Early look at DeFi on Ethereum
DeFi (Decentralized Finance) is the new new thing on the blockchain, like with new new things ( remember ICOs ?) there is a learning curve and a ton of new concepts and issues, rather than go deep into any one of them I’ll try to give you an overview and point you to other resources if you want to learn more, let’s dig in…
Don’t sugar coat it doc.
Think about what financial products you use… A checking account that gives you 0% interest, a savings account that gives you 6% APR , a loan you have to beg for at 12% APR, Insurance and credit cards to name a few, what all this instruments have in common is that there is a middle man ( your bank ) and this middle man nickel and dimes you, sets and changes the terms whenever it pleases and generally treats you like crap, DeFi at its core wants to eliminate the middle man, decentralize the whole process and in the parlance of our times let’s you be your own bank.
While this sounds great ( unless you are a bank ), it is literally day zero of this effort, and as such there are multiple issues both intrinsic ( you do know how to operate a bank don’t you ? ) and growing pains, mainly horrible UI/UX, a lack of on-boarding , early adopter risk and well the products themselves are a bit on the weird side.
If DeFi is to be successful, it needs to successfully emulate fractional banking ( or a similar mechanism ), which in turn facilitates lending and interest rates.
The story of fractional banking as told in economics classes is that you give your money to the bank so it can keep it safe, the bank then lends it to others and charges them interests and the bank gives you back the interests minus the cost of running the bank, an important detail is that the bank does not have every single customers money at hand since it is not expecting all the customers to come and demand their money at the same time (a run on the bank) , hence the fractional part, banks are also required to have at least some percentage of the costumers money at hand, this are called reserves and currently in the US they are a low low 10%.
The problem with traditional banks
Somewhere along the way the above story changed into something else, banks have played fast and loose with credit on one end, and the service has become both inefficient and one sided on the other, your checking account doesn’t give you interests, there’s fees everywhere and we had the 2008 financial crisis as a result of lax regulation.
The reason is clear, banks as a group operate a monopoly and banks control the money which in turn controls politics. Cryptocurrencies flawed as they might be are a very clear competitor to this system across the board, the currencies themselves be it Bitcoin, Ethereum or a yet to come one are fast turning into a competing Fiat ( government backed currency ), ICOs are an alternative to the VC model of funding, and now DeFi can be an alternative to the bank monopoly.
Now that we have an overview of what DeFi is, let’s look into a couple of products already running on the Ethereum Blockchain:
⚙️ Why Ethereum ?While some DeFi products might come up in other cryptocurrencies/blockchains, due to its programming nature and track record, Ethereum is where most of the progress is happening right now and as such I'll focus on that for now.
Maker DAO, Dai,MKR and CDPs :
Quick Explanation:Maker DAO is a Decentralized Autonomous Organization, Dai is an Ethereum Stablecoin pegged to the Dollar, MKR is an utility token and a CDP is a Collateralized Debt Position, they all work together to provide DeFi products.
That’s a lot to unpack and clarify, so let’s go slower:
DAI is an Ethereum based stable coin; this means that
1 DAI should equal 1 USD and that you should be able to
exchange back and forth from ETH BY YOURSELF in a DECENTRALIZED Manner.
Or if it was a traditional bank ad, it would look something like this:
I’ve been promised the moon before, so let’s first check the peg/price :
So, the story checks out so far, the price in a year and a half mostly followed the peg to the USD ( not perfect, but close enough ) , how about exchanging
ETH for DAI ?
The above is a Dapp interface at https://eth2dai.com , you can use it to exchange back and forth Dai and ETH by connecting your wallet, Dapps (Decentralized Apps) in case you need a reminder should be just the UI/UX for interacting with smart contracts on the Ethereum Blockchain, in this case the contract can be found here :
So the first DeFi product in case it’s not clear is a stablecoin worth 1USD that you can convert by yourself, so this means that as long as you have access to ETH on your country and a computer, you can move it to USD by yourself, you can later send it/spend it or convert it back to local currency, this last part is currently the bottleneck since you need a local exchange and bank, regulations and taxes might also apply.
CDPs & MKR:
CDP is a
Collateralized Debt Position that generates
DAI against a collateral of
ETH ; unlike a regular loan from your bank, your collateral is variable and tied to the price of
ETH and how much you borrowed, there’s also a yearly fee ( currently 20%) and your loan can be closed with a 13% fee if you don’t add enough collateral on a price swing, adding to this complexity you need to pay fees in a token called
CDP is a complex thing to grasp, but if you’ve heard or used a variable interest loan, you are halfway there, the catch here is that the loan is collateralized with
ETH , so if the price goes up you are in the clear, but if it goes down and below a predetermined level, you need to add more collateral or risk losing part( or all ) your collateral ( depending on the price ), also keep in mind this is a loan, so you need to repay whatever you borrowed in
DAI when you want to close it, in other terms, its like a pawn-shop loan on your eth.
Granted, a traditional bank would have a slightly harder time marketing it :
CDPs never really made sense to me until I started playing with them, to do so you’d need to connect your wallet — metamask works great, ( Infuriatingly, there’s no sandbox or calculators to play with the system ), and then you can finally get to the interface like this one:
Here I am generating
100 Dai ($100) and leaving
1 ETH as collateral, my liquidation price is
$150 ETH/USD , when I want to close my loan and recover my
1ETH , I’d need to repay the
100 Dai along with the stability fee ( in Dai or MKR).
Why would you open a CDP ?
A CDP is intrinsically a bet that the price of ETH will go up and that you’ll make something more productive with your loan than what the interest + collateral takes out from it.
The most popular use so far is leveraged trading, so in the above case, you’d change the
100 Dai back to ETH giving you a grand total of
1.48 ETH , since your loan is denominated in
Dai not ETH , you’d need to pay back ~
$100 + 20% = $120 after 1 year. If the price of ETH goes up more than 20% in a year, you made a profit on the 0.48 ETH and still have your original 1 ETH, otherwise (the price goes down) you’d have to add more collateral or risk losing all or part of your 1 eth.
Another use is to simply generate liquidity and keep your
ETH long term, say you want a new laptop, are unemployed but know you will get some money later this year and have some
ETH, Instead of exchanging your
USD and buying your laptop, you could pawn them, get
Dai, change them to dollars or local currency, buy your
laptop and then reverse the process at a later date when you have the money or even pay back the loan as you go in the installments you decide.
Compound is another alternative to DeFi products from MakerDAO, like with CDPs you can borrow via a similar collateral mechanic, but you can also earn interest if you supply liquidity in the form of a token…
Or in Bank speak:
Before you get excited, let me just show you the current offerings at Compound:
While the 14.70% APR on DAI looks awesome ( 1yr Treasury Bonds ~ 2.6% APR for comparison) this rate is variable and would require you to switch your
eth to Dai , so you’d lose if the price goes up, alternative, if you are not in the space or don’t want to exchange your eth, you can simply buy Dai with your local currency at an exchange, this on ramp I think is still not efficient or well developed enough to recommend to newcomers (think your grandpa) , but it’s getting better everyday.
Additionally, as of now the whole documentation of Compound is a couple of posts on Medium : https://medium.com/compound-finance/faq-1a2636713b69 , so this might not be enough for you, the process itself is similar to borrowing DAI, you connect your wallet to a Dapp and go through a few steps ( some fees do apply).
As mentioned at the start, these are just a few DeFi products currently out there, but you can already see how you could mix and match to make something more complex, for instance you could
borrow Dai with your ETH and
earn interest on your Dai, you now have a very complex financial derivative you just made on your laptop in a few minutes.
The principle that the buyer alone is responsible for checking the quality and suitability of goods before a purchase is made.
- Security issues. These are early days, as such, the smart contracts powering DeFi could be open to bugs and other issues, while the code is public, you’d have to know Solidity and have the time, interest and skill to audit them yourself.
- You are on your own. Calling your bank for help is usually a really bad experience but at least you can contact them, here you carry all the responsibility.
While these are early days, true products exist and work as advertised, DeFi does measure up to the recent hype, at least as a product category.
There is also a lot of issues with these products due to how new they are and the startup nature of the teams behind them, in a perfect world banks would embrace these new tools and be part of the effort (yeah right ), like the dinosaurs they will most likely roar and claw at the sky before being hit by a DeFi meteorite, but we are probably years if not decades away.
Now if you excuse me, I am going to open a CDP ( a small over collateralized one )
Thanks for reading !
About the Author:
Born Eugenio Noyola Leon (Keno) I am a Designer, Software Developer & Artist currently living in Mexico City, you can find me at www.k3no.com