more. At this point, information about DeFi too often falls under the domain of “internet hustle culture” where conmen and fake gurus, stand on every corner to sell you a dream while they take your money.

Such was the case with Celsius, where it came forth during the ongoing court proceedings that the CEO had recklessly played monopoly with user funds and left a billion-dollar hole in their balance sheet. We are reminded why Bitcoin was invented in the first place: to avoid dealing with shady custodians and profit-seeking third parties. This is what DeFi is all about, and hopefully, the direction it's heading long-term as the market matures.

Advantages of DeFi

Decentralized finance (DeFi) can eloquently be defined as this[1]:

“An ecosystem of protocols, applications, investors and traders that use smart contracts to perform financial transactions in an open, permissionless and transparent way.”

The TL; DR description of this section could be that DeFi is much faster, cheaper, and more accessible compared to corresponding services in TradFi. I will not dig deep into the fundamentals of DeFi here, but merely highlight a few key points to make sure we are on the same page:

-       The main quality of DeFi is, as the name suggests,” decentralization”. There is no intermediary company standing between transactions to collect user data or to profit from transaction fees.  

-       DeFi uses cryptocurrencies instead of state-issued fiat money. Cryptocurrencies are code with a set of rules embedded within them or for a fancier term they are “programmable money”. The code behind smart contracts serves a similar function to legal documents in a limited holding company.

-       Smart contract code is transparent and auditable while transactions on DeFi applications are public. In sharp contrast to traditional financial institutions which usually operate behind closed doors.

-       Another buzzword to describe DeFi is “composability”. Due to the open-source nature of blockchains, DeFi applications can be built and used over, under, sideways or parallel to each other “like Lego bricks”. This makes DeFi more flexible and interoperable compared to TradFi or FinTech solutions.

-       Additionally, fully decentralized DeFi projects (DAOs) are based on an open governance model which means that any stakeholder can participate in important decisions about the future of a project. Anyone with a stake in the project can initiate or vote on protocol changes via governance tokens, thereby participating in decisions that would usually be carried out by the board of directors in a traditional company.

What are the disadvantages of investing in DeFi then?

As the DeFi asset management platform Yearn.finance writes in bold on their website:

 “These are not risks for ants”.

Whatever that means exactly, the connotation is clear: Investing in DeFi can lead to massive profits but it’s also a high-risk game. We will get much more into that in Part 2.

Advantages of the DeFi Sector

If we look at DeFi on a sector level, what is the major advantage it holds over TradFi?

Most importantly; anyone with a stable internet connection, a PC or smartphone, and a crypto wallet can access it.

In TradFi, asset management companies like Blackrock and Vanguard are only available for the wealthiest percentage of the global population. In DeFi, anyone can buy a few tokens and act as their own asset manager, regardless of their situation, where they are from, or what their personal history is.

According to Vinay Gupta in a Twitter thread from early 2022, the major advantage of DeFi is that older people don’t understand it.

The boomer generation (1946-1964) sits heavily on real estate, stocks, venture capital, media distribution, retail, and patents. Meanwhile, the younger generations are generally left with scraps in exchange for hard labor. Due to the effect of compounding interest, the younger generations have a hard time catching up since they started out with less money. They lack the capital to take life-changing loans or buy into the older generations' resource pool.

The numbers speak for themselves.

Gupta points to the following chart from Washington Post to illustrate the wealth gap between generations.

A study from November 2021 analyzed income trends in nine European countries between 2008-2017. The results show that income of the younger age groups stagnated or declined in most countries since 2008 (around the global financial collapse), while income of the older population increased.

A pre-pandemic study of income trends in the Netherlands shows that the boomer generation stands out both in terms of income and wealth. More than 2/3 of total net wealth was held by households with a main-income earner older than 55 years, and 42% was held by households over the age of 65 - excluding pension assets. The current generation of 35–45-year-olds in the Netherlands owns on average EUR 100,000 less than the current generation of 45–55-year-olds when they were the same age. In the UK, a report from 2019 shows that Millennials (1981-1996) are the first generation in history that is poorer than the previous generation.  

In the United States, a study from 2021 finds that the average 64-75-year-old American is 94% wealthier than the average 35-year-old, while today’s American 40-year-olds own half the wealth of older generations when they were the same age. Millennials only possess 5% of the US total wealth. And here is another interesting fact:[2]

“If we look closer at the wealth distribution of millennials, it was recently revealed that Mark Zuckerberg, who has an estimated net worth of $97 billion, single-handedly owns 2% of all millennial wealth.”   

Mark Zuckerberg and other tech billionaires have made their fortunes from creating addictive web platforms which users pay for with personal data instead of money. The daily operation of these platforms is carried out automatically by computer code, instead of humans as we are used to. Those are the facts. Whether you think that Web 2.0 services like Facebook or Google are good for the world or not, I think it’s safe to say that they have outsmarted the system.

The blockchain movement represents a rebellion against all powerful, centralized institutions - whether banks or Big Tech monoliths - by emphasizing values that are more in tune with the digital age. The advantages DeFi holds over TradFi are the same as those Web 3.0 holds over Web 2.0: decentralized/centralized, open source/proprietary, permissionless/ limited access, transparent/opaque, publicly owned/privately owned.  

DeFi has the potential to disrupt wealth distribution by creating an entirely new group of young, tech-savvy millionaires. Like Bitcoin did with long-term holders in 2013, 2017, and again in 2021. The only barrier to entry is the technical complexity of DeFi and the fast-moving market – both in terms of price and innovation.

Let’s jump into DeFi with a Crypto Investing 101 course. I am still undergoing a steep learning curve myself, so any constructive feedback or comments are welcomed.

Trading Crypto

Overarchingly, there are two types of exchanges for trading crypto: Centralized exchanges (CEXes (that’s what they are called)) such as Binance and Coinbase, and decentralized exchanges (DEXes) such as Uniswap and SushiSwap.

CEXes act as intermediaries to transactions like regular banks. On the plus side, they are easy and convenient to use - at least once you are fully onboarded and have gone through the rather tedious KYC processes. CEXes oversight of customer data is "against the spirit of crypto", but also necessary to comply with financial regulations.

The biggest minus with using a CEX is that you essentially delegate the control of your crypto to the exchange. The recent Celsius freeze illustrates perfectly how bad it can turn out. 

DEXes run on smart contract code and the exchanges are therefore not governed by an intermediary company that takes a cut for deposits or transactions. As a result, DEXes are generally cheaper to use compared to CEXes. The flip side is that you cannot just deposit your money on a DEX like you would on a bank account or a CEX. They may require a bit of studying and technical flair to use.

It's important to note that DEXes are unregulated or at least a deeply gray area of the law. In the true spirit of Bitcoin, a DEX offers full privacy to customers without questionnaires or registering processes. On the other hand, the biggest risk for a user is a hacking attack on the platform which could put all customer holdings at risk. In such a worst-case scenario, there would most likely not be a legal remedy or any way to recover the funds since there is no one to hold accountable on behalf of the DEX (in theory). 

Storing Crypto

There are two main options when it comes to storing your crypto: hot wallets or cold storage

Hot wallets are digital wallets. They can either be custodial or non-custodial depending on whether you have ownership of your private key. Your private key is a string of numbers and letters, a kind of password that you use to sign off on transactions from your wallet. If you hold your crypto on a CEX such as Coinbase or Binance, your wallet is custodial, since you hand over the custody of your private keys to the exchange. Metamask is one example of a non-custodial wallet where you can access your private keys. You will typically need a non-custodial wallet to communicate with DeFi applications.

Cold storage means that you store your public and private keys offline. Your wallet is safe from cyberattacks, while you remain in full control as Bitcoin intended you to be. The most commonly used methods for cold storage are paper wallets or hardware wallets.

A paper wallet is simply a piece of paper that contains your private key and public address. They are usually generated for free via a website. If they are stored securely for example in a bank box, hidden away from thieves and wear and tear, they should be completely safe as such. However, as they are typically generated on a third-party website, you have to trust the web operator. Relying on trust in the crypto space is never a good thing. And if your computer is infected with malware during the creation process, your private key could be exposed. For these reasons, blockchain expert Andreas Antonopoulos calls paper wallets an obsolete technology and warns against using them

Hardware wallets are not actually wallets, but like paper wallets, a method of storing your private keys offline. They are considered to be the safest choice, since they are not connected to the internet unless you make a transaction, thus minimizing the risk of attacks. The most popular hardware wallets are made by Ledger and Trezor. They are relatively easy to set up. Here is an excellent guide for setting up a Ledger Nano X wallet.

On the downside, you have very limited options to earn passive income from your holdings, once your is crypto stored on the hardware wallet. However, hardware wallets can be integrated with non-custodial hot wallets. For example, Ledger can be integrated with MetaMask and WalletConnect.

By remaining in control of your crypto, you are also the guardian of it, which means that if you lose access to your private keys or give them out to another party by mistake, you are in deep trouble. One measure to prevent you from losing access to your crypto in such a situation is by having a multi-signature wallet.

Basic Investment Strategies

I see three basic investment strategies for “traditional” crypto investing: short-term holding, long-term holding, and dollar cost averaging.

Short-term holding is essentially the same as day trading. Investors try to “catch the waves” of market movements by buying and selling assets on a daily or very frequent basis. Timing the crypto market is extremely difficult.

Long-term holding (HODL’ing) is about buying and holding assets over a longer time frame, at least one year. Particularly in crypto, investors have to stomach abrupt price swings from time to time. They have to resist the temptation to sell at a loss even when the market drops by 50% or more in a matter of days.

Dollar-cost-averaging (DCA) is similar to putting money into a weekly or monthly savings account. At regular intervals, you invest a predetermined amount of money (or crypto). DCA has been highlighted as a good way to mitigate market volatility. But still, when the market price is either very high or very low, the desire to sell can overcome the confidence to keep investing for most people. 

Before the emergence of DeFi, the buy-hold-sell model was the main option to earn income from crypto. But over the last few years, really since 2018, and taking off during “the DeFi summer” of 2020, the space has been rapidly evolving. Today the DeFi space offers a wide and fast-growing range of revenue streams for crypto-HODLers that mimics how the rich get richer in traditional finance but with the added advantages of DeFi.

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[1] DEFIYIELD App (2021), The Wall Street Era is Over. The Investor's Guide to Cryptocurrency and DeFi, pg. 17.