The Private Equity for Families Blog

Decentralized Finance Products Are Like Climbing Everest

If you think trying to understand Bitcoin (BTC) and its blockchain is difficult, wait until you have your first encounter with decentralized banking or insurance products. It will seem as daunting and risky as climbing Everest without a sherpa.

Because I am not qualified to guide in this emerging territory, I have asked Will Mason, founder of Upswing, LLC and an entrepreneur with knowledge about the space, to help me. Will’s commentary is shown in italics.

Will’s first step was to send me an article from Coinbase from January 2020 entitled “A Beginners Guide To Decentralized Finance (“DEFI”). Here is the link: https://blog.coinbase.com/a-beginners-guide-to-decentralized-finance-defi-574c68ff43c4

Here are a few kernels of insight.

  • Decentralized finance products are like an app running on an incorruptible blockchain containing the rules of association for that application. Insiders call these apps “dapps”.
  • The Blockchain is completely open source code for anyone to audit.  It is permission-less, public, transparent, and provides a very quick settlement.
  • These smart contracts can transact a loan or a payment using a stablecoin whose value is pegged by smart contract to any currency, like the USD or with tokens that run on the network. This enables an internal, universal, borderless currency for the specific dapp. People can swap in and out of tokens of their own choosing without any permission. This is where UniSwap is one of the most important parts of the DEFI landscape as will be discussed below. 

Banking the Unbanked

Using DEFI applications and stablecoins that operate on those blockchains, people around the world, who have never used a bank, will have access to banking services with their mobile phones.  If you live in a corrupt, poorly run government, it won’t matter much.  Many people in the U.S.A. will not realize the necessity of this.  Most of us are quite comfortable putting money into a bank and not worried about seizure by the government.  This is not the case for most of the world.  The ability to transact in algorithmic or collateral backed stablecoins or in a blockchain’s native currency, such as bitcoin or ether, will slowly but surely remove all fiat from the vast majority of transactions.  Smart contracts will allow the sender to send tokens to the receiver instantly, with instant settlement, in a completely public and transparent way, and there is not much any government can do about it.  A perfect example of how this will change things is in remittance.  Western Union’s business model will be challenged.  Why send money through Western Union, get charged a high fee, and have my family member have to go into a Western Union bank in Honduras where gangs are waiting outside  Yes, this happens all the time.  People not only pay a fee to Western Union, but they also have to pay a fee to the local gangs. With alternatives like Bitcoin, stable coins or tokens the unbanked are likely to choose anonymity, lower fees and no physical risk.

Blockchain’s Security Doubles According To Moore’s Law

The key to all permission-less, decentralized networks, aside from popularity, is security. Security for the blockchain ledger supporting all the BTC transactions since inception follows the power of Moore’s law, which has demonstrated that computing power doubles every 2 years. Here is how Will Mason describes the level of security underpinning the Bitcoin blockchain ledger:

If we set a difficulty rating of 1 for the first Bitcoin block ever to be mined, what is the difficulty rating now?  11 years of logarithmic adoption and by logarithmic enhancements in computing power bring the difficulty rating now to a staggering 21.7 trillion.  Another way to look at this is the network is 21.7 trillion times more secure then when it started.  This will only continue to grow, and at substantial rates.  More people are adopting it, which brings a higher price, which brings more miners, which secures the network more, which will make more people adopt it; so on and so forth.  This circular feedback loop is still in its infancy.”

Uniswap Is A Decentralized Trading Place

We are used to centralized trading markets being open 5 days a week with hours between 8am and 4pm depending on the exchanges. These trading markets are private businesses and they are usually publicly held and owned by stockholders. NYSE, NASDAQ, AMEX, CBOE, and ICE are all regulated by governmental watchdogs. Some critical parts of the centralized trading system are self regulated like the Depositary Trading & Clearing Corporation. Sometimes these exchanges are fined for not following trading rules and there are periodic audits. However, their information is private and there is little visibility by users into their day to day operations.

Coinbase is one such centralized trading places. Coinbase is privately owned and is in the process of preparing for an Initial Public Offering of its shares. It is regulated by state and federal agencies but it has horrible accountability to users. If a Bitcoin transaction has a glitch, good luck getting anyone to answer your email or call.

I am showing Will Mason’s description of Uniswap below. You will see it is organized and validated quite differently:

Decentralized exchanges are exchanges with no middle point.  They are a Dapps (Decentralized Apps) that facilitate the exchange of tokens.  Using smart contracts, users can connect their web 3.0 wallet to the interface and swap one token for another with instant settlement. 

These decentralized exchanges run off a blockchain network like Ethereum, Solana, Binance, or Cardano, and there are LP’s (liquidity providers) who earn fees for providing liquidity to pairs of tokens.  Why would people provide this liquidity?  Every transaction that goes through Uniswap is charged .3% of the token that is being exchanged.  Those tokens are given to the LP’s who are providing liquidity.  The biggest liquidity pair on Uniswap right now is WBTC (Wrapped Bitcoin)- Ether.  This currently has $363m worth of liquidity and did $32m in volume over the last 24 hours, generating $96k in fees.  That $96k in fees is paid to the LP’s.  Whatever percentage of the LP pool you are is what percentage of the $96k you get.

Uniswap, which is the biggest decentralized exchange (DEX) on the Ethereum network, is currently doing $1 Billion in volume a day.  Yes, a day.  More than Coinbase.  The more people who use Uniswap, the more fees, which drives more liquidity providers; so on so forth.  At https://info.uniswap.org/home, you can look at total volume, volume for specific pairs, and the amount of liquidity that is locked up on Uniswap as well.  I have personally provided liquidity to several pairs to help bootstrap certain dapps.

Blockchains operate with their own native currency, which can at times be somewhat volatile.  Stablecoins, such as USDC (which is backed by actual dollars), are the main medium of exchange on any blockchain.  This stable medium allows transactions for insurance products, banking services, and the purchase of goods with significantly less volatility.

Obviously, the aspiration is to eliminate the conversion risk and have the stablecoins become a replacement themselves for the Euro, USD, Renminbi etc. Right now that regime change is just a twinkle in a Bitcoin miner’s eye but centralized finance systems are being tested by the Covid recovery. There may be a Defi product in your wallet sooner than you think.

The above commentary is for informational purposes only.  Not intended as legal or investment advice or a recommendation of any particular security or strategy. Information prepared from third-party sources is believed to be reliable though its accuracy is not guaranteed. Opinions expressed in this commentary reflect subjective judgments based on conditions at the time of writing and are subject to change without notice.

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Rob McCreary

Rob McCreary has more than 40 years of transactional experience as an attorney, investment banker and private equity fund manager, and has spent his career in building entrepreneurial organizations with successful track records Founder and chairman of CapitalWorks, he is responsible for developing and maintaining senior relationships with investors and portfolio governance.

This blog represents the views of Rob McCreary and do not reflect those of CapitalWorks or its employees. This blog is not intended as investment advice. Any discussion of a specific security is for illustrative purposes only and should not be relied upon as indicative of such security’s current or future value. Readers should consult with their own financial advisors before making an investment decision.

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