The Cryptocurrency Revolution contains everything that has to do with money and value. It aims to redesign the whole concept of how we create and interact with value. Instead of relying and trusting someone with anything that has value to you ( from its creation to interaction ), Cryptocurrency allows you to trust something, that something is called Math. Before diving into the DeFi ( Decentralized Finance ) world, let me cover the basic concepts so you can understand how massive it really is.
Code ( here referring to computer code that is produced by a computer language ) is a simple set of instructions that can be used to execute or trigger certain actions once conditions are met. This Code is written into a Program and elements of interactions with the Code are added by the developer ( when you click on a button in a Program you send a command for the Program to process, this Program executes certain actions depending on what you have clicked ).
Let us Analyse the Idea of a Program, the Service it can offer and the Problems that it could have :
When a Program is Closed Source it means that only the people who created the Program can view and edit its code. That leaves us with the Trust Problem. You as a user have to trust the developers. You have no way of knowing the developers intentions nor can you verify if the Program does what the developers claim it does.
As example : A Program that sends money from your wallet to another wallet. A developer can simply edit the code so that instead of your money being sent to the wallet you want, it will be sent to the developers wallet. Of course that is a very extreme example, but the point is that you have to trust the developer to not be a malicious actor.
Of course there are many ways to help you trust that the developers are not going to steal from you in form of official registration of the company with the authorities ( which means that stealing and getting away with it will be much harder ), provision of documents that prove collaboration with Government Regulators and Institutions and things like Security Audits ( the developers pay another Company to verify its code and tell you if it has security vulnerabilities ). In the end you do not remove the Risk of the developers doing something malicious, you are only given assurance of intentions that you have to trust.
These Programs are packaged into a Service that the Bank / Company provides to its costumers. Everybody trusts Banks right ? They can’t just steal your money and run away. They can but they don’t have to. Like I already explained in “Part 1, Introduction” once you put your money in the Bank you do not own it anymore, you only own a paper or some numbers on a screen that serve as a statement that the Bank owes you that money ( which means you can withdraw it from the Bank at will and use it to pay for goods and services, but the Bank can also use your money however they like ).
- Freedom and Corruption
The Company / Bank ( lets call them the Centralized Entities ) that make the Programs, ultimately decide who is able to use them. Varying concepts such as Discrimination and Censorship could be used to decide who gets to use the Service CTs provide. Which means that you have to abide by their Ethics whether you agree with them or not.
As example : You have a Journalist who is reporting or researching corruption within the Government. The Bank can simply freeze his / her account, deny any Services and access to funds. Using this form of Censorship the Bank / Government can avoid its criminal activities being exposed to the general Public.
Now of course comes the Argument of fighting Criminal Activity. The Bank can deny access of funds to criminals thus weakening them. But the Problem comes back to the Concepts above, Trust and Corruption. Since “everybody has its price”, Banks just like Governments are run by people and can be easily corrupted. Since we have our Trust Problem from above we have no way of verifying if the Bank is supporting the criminals or fighting them. Well according to the “Recently leaked FinCEN files whose reports describe over 200,000 suspicious financial transactions valued at over US$2 trillion that occurred from 1999 to 2017 across multiple global financial institutions” we don’t even know the half of what is really going on behind the curtains of Centralized Entities. This is only the recent Report about Corruption involving Banks, there are many others.
Before considering the fact that these are only Public because files were leaked ( think about all the current Criminal Activities that are happening and those that never went public ), try visualizing the above number of 2 Trillion $ Dollars to get an idea of how much money is at stake on just that one leak.
It is not to say that Cryptocurrency or DeFi have a solution for the Criminal Activity Problem. Criminals will always find a way to fund their operations even using Cryptocurrency that are considered easier to track due to their Open nature ( to achieve Decentralization each participant has to have the entire Ledger, or the so called book of transactions, as the Database ). So every single transaction is publicly available.
DeFi vs CeFi
So how does this whole concept work in a Decentralized Finance ecosystem and what Advantages exist against Centralized Finance ?
First let’s talk about Platforms ( some of it already covered in Part 3, Investment Strategies ). I will focus mainly on Ethereum since it is the one I talked about in the previous part. Other Platforms are taking similar or different approaches to creating Decentralized Applications, but Ethereum is the one that currently ( as of writing this article ) has the most amount of developers and activity in this Sector.
Ethereum has something called “The Ethereum Virtual Machine”. Basically a Virtual Machine ( VM ) is a virtual copy of a computer inside of a computer. There are many uses for VM’s in Computer Science but that is besides the point. The main Idea that you need to understand is that since there is a Concept called Decentralization, it means that every participant can interact with the Ethereum Virtual Machine. Decentralized Finance Applications are Programs that run on the Ethereum Virtual Machine.
So how does that solve any of the above Problems ?
Ethereum on its own is open-source. That means that everybody can view the entire Code and know exactly what everything does within the system ( that is if you are a Programmer ). Now you might think that if everybody is able to view the Code it would make it less secure, after all Hackers can find vulnerabilities easier. That critical thinking is correct, however, the Study “Is Open Source Software More Secure ?, by Russel Clarke, David Dorwin and Rob Nash” concluded that “neither open source or proprietary software is less secure”.
But it is also stated that “open source does not pose any significant barriers to security, but rather reinforces sound security practices by involving many people that expose bugs quickly, and offers side-effects that provide customers and the community with concrete examples of reusable, secure, and working code”.
Since everybody can view the Code everybody can find Security Vulnerabilities and Problems in it. That in turn means that people are able to contribute to the Code with solutions or notify the developers about vulnerabilities. Of course people can also exploit them instead, but once exploited the whole community can react to it much faster then a single company whose Software is closed source. The bigger the Platform becomes the more developers it attracts. More developers means a bigger Community and more participation. That leads to higher chances of somebody discovering bugs and vulnerabilities and helping to fix them. Platforms can also host Community events such as Hackathons where people are invited and rewarded for trying to “hack” or break the Platform. This in turn is a win win situation because hackers get a reward and the Platform can fix those vulnerabilities.
Open Source concept does not solve the Trust Problem completely if you are not a Programmer. It does however give you more Sources to verify authenticity of the Program and give you an idea if it really does what the developers claim to do. Using the concept of Peer Review you can get the opinion of many different independent people who are qualified in that Field ( and understand the Code ) to give you their Analysis. Of course you need to exercise critical thinking in order to avoid Bias from said people. But the more people you ask the higher the chance to see all the Points of View and find about details that would be ignored during Research that could point to potential red flags.
The same goes for Decentralized Finance Applications. If the creators of a DeFi App choose to make it Open-Source, it gives them more credibility and trust by the community.
- Freedom and Corruption
The Problem of Freedom is technically solved. However another Problem arises when the concept of Freedom is implemented : Consequence. Every single Person is “able” to use Cryptocurrency, so there is Freedom of choice. But if you live in a Country that does not allow the use of Cryptocurrency you will bear the consequences ( here is an example of legality of Bitcoin ). So everybody can use Cryptocurrency, but whether you will be punished for doing so is a different question. It is already a step forward from CeFi where certain people may be explicitly banned by the Bank from using its Services however.
Concepts such as Corruption can never be truly 100% solved. In a Psychology perspective every Human has weaknesses and everybody can be broken. But the difference with DeFi and Cryptocurrencies is that everything is open and transparent, so everybody is able to see irregularities and spot malicious actions. The developers of a Decentralized Finance Application or a Cryptocurrency Platform are capable ( in theory ) to release an update that would simply steal everybody’s money. If the Industry is well Regulated and the Project is officially registered and licensed they will run a risk of being caught. But before that even happens the community will be able to spot that malicious action, since the Code is open source nothing can be hidden ( contrary to closed source where the developers are able to do such actions without anybody noticing it until it is too late ).
Well then a critical thought such as : “Are the creators and developers of an Open Source Cryptocurrency or a DeFi Application able to block people from using it or can just freeze their wallets ?” arises.
The answer to the above question is a Yes with a But ( this applies to most Cryptocurrencies using Proof of Work and Proof of Stake consensus algorithms ). Since it is a very big and complicated topic, I will only summarize it. You can think of it this way : in CeFi you have control that is centralized, there is only one person or group of people that can decide who they offer services to. That means they can easily decide to deny service to a certain person and it will be final. In DeFi and some Cryptocurrency Platforms the control over certain decisions is given to the participants. Whether you receive more control for having more computational power provided to the network ( Proof of Work ) or you receive more control for having more Governance Tokens or Coins( Proof of Stake ), certain decisions will be decided by a majority. Now this is a VERY simple example that does not apply to every Cryptocurrency Project out there. But in the end in most cases it is possible for miners ( PoW ) and block producers ( PoS ) to simply ignore / reject blocks sent from a certain wallet address, thus not allowing it to make any transactions. However since Cryptocurrencies are pseudonymous, it becomes much harder to target certain people. So “censorship” is extremely improbable, but not impossible in most Projects. If a Cryptocurrency Project does decide to do it, it will loose trust within the community and could lead to a disaster.
So we have our Cryptocurrency Platforms that allow us to build Virtual Programs that are accessible to every single person in the world. These Programs are then called Dapps ( Decentralized applications ). I want to cover them in two simple categories : General and Finance.
Under General Dapps we have things like :
- and many more
And everything else that can be made into an application. There is no limit for imagination and many things are being built today. There are many Cryptocurrency Platforms that are building these applications. You can explore and find out about many Applications in a Website called dapp.review ( under explore Decentralized Applications ).
And you can read their Quarterly Dapp Market reports ( they do not have a section for reports, so I linked the Q2 2020 Report ).
This can help you evaluate Cryptocurrency Platforms and see their activity by users and transactions.
The reason you want to evaluate the activity of Cryptocurrency Platforms is quite simple :
The more Dapps a Platform has the more activity it attracts ( of course quantity does not mean quality, there are successful and unsuccessful ideas, it all depends on what people need, want and use ).
The more activity the Dapp has, the more demand there is for the Cryptocurrency token with which transactions for the Dapp are paid with ( for example you have a Dapp that runs on Ethereum. Every transaction that the Dapp executes it consumes the Ethereum token ).
You can think of the Cryptocurrency token of a Platform as fuel. If more people want to use fuel ( to do transactions on a Dapp for example ) there will be higher demand for the said token, which then raises its price. You need to keep in mind that some of these Dapps can create their own token for different purposes within the Dapp. In Ethereum there is the so called ERC-20 tokens. Anybody can create these tokens in any amount they want. However in order to attract people to buy those tokens you need to give them a use, because nobody would want to buy something useless. If a Dapp has their own ERC-20 token that serves a certain purpose, it could also be seen as an investment. However in order to send an ERC-20 token to another wallet and perform a transaction, which is essential for any Dapp to function, you need to use the fuel which is the Ethereum Coin ( also called Ether ). So you can decide whether you want to invest in a ERC-20 token of a Project that runs a Dapp, or you want to invest in the Platform that hosts the Dapp and serves as fuel for the Dapp to function. Because at the end of the day if the Dapp will be successful it will automatically mean that the Platform will be more valuable.
Another critical thought would be : What if the Dapp decides to move to another Platform ? It could totally do that. But it needs to consider interoperability. If a Dapp is for example running on Ethereum, it can easily interoperate with other Dapps that run on Ethereum. Currently cross-chain interoperability ( meaning between two different Cryptocurrency Platforms ) is a big Problem and many Projects are aiming to solve it. Right now if you want your Dapp to have the most exposure, you build it on popular Platforms. The most popular currently being Ethereum. This will change overtime as more Platforms gain strength and usage thus allowing competitiveness.
Note : Like I already mentioned in Part 3, in order to avoid bias from my side I will solely mention Ethereum and focus on it as the Platform of choice. It is currently the most popular and the one with the most activity ( as of 2020 ).
The DeFi World
DeFi Dapps are mostly focused in revolutionizing the whole Finance Industry. This Industry is massive and there are many Problems to solve. If the Arguments from previous parts and the ones above are enough to consider DeFi “safer” and more “trustworthy” then CeFi, then DeFi could replace any Service that any Bank or Financial Institution is currently offering with the advantages of Finance 3.0. The Website called defipulse.com can help you see current DeFi Dapps that are built on Ethereum.
I suggest you to read these articles and reports. They can help you visualize the opportunities offered by DeFi :
- Synthetic Assets in DeFi: Use Cases & Opportunities by Dmitriy Berenzon
- Mapping Decentralized Finance by Joel John & Lawrence Lundy-Bryan
- Decentralized Finance: On Blockchain- and Smart Contract-Based Financial Markets by Fabian Schär
In the DeFi List you can see Projects that run on Ethereum and their respective use within a Category. If you are familiar with Financial Services that currently exist you will see that many things can already be done in a Digital manner using a Cryptocurrency Platform’s Dapp. Some of these Projects are new, unregulated and have Risks. To be able to identify Risks in an Industry that is very immature you need to read Reports and Research. Some suggestions for reading about the topic of Risk in the DeFi world :
- Decentralized Finance: Usecases & Risks for Mass Adoption by dGen ( dGen is a not-for-profit think tank based in Berlin, Germany )
- A guide to financial risk in DeFi by Seth Goldfarb
And of course for some skepticism for critical thinking :
- Is DeFi resilient enough for mass adoption? by Greg Lang
- DeFi in 2020: Is Decentralized Finance Really Ready for the ‘Mainstream’? by Rachel McIntosh
- DeFi Beyond the Hype by the Wharton Blockchain and Digital Asset Project
“DeFi is a new, fast-growing area. Yet it remains immature, with a variety of unresolved economic, technical, operational, and public policy issues that will be important to address.”
Keep in mind that many people dismissed Bitcoin and Ethereum for many years with the only Argument for their criticism being fear of the unknown. The above Reports and Articles outline current Problems and Challenges with DeFi but also point out to its massive opportunities if it succeeds. Just like Cryptocurrencies started by being something that everybody feared, with time it became something that is offered by Global Banks and Institutions.
All of the above is to just understand how massive DeFi is, but there is currently not many ways to Analyse DeFi Dapps and be sure that they are secure and not a scam ( for people who do not understand Programming Languages ).
There are Projects focusing on Analyzing DeFi Dapps, give them Risk Assessment Reports and a Risk Score. One such Project is Gauntlet Network and you can read their “Risk Scores for DeFi — Alpha Release by John Morrow” article to learn more about how they intend to bring this Analysis in a simple form that everybody can understand.
Another important thing you should look for in any DeFi Dapp Project is a report of a Security Audit of their Smart Contract. This does not always guarantee that the Dapp is secure, but it gives it more credibility.
Investing in DeFi
There are many ways you can make money with DeFi. However I will only cover the Investing into a specific DeFi Dapp’s success part.
For new and inexperienced users I would suggest sticking with option number 1 as it poses substantially less Risk. Otherwise you can do it in two ways :
1 - You can Buy the Cryptocurrency’s Platform coin ( in the Ethereum Platform as example that would be the ETH coin ). Using MyEtherWallet, or any Cryptocurrency Exchange of choice to buy Ethereum coins.
2 - You can Buy the DeFi Dapp’s own token ( be careful to not buy tokens that have no use cases within the Dapp. Read the Projects Tokenomics aka the Business Model and make sure it will have a use case. Many DeFi Dapps Governance tokens are only used for Voting on change Proposals. This can be seen as valuable to you because you can influence the Project with your vote, but it does not guarantee that the token will rise in Price only because of the Governance ability ).
The article “Digital Assets Initial DeFi Offering” by Gisele Schout, covers some DeFi Project tokens, what they have to offer and where they derive their value from. DeFi tokens that only get their value from the Governance ability are inferior to DeFi tokens that offer a variety of features. Keep in mind that Projects evolve and add new features, so be sure to follow the news about your favorite Projects.
You can also purchase a DeFi based Index token. That way you will have exposure to some DeFi Projects at once without the hassle of storing each of them separately, spending money on transaction fees and dealing with many technical issues you may encounter.
Note : This Index token was only recently created ( September 2020 ). So please read about it as much as you can and give it some time and thought. I would not recommend investing in this Index for inexperienced users. If you do decide to buy it you are doing so at your own Risk.
The DeFi Pulse Index is an ERC-20 token that automatically re-balances its own portfolio of included assets. “DeFi Pulse Index is the first of its kind, an index of decentralized finance that isn’t synthetic or a derivative but rather you own the tokens that comprise the capitalization weighted index.” in the Introducing the DeFi Pulse Index article. You can read more about the Index Construction in here.
You can find the security Audits of the Set Protocol on the official website under Security.
Since it is an ERC-20 token you can simply send it to an Ethereum Wallet you control or buy it with an Ethereum wallet you already own using the TokenSets Platform Tutorial ( you can read more about the TokenSets Platform in here ). Keep in mind that sending any ERC-20 token to anywhere within the Ethereum Network requires the ETH coin as fuel ( also called gas ).
There are other DeFi Indexes that have their own strategy and different tokens in the Index. You can read about some of them in the article : “DeFi Index Funds: The benefits of diversification and a comparison of recent performance”, by Overanalyser.
Despite its current immaturity and Problems, Decentralized Finance Applications have seen tremendous growth. They aim to offer Financial Services without limitations in a much more transparent and secure way. Some Projects even aiming to be completely governed by participants that can then vote for Proposals and changes. But like everything it still needs time to show its true potential and to prove that it is scalable and resilient. That in turn lies in the development of Platforms that these Dapps run on. However nobody should underestimate the potential it has. With the right People and the right Ideas DeFi could completely redefine how everybody interacts with Finance. So keep an eye on this new Revolution and decide for yourself whether it is worth it being an early investor or not.
This content is for Information and educational purposes only and should not be considered investment advice or an investment recommendation.