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DeFi 2.0: Introducing Creativity to Finance
The future of finance is not zero-sum
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With many cryptocurrencies hitting an all time high last week, the crypto ecosystem has never been more active. There are more eyeballs than ever before on the market, and there is a growing need for crypto to find product market fit.
So far the most natural fit for blockchain technology has been in disrupting the traditional financial market, and with the rise of Decentralised Finance (DeFi) applications has disintermediated traditional banking institutions. In 2020, we saw a huge rise in the number of platforms allowing users to conduct various basic banking functions such as borrowing and lending assets. In 2021, we are seeing the evolution of this space with increasingly creative platforms that aim to increase capital efficiency whilst decreasing the barriers to entry for the average user to access capital or earn money from their current crypto holdings.
What is DeFi 1.0
DeFi or Decentralised Finance allows anyone in the world to lend, borrow, or trade blockchain-based assets at any time. It effectively tries to replicate the traditional finance markets in a decentralised manner. DeFi doesn't discriminate against who uses the application, and is completely transparent in the way these applications are built and operate.
For cryptocurrencies to truly enter the mainstream and replace the current banking system, the adoption of DeFi is incredibly important as it creates various markets in which participants can trade and have an opinion on assets (think derivative markets such as futures and options). However a huge advantage of DeFi is that it empowers individuals to borrow money, earn money through lending and even take out insurance on their DeFi assets. This is in major contrast to traditional banking systems which are heavily skewed in favour of banks. In a traditional system, interest earned on deposits and who determines who can borrow money are controlled by the bank. With DeFi, you are in control.
Some real life examples that may help to illustrate what DeFi 1.0 is and how it works are outlined below:
Use a decentralised exchange such as Uniswap to buy a crypto token. Decentralised exchanges provide new tokens the ability to be listed and liquid faster, without much barrier to entry. It also allows anyone to trade that token with ease, without needing to go through identity verification processes.
Following on, these decentralised exchanges need to ensure there is enough liquidity for a market to exist and for trades to settle. In a centralised world, the exchange would typically match buy and sell orders in the market. In DeFi land, this is done through having a liquidity pool.
Users called liquidity providers (LP) add an equal value of two tokens in a pool to create a market. Now that there is liquidity on both sides of the market, orders are fulfilled at a price set by a smart contract (A smart contract is a self-executing contract with the terms of the agreement between buyer and seller being directly written into lines of code. In this case the terms of agreement are centred around the price and volume of the purchase/sale).
The best part about this is that anyone can be a liquidity provider. In exchange for providing liquidity (and locking up your tokens), you can earn a percentage of the fees generated by that trading pair, which provides crypto holders passive income. To keep track of this, you receive an interest bearing token.
Taking advantage of liquidity pools, you can also borrow and lend crypto through protocols such as AAVE. Like traditional lending, you can choose to borrow tokens at a rate determined by the level of demand for the token, and how much funds are locked up in a liquidity pool. On the other side, token lenders can earn a compounding percentage on their deposit.
Given the nascent nature of DeFi, some of the yields you can earn on crypto lending and liquidity pools are quite extraordinary (in some cases above 1,000% APY). However, as more capital enters the space and counterparty risk lowers with more sophisticated players in the space, this yield will drop.
Whilst there is a general lack of sophistication in DeFi currently, the entire movement is gathering steam quite quickly, with enormous sums being thrown around on a daily basis. According to DeFi Llama, the total value locked within DeFi apps and protocols is at a whopping US$257.7B, or just under 10% of the total crypto market cap. This initial surge has also led to a number of innovative protocols aiming to better align the interests of market participants.
Enter DeFi 2.0
Whilst the large bulk of DeFi 1.0 happened using the Ethereum blockchain as the infrastructure layer, much of the DeFi 2.0 activity is occurring on other infrastructure (Layer 1) protocols such as Solana, Avalanche and Fantom. This is largely due to the high Ethereum transaction fees that make it painful to serendipitously move between applications and protocols. The new chains on the block are quicker, cheaper and offer more exciting opportunities.
Right now, DeFi 2.0 is in a state of money legoing, where people are trying to extract the most yield with the least amount of capital. One of the more interesting projects is OlympusDAO.
Olympus (OHM) is aiming to be the stablecoin of crypto that is not pegged to a fiat currency (e.g. USD). Instead, it introduces the concept of bonds to crypto. Stump up your crypto as collateral and receive OHM tokens in return at a discount. OlympusDAO then adds this collateral to its reserve pool. This ensures that every Olympus token is backed by collateral stored in the treasury.
What's even crazier is once you receive your OHM token, you can stake it to earn more OHM. The reward for staking your OHM? A measly 8,209.5% APY (annual percentage yield). Almost seems unbelievable and ponzi like compared to your bank's 0.1% interest rate.
However, the APY that Olympus shows you, isn’t really a true interest rate. Rather, the APY is telling you how much your OHM balance will increase based on the current minting rate. For example, if you put in 1 OHM token today, you will have 82 OHM tokens in a year, but there would also be more OHM tokens in circulation. You are essentially ensuring your percentage ownership of OHM stays equal. Nat Eliason does a great job of breaking down OlympusDao and why it isn't a ponzi here.
Taking this to the next level
As with everything crypto related, when anything new receives some attention and popularity, a number of copycats emerge, hoping to catch some of the market tailwinds. Just look at the number of dog coins that have emerged in the last few weeks. This phenomenon has led to many forks of the Olympus protocol.
One such fork is led by talented developer Daniele Sestagalli. Sestagalli first immersed himself in crypto back in 2011, and has since worked on a multitude of projects including creating a blockchain framework for the music industry. More recently, Sestagalli has taken charge of creating an ecosystem of DeFi applications that help break down the barrier to DeFi, but are also innovative in offering people the opportunity to express their decision making on the blockchain.
The first of his applications is Abracadabra which allows users to borrow a US dollar pegged stablecoin called Magical Internet Money (MIM). In order to borrow MIM, you can use an interest bearing token (e.g. LP Token) as collateral (remember from above that an interest bearing token is received when you contribute to a liquidity pool).
Whilst previously useless, Abracadabra has provided utility from these interest bearing tokens and can leverage their funds to maximise capital efficiency. Moreover, Abracadabra is also interoperable across multiple blockchains such as Ethereum, Avalanche, Binance Smart Chain, Fantom and Arbitrum One. This is unique in the world of DeFi when most projects are built on Ethereum, and developers are loyal to their chosen protocol.
As aforementioned, Sestagalli forked Olympus with the goal of creating a decentralised reserve currency native to the Avalanche blockchain. Wonderland (TIME) tokens are backed by a basket of assets and work quite similarly to Olympus. Users can either buy TIME tokens on the open market through decentralised exchanges or mint new TIME tokens by contributing to the reserve.
Those who choose to stake (lock up) TIME, will earn new TIME tokens from the treasury when it is minted by the protocol. But, stakers are not diluted down by the additional TIME that is minted. Instead, the protocol uses a rebasing mechanism every 8 hours which effectively tops up your TIME balance such that you retain the same ownership percentage of the total market cap of TIME. As a result, this has evolved into a mind blowing 68,585% APY for stakers.
To juice this up further, you can employ some money lego tactics and borrow MIM from Abracadabra and then use that to mint new TIME tokens and then stake that to earn more TIME tokens. Alternatively, you can also use your staked TIME tokens which are called Memories (MEMO) as collateral to borrow MIM. Please note that over collateralisation and stacked borrowing can result in large financial losses.
The third project led by Sestagalli is Popsicle Finance, which is a yield enhancement platform that aims to make it easy to maximise yield as a liquidity provider. Essentially, the platform aims to automatically compare across various liquidity pools and allocate a user's crypto assets based on various rules. Given the extreme proliferation of DeFi applications, a one stop solution towards maximising yield is incredibly important in promoting capital efficiency and also reducing the barriers to entry to accessing these liquidity pools.
Furthermore, the platform is decentralised and governed by its users - the holders of the ICE token (effectively a DAO). All performance fees charged by Popsicle Finance are also distributed to ICE holders in the form of more ICE tokens. This follows the central theme of providing users an incentive to continue to use the platform and be involved in the ecosystem.
Unfortunately, in early August, Popsicle Finance was hacked and lost about USD$20 million. Following this, the platform has been under review and is not accepting new deposits. In good faith, Sestagalli has promised to repay affected users and the platform has also taken loans to repay users. Sizeable security compromises are to be expected in DeFi and crypto largely given the nascency of the industry and the anonymity of stolen funds.
The ecosystem that Sestagalli is building is nothing short of special and inspiring and the speed at which he has built these applications is phenomenal with these platforms being largely built in 2021. Sestagalli has succeeded in breaking down the barriers to entry to DeFi and providing everyone the ability to efficiently allocate capital. Whilst his next move is uncertain, it's almost certainly going to be interoperable across blockchains and accessible by the masses.
The Future of DeFi
The future of DeFi is surely to uproot and disrupt traditional finance organisations. It'll likely come through with a sea of Memes and large communities gathering and aligning on incentives. Sestagalli is a pioneer in this space, forging ahead with the #OccupyDeFi movement, hoping to keep "DeFi open, decentralised and censorship-resistant” as more VCs and centralised protocols enter the space.
The trend towards tokenizing everything is key for greater capital efficiency. In TradFi, we are able to take out loans based on our equity ownership of a house. With DeFi, the tokenisation of everything will allow us to stump up collateral in various forms without much restriction. You can already take out loans whilst using an NFT as collateral. Imagine if you could do that with literally any other online property. You could use your membership to a community as collateral or you could even collateralise your twitter account. Whether that's a wise move is another question, but the important thing is that the optionality exists and users are not restricted in the financial decisions they make.
However, with decentralisation and anonymity comes security concerns and UX issues. Rug pulls are common in DeFi land, but there is a growing smart contract audit and insurance industry that hopes to protect investors from such security breaches. Moreover, the UX of these platforms – whilst clunky – are improving slowly and are largely dependent on external platforms and providers improving their own onboarding flows.
Ultimately, the power of community paired with creative and collective wealth generation should propel DeFi far beyond TradFi. To ensure you benefit from this fundamental shift away from traditional finance, I’d encourage you to really get immersed in the ecosystem and understand how the fundamentals for these projects work. Better yet, you could invest a small amount in one of these projects and have some skin in the game while you learn (Not financial advice).
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*Full disclosure, at the time of writing this article I own $TIME and $OHM tokens.