Your Primer for DeFi
What is Decentralized Finance (DeFi)
Decentralized Finance is one of the hottest topics in the world of cryptocurrency in the last 12 months. Like the rest of cryptocurrency, it is poorly understood and lacks a conceptual framework. I’ve decided to put pen to paper and create a framework for thinking not just about DeFi, but also CeFi. This letter is a primer for understanding Decentralized Finance.
TLDR;
There are 4 Kinds of Financial Services (Saving, Sending, Credit, Investment)
DeFi gives people the same services that Traditional Financial Services Offer
Decentralization is measured along 3 dimensions (Money Supply, Governance, Network)
Just because its on a blockchain, doesn’t make it DeFi
What is Finance?
In general there are four types of financial services
(Saving) Storage of Money
(Sending) Transferring of Money
(Credit) Lending and Borrowing of Money
(Investment) Buying and Selling Stocks / Commodities / Tokens / Coins / Collectibles
Everything your bank offers you is one of, or a combination of these four services. For the sake of simplicity, I’ve left insurance out of the picture as it doesn’t quite fit into the picture in a meaningful way (yet).
CeFi and DeFi
CeFi - Centralized Finance
DeFi - Decentralized Finance
Banks and Wealth Managers offer you Centralized Financial Services. Code on cryptocurrency platforms like Ethereum offer you Decentralized Financial Services. (DeFi services are autonomous money programs built with code). Just to be clear, there are Centralized Financial Services companies that are fully integrated with cryptocurrency platforms. I call these kinds of companies Crypto Banks.
Examples of CeFi
HSBC, JP Morgan Chase, Royal Bank of Canada are all centralized financial institutions that are NOT integrated with decentralized money. Crypto.com, Binance, and Kraken are centralized financial institutions that ARE integrated with decentralized money. Just because the later examples integrate with cryptocurrencies, doesn’t make them DeFi. Furthermore, just because something is a cryptocurrency, doesn’t make it decentralized. There is a lot more nuance to decentralized than just carrying the title of “Cryptocurrency”.
What is Decentralized?
Decentralization is not something that can be measured simply by looking at one facet of a system. As far as I can tell, there are at least 3 dimensions to the decentralization of a financial system.
The Supply of Money ( Quantity / Distribution )
The Governance over the Money ( Leadership )
The Infrastructure of the Money ( Hardware / Network )
A financial system cannot be called decentralized unless it optimizes along all three of these dimensions. If a financial system does not satisfy the criteria among one of these dimensions (ex. Governance), then it fails the decentralization test.
Answering the question on whether or not a network (like Bitcoin or Ethereum) is decentralized is a letter all in of itself. So I will leave you to muse over whether or not they are optimized along any one of these dimensions. Instead, I’ve now laid the groundwork for addressing the initial topic of this letter.
DeFi is Bigger than Ethereum
Bitcoin is a platform for the storage, and transfer of wealth. It doesn’t quite allow (with ease) for borrowing and lending, or investment. This gap in functionality is what prompted the founders of Ethereum to create it in the first place. Ethereum allows people to borrow and lend, and invest in a wide plethora of cryptocurrencies, all without leaving the Ethereum network. Companies can now create their own token that behaves like their stock.
This augmentation of functionality does not mean that Ethereum is DeFi, it means that Ethereum augments the already present phenomenon of DeFi seeded by Bitcoin. Ethereum simply builds upon what was already established. I reject the notion that Ethereum is responsible for the creation of DeFi. However, Ethereum has successfully served as a proving ground, and a place for experimentation. Much of what we know about creating DeFi services is because of Ethereum.
Words of Caution When Dealing with Ethereum
I will go one step further and mention that I don’t believe Ethereum to be a good platform for DeFi in general. Even though Ethereum laid the groundwork for borrowing, lending, and investing, it may be time for Ethereum to pass the torch to a more competent project. The gas fees on Ethereum have made it a platform for crypto elites. Interacting with DeFi on Ethereum can cost upwards of $50 for a simple transaction. This completely prices out most of the target demographic that cryptocurrencies aimed to help in the first place. That is, the lower class, and the unbanked.
Many DeFi Tokens are Actually CeFi
One must be careful when investing in DeFi tokens on Ethereum, as many are CeFi tokens disguised as DeFi. Many irresponsibly carry the name of DeFi without considering the philosophical characteristics of whether or not their token is truly decentralized. It is not hard to spot these deceptive tokens if you know what to look for.
Look for Centralized Supply: Did the founders of the project mint a collection of tokens for themselves? How are they using this % of tokens? When are they released? Under what conditions?
Look for Admin Back Door Access: Does the token have a back door only accessible by the administrator/owner of the token? This by definition completely fails the decentralization test, as there is a role in the system that is above everyone else. In contrast everyone on the Bitcoin network is 100% equal to the next. The hierarchy is flat. Watch out for “DeFi” tokens with a non-flat hierarchy of governance.
Look for Centralized Running of Hardware: This is not easy to determine, and is among the more controversial aspects of decentralization. The reason being is because the decentralization of hardware matters most when the network itself is under attack. For example, can the Bitcoin network sustain an attack from China if they decide to shut down all the computers running Bitcoin within the borders? I believe experts have successfully argued yes1 . In the case of Ethereum, the network is reported to be run mostly in the cloud.2 In other words, on servers own by centralized entities such as Amazon, Microsoft, and others.
DeFi is Hard, and it Takes Time to Do Right
Proper decentralization is hard. I would make the case that Bitcoin itself wasn’t decentralized for the first few years of its existence. It is simply not possible to build the infrastructure required for sufficient decentralization that soon after its launch. Decentralization takes years. However, it is worth doing right for the simple reason that if it’s done wrong, it could be a “total loss” sort of error.
If all goes well, decentralized finance will bring the four categories of financial services to the masses. Bitcoin is already bringing the first two to people in the developing worlds. The network that is bringing decentralized credit and investments to this same demographic has yet to be determined. The competitors?
Bitcoin on the Lightning Network
Ethereum (if it succeeds in scaling)
Cardano (If it succeeds in overtaking Ethereum)
Remember. Be skeptical. Do your research. Just because something is on the blockchain, doesn’t make it decentralized.
Don’t Invest in Something you Don’t Understand
I recommend everyone do their own research when making investments. I will never tell anyone to invest in anything except Bitcoin. That is because I see everything other than Bitcoin as a risky, yet to be determined investment, whereas Bitcoin is not really an investment, its decentralized money. All things being equal, Bitcoin is relatively easy to understand. I recommend people stay away from other cryptocurrencies until they accumulate the information to form an opinion about something. An opinion other than “I think it will go up”. Once you understand Bitcoin, you will have a much easier time understanding how the rest of the cryptocurrencies fit into the broader picture of things.
All The Best,
Keegan Francis
Dan Held on Bitcoin Security - https://danhedl.medium.com/bitcoins-security-is-fine-93391d9b61a8