The Breakdown - A Simple Explanation of DeFi and Yield Farming Using Actual Human Words

Episode Date: July 23, 2020

Today on the Brief: US Gov’t forces China’s Houston consulate to close US previously-owned housing market grows 20.7% May to June Insider stock selling reaches record levels Our main discussion: DeFi 101 Today’s episode of The Breakdown is a primer for anyone who has lost track of the terminology surrounding decentralized finance. In it, NLW goes over: DeFi’s background and origins Market making in a traditional context Automated market making  How liquidity mining incentives economic participation  How decentralized exchanges differ from centralized exchanges  What “yield farming” actually means Why we shouldn’t be concerned about the Yield Farming bubble

The countryman is busy gathering his harvest. Today, one can still hear the song of the side and watch the beautiful rhythm of its swing. Following the binder come the stucers, setting up the sheaves to keep the heads off the ground. Now for next year's harvest. Warming never stopped. Welcome back to the breakdown. In everyday analysis, breaking down the most important stories in Bitcoin, Crypto, and beyond.

This episode is sponsored by BitStamp and Crypto.com. The breakdown is produced and distributed by CoinDesk. And now, here's your host, NLW. What's going on, guys? It is Wednesday, July 22nd, and the audio that you just heard is this awesome old 1950s farming PSA type video that someone turned into an incredible meme about

yield farming in Defy. And so that is, in fact, our main topic for today. We're doing a basically a 101 ELI-5 type of explanation of some of these key terms that you might be hearing about. And just to let you know, if you are a Defy Pro, this is not going to offer a lot of insight for you. This show is definitely aimed at the folks who are maybe coming from the macro perspective and who really just want to understand this thing that they maybe are hearing about because it's kind of reaching that level of buzz. So if that fits you, awesome. And if not, well, I hope you enjoy the brief. And with that, let's get into it. First up on the brief today, the Chinese consulate closure. So the U.S. has ordered the China consulate in Houston closed, accusing China of conducting,

quote, massive illegal spying and influence operations throughout the United States against U.S. government officials and American citizens. Basically, this comes on the heels of a Tuesday indictments on two hackers in China who have been accused of targeting firms around coronavirus research, stealing hundreds of millions of dollars worth of sensitive information from companies around the world, and doing so on behalf of Beijing's main civilian intelligence agency. The reason that I'm bringing this up, in addition to the fact that the markets are clearly watching it, is that if you'll remember last week's episode on my primer about the key fault lines in the U.S.-China relationship, the main reason that people think that we might not be in a

Cold War is that we're so economically interdependent, that the terminology refers to a time that doesn't reflect the time that we live in. Well, the thing is, if you see all of these initial moves as unwinding that connection, making it possible to return to bipolar spheres of influence by unwinding the actual interconnection, then this fits right in that model, which makes it important to watch. Next up on the brief today, US-used home sales rose 20.7% this month. So what happened? Sales rose to a seasonally adjusted annual rate of 4.7 million, which is the biggest monthly increase in records going back to 1968. Importantly, however, June's sales still

marked an 11.3% decrease from a year earlier. So the gain that is record setting is the gain from a month previous, it still doesn't mean that the housing market has completely recovered to what it was last year. Now, in a lot of ways, this is super understandable. You have the spring demand that's been backlogged that has just moved up into summer, but you also have new categories of people who were perhaps in apartments and want more space, people who are no longer enamored of cities and who want out. All of them are coming into the market at the same time. Simultaneous to that, you have a low supply because people haven't been wanting to show their houses, obviously, they haven't been able to in some cases during the coronavirus crisis.

I'm sharing these numbers because, one, I want to make sure that we see good indicators and positive indicators as well as just the negative indicators, even though I have a bias to be nervous, I think, about the continuation of the health crisis without a lot of clear path forward. And I want to make sure that we show these sort of numbers that suggest that for a lot of people, the world is moving on and life is moving on and the economy is moving on as well. At the same time, as I've said before, as I said yesterday, I think, the real estate market is so wacky that it deserves study in its own terms because obviously it has interconnection with so many other parts of the overall economy from the banking sector and beyond.

So really important to watch these numbers, even as they aren't telling us one thing clearly. Last up on the brief today, the growth of insider selling. So there was a Bloomberg article called Insiders Who Nailed Market Bottom are starting to sell stocks and it kicked off like this. As U.S. stocks climb to their most expensive levels in two decades, the executives in charge of the companies benefiting from the rally are showing signs of anxiety. Corporate insiders, who's buying correctly signaled the bottom in March, are now mostly sellers. Almost 1,000 corporate executives and officers have unloaded shares of their own companies this month, outpacing insider buying

by a ratio of almost five to one. Only twice in the past three decades has the sell-to-buy ratio been higher than now. It's not hard to tell why this might be an important indicator, right? You have people who are inside of and invested in these companies who are getting nervous about how they are valued publicly. It doesn't mean that they're right and that everyone else should turn into a seller. It's just a worthy note. This year of anything has shown that we can't read history into every indicator because it keeps changing our expectations and challenging our expectations. but certainly, given the historic nature, this idea of insider buying being outpaced by a ratio of 5 to 1 by insider selling, seems, again, like something that is worth noting and keeping an eye on.

But with that, let's turn to our main topic, an explanation of defy and yield farming using, like, actual human words. First, let's discuss why this matters and why I wanted to do this show. So there's a couple reasons. The first is that this is one of the medical... concepts in decentralized finance that I believe is actually bigger than just the crypto space, right? It is a different way of looking at the world of finance that I have a hard time believing is going to stay constrained to crypto assets. There's simply too much exciting and interesting things to do in this context of permissionless finance and disintermediated finance that I think

the broader markets are going to find their way to adopt versions of, even though centralized finance has of course yielded an incredible amount of wealth. I still believe that people who are involved in finance are always looking for new opportunities, new types of financialization, frankly, and I think that that's what defy is. Second, obviously within the crypto industry, there is nothing driving more hype than terms like yield farming and liquidity mining. And I've seen a lot of folks basically asking for this type of 101. It feels like if you haven't been paying attention for the last couple months, you are so awash in new terms and concepts that it isn't clear where to jump in. So hopefully this is useful both for those people who are kind of trying to catch up on what's the latest in crypto,

and for those who are outside of crypto who are in finance, who want to keep at least one little side eye on things that might affect their industry, their domains later on. First, let's start at the highest level. What is decentralized finance? Well, this was called open finance for a while. It was called decentralized finance. people started talking about it in 2018. For many people, it represented the narrative that came after the sort of ICO

boom's decentralized everything, decentralized the world. If a lot of the projects during the ICO boom were looking at what it would look like to have decentralized, disintermediated alternatives to major applications, social networks, etc., decentralized finance really focused that interest on areas of finance specifically, lending, derivatives, etc. The key concepts, I believe, within decentralized finance or defy, are the idea of things being permissionless and disintermediated. Permissionless meaning that because of the way that the system is organized, you don't

need any centralized actor to give you permission to do something like take out a loan. You do it simply by inputting collateral into a system and automatically getting that loan back. This applies to a huge number of different domains. minting new tokens, minting new synthetic versions of real-world assets. Basically, the common thread across all of these is that it's permissionless. There's no one individual actor or institution that gives one permission to do that. It's designed based on a protocol that has specific constraints and requirements,

but once you meet them, you're allowed to do that no matter who you are or who you represent. Now, and this is the real 101-level example. Like I said, if you're a pro at this, you can feel free to skip ahead. But let's use Maker Dow as a quintessential example. MakeerDAO is a protocol that allows people to mint stable coins. In the MakerDAO system, one die equals one USD. Now in this system, people are allowed to basically mint their own die, and the way that they do that is by taking out something called a collateralized debt position.

Effectively, they send the system an amount of collateral first, and then they can take out die in relationship to how much collateral they put in. Originally, the system was just ETH. Ethereum's ETH token was the only collateral allowed. Now it has expanded to multi-collateral dye. It even has a vision to including not just other crypto assets, but eventually real-world assets, or at least their synthetic representations of real-world assets,

as collateral, to make the system more resilient. But let's use the example when it was just ETH, just for clarity. So let's imagine you deposited $150 worth of ETH. theoretically you can withdraw up to 100 die because the minimum collateralization ratio is 150%. You have to have $150 worth of collateral for every $100 of dye you mint. However, there's a good reason to not take out that much because basically if the value of your collateral, in this case, ETH falls below that minimum threshold. So let's say that 150 equals one ETH.

Well, if ETH goes down to 140, your contract is going to be liquidated. if you've taken out the full 100 die. What this means practically is that people end up over collateralizing even above the minimum 150% ratio so that they can ensure that they don't get liquidated. But the key idea here is that all it takes to mint this USD representation, this USD stable coin in dye, is depositing other crypto assets as collateral.

And if for some reason you want to get your collateral back, you can basically give back the die that you took out against it plus a small what they call stability fee. As I mentioned, MakerDAO has continued to evolve. It evolved from a single collateral system with just ETH to a multi-collateral system and has visions for even wider array of collateral to be a part of the system. But I think the relevant thing for you guys, if you're just getting into this space, is understanding why this might matter,

because I think it's representative of the decentralized finance space as a whole. Stable coins, as we've discussed on the breakdown, have an incredibly important role to play in a world where, local currency regimes are subject to pressures from outside forces that they can't control, and individuals and businesses don't necessarily have the ability to move easily outside of that regime into something that they would prefer like US dollars. In that context, we've seen USD-denominated stable coins explode in popularity this year. The problem is that as much as they sort of seem to be outside the current system, they are actually subject to the current system as well.

Tether, for example, keeps a blacklist of 39 addresses worth more than $49 million in USD based on law enforcement requests from U.S. agencies. The same is now true for the Center Consortium, which runs USDA. So if you want something that is truly uncapturable by authorities, or at least is more uncapturable by authorities, you have to look to something like one of these decentralized systems. BitStamp is the original global cryptocurrency exchange. Since 2011, BitStamp has been the preferred exchange for serious traders and investors, trusted by over 4 million customers, including top financial institutions.

BitStamp is built on professional grade trading technology. Their platform is powered by a NASDAQ matching engine, and their APIs are recognized as the best in the industry. Download the BitStamp app from the App Store or Google Play, or visit bitstamp.net slash pro to learn more and start trading today. That's bitstamp.net slash pro. What's going on, guys? I'm excited to share that one of this month's breakdown sponsors is crypto.com.

Crypto.com offers one of the most cost-efficient ways to purchase crypto out there, as they've just waived the 3.5% credit card fee for all crypto purchases. What's more? With crypto.com's MCO Visa card, you can get up to 10% back on things like food and grocery shopping. When you buy gift cards with the crypto.com app, you can get up to 20% back. Download the crypto.com app today and enjoy these offers until the end of September. Maker also introduced a key term to understanding Defi, which is total value locked or TVL. This is a measure of how much capital is in the defy space.

And basically, the idea here is that each of these different defy protocols and platforms has people lock up assets in some way or another. So in the context of Maker, it is their ether bat or other. collateral that they use to mint dye. And so when the total amount locked into maker CDPs grows, that means that more people are interested in the space, or at least more capital is involved in the space than there was before. For that reason, total value locked has been one of the main measures by which people understand the trajectory of an interest growth in the defy space. This is also why you've been hearing so much more about defy recently is, in part,

the growth in TVL. It took more than a year for DeFi platforms to get to one billion total value locked in Defi, and then it only took five months to get to $2 billion in total value locked. But then it only took two weeks to get to $3 billion in total value locked. There is clearly a growing emergent interest in this space that just seems to be accelerating. Additionally, you have a jump in the total value exchanged via decentralized exchanges. July just hit $1.6 billion in total volume, which already beats out June's all-time record. Now, to understand what has been driving this, we need to introduce a few more concepts. First, let's talk about market makers. In traditional markets, market makers are large actors that make both bids or offers to buy and asks or

offers to sell. The key purpose of market makers is to provide liquidity and depth to markets. Traditionally, this is done by large brokerage firms. Now, one of the major issues in crypto, especially around these smaller assets, is liquidity. In fact, exchanges and issuers often need individuals and hedge funds to play a market-making role to ensure that there is enough liquidity to get the market moving in such a way that prices can be something resembling accurate. Electric Capital Managing Partner Avichal Garg explained the difference between market-making in traditional markets and market making in crypto in this way. He said, in some types of products,

the product experience gets much better if you have liquidity. Instead of borrowing from VCs or debt investors, you borrow from your users. And from this, we get into the idea of automated market making or liquidity mining. Liquidity mining, in effect, decentralized and automates this approach to market making that has historically been the province of big brokerage firms and other large institutions. So let me describe liquidity mining using a text from the Humming Bot F-A-Q. They write, liquidity mining is a community-based, data-driven approach to market-making, in which a token issuer or exchange can reward a pool of miners to provide liquidity for a specified token. You earn rewards by running a market-making bot that maintains orders on exchange order

books. Liquidity mining is similar to Bitcoin mining in that miners run open source software on their own computers and use their own scarce resources as in an inventory of crypto assets. In addition, a collective pool of participants are working together for a common goal, providing liquidity for a specific token and exchange. In return, miners are paid out rewards according to transparent, algorithmically defined rules. These rewards are what will get into when we talk about yield farming. And basically, the idea of liquidity mining then is to create an incentive for holders to keep liquidity in the ecosystem and get rewarded for doing so. This has, of course, implications for how exchanges work. From the Chainlink blog, this is a description of

decentralized exchanges and the role of automated market makers therein. They write, automated market makers fundamentally alter how users swap cryptocurrencies. Instead of using a traditional buy-sell order book, both sides of trades are pre-funded by on-chain liquidity pools. Liquidity pools allow users to seamlessly switch between tokens on-chain in a completely decentralized and non-custodial manner. Liquidity providers earn passive income via trading fees based on the percentage of their contribution to the pool.

So basically, instead of saying, I am willing to sell my crypto assets at X and Y a price. You are contributing your crypto assets to a pool, getting rewarded for doing so, and because of that, the protocol is able to automatically allow someone else to exchange their crypto assets for crypto assets in that pool without having to go through this traditional buy, sell order book process. Now, this concept of pools comes up a lot, so I want to read you an excerpt from an excellent piece by Brady Dale at Coindesk that was trying to give a written 101 level on

yield farming. He explains pools this way. Let's say that there was a market for USDC and Die. These are two tokens, both stable coins, but with different mechanisms for retaining their value, that are meant to be worth $1 each all the time, and that generally tends to be true for both. The price uniswap, which is an automated market making protocol slash decentralized exchange, shows for each token in any pooled market pair is based on the balance of each in the pool. So simplifying this a lot for illustration's sake, if someone were to set up a USDC slash die pool, they should deposit equal amounts of both. In a pool with only two USDC and two die, it would offer a price of one USDC for one die. But then imagine that someone put in one die and took out one USDC. Then the pool would have

one USDC and three die. The pool would be very out of whack. A savvy investor could easily make 50 cents profit by putting in one USDC and receiving 1.5 die. That's a 50% arbitrage profit, and that's the problem with limited liquidity. Similar effects hold across Defi, so markets want more liquidity. Uniswap solves this by charging a tiny fee on every trade. It does this by shaving off a little bit from each trade and leaving that in the pool, so one die would actually trade for .997 USDC after the fee, growing the overall pool by 0.003

USDC. This benefits liquidity providers because when someone puts liquidity in the pool, they own a share of that pool. If there's been lots of trading in that pool, it has earned lots of fees and the value of each share will grow. And now, after this explanation, we're back to yield farming. As Brady again says, you can stick your assets on compound and earn a little yield, but that's not very creative. Users who look for angles to maximize that yield, those are the yield farmers. Basically, the idea of yield farming is being willing to move around to different pools seeking the greatest fees. That's what you're reading about when you see people who are yield farmers. What they're doing is actually going and seeking out the best value for where they

can park their crypto assets. In some cases, that has to do with the interest rates. In other cases, it has to do with actually getting a new token for providing that liquidity. Again, Brady's article says liquidity mining is when a yield farmer gets a new token as well as the usual return in exchange for the farmer's liquidity. Richard Ma of Quant Stamp put it this way. He said, the idea is that stimulating usage of the platform increases the value of the token, thereby creating a positive usage loop to attract users. So if this sounds very insular and just a lot of yield farmers trying to basically put their money to work and get benefits in order to attract more yield farmers and so on and so forth, that is one of the main critiques of this, is that there

is an actual demand for these assets outside of this sort of very interesting financial engineering sandbox that they're playing in. And I think that's a legitimate criticism. At the same time, and I kind of mentioned this yesterday, and maybe now let's consider this the section on the kind of big wrap-up and what I think. So this is my two minutes of editorialization on top of, like I said, a very 101 overall content piece. I think that this bubble doesn't concern me, per se, because it is such an enfranchised user base that is perpetuating it. It really takes a wholly different level of technical acumen and understanding of this space to be able to participate. Part of the excess, actually a huge part of the excess of the ICO boom, was the fact that it was so

dead simple for anyone to participate. All you had to tell someone was go to Binance register and you can start buying. That was, in fact, part of the innovation of tokens is that there were such a massively lower friction way to exchange assets to get value in companies. There is a lot that's amazing about that, but one of the negative impacts is that pensioners and hairdressers and moms and aunts and anyone else could just get in there and start buying things that they really had no understanding of. That is just not the case in this space right now with Defi. Does that mean there's no risk? Absolutely not. The risk profile remains the same. The issue here for me or the upside for me is that the people who are taking the risk are in many ways self-qualified to do so.

I have a hard time visualizing the person that on the one hand has done all it takes to actually participate in this space in terms of learning and setting up infrastructure, and then at the same time is unaware of the clear and present challenges to it and the risks involved. As I've said before, and as I kicked this off, part of the reason that I am spending some time on defy is that I think it's one of these concepts that will probably make its way into other parts of markets, even outside crypto assets. it's something that could attract certain types of financial professionals to this space as well. And for me, I'm very enthusiastic about the fact that these experiments are being done in this sort of walled garden,

walled not because someone is exclusionary, but because the barriers to entry are naturally so high. I think that in the long run, to the extent that Defi does make a dent in the world, part of the reason will be that it was allowed to run these experiments that come with incredible risk and huge systemic risk and risk of cascading failure inside an environment where, relatively speaking, there's not that much that can actually get lost and wiped away. Now, a few platforms to mention that are worth going and checking out. Compound is an algorithmically operated protocol for borrowing and lending. Basically, what it does is it incentivizes people to earn interest by depositing their

crypto that would otherwise just be sitting there into a pool, and then you can also borrow in a different collateral. So you can be both a lender and a borrower to compound. The only thing you can't be is just a borrower. You have to lend if you're going to borrow anything. It was Compound's token and the launch of the Comp Governance token that really kicked off this yield farming craze a couple months ago. Synthetics is a company where there are synthetic on-chain representations of real-world assets

like Forex and commodity that, again, are allowed to be minted by people who deposit a collateral, in this case a synthetics token, and then can actually mint these sort of synthetic versions of real-world things on the basis of a price feed. That price feed brings us to another company that's important in this space, ChainLink. Chainlink is basically a decentralized price feeds platform. They build oracles that allow DFI platforms to use information and data from the real world. In this case, price feeds of things like Forex, of commodities, etc., in the context of an automated platform.

To really get a sense of all the big players in this space, go check out defypulse.com. That's where you'll see that right now there's 3.23 billion value locked in defy. You'll see that maker dominance sits at 21.13% of total value locked. You'll also see the charts of maker compound synthetics, AVE, Curve Finance, Balancer, Insidap, WBTC, Uniswap, etc. All these other protocols that are involved in this space and the total value locked within them. it's a great place to actually get a picture of what's going on in this defy market. So to sum up, guys, I think that this is a really interesting space. I think that if you are outside of it, it is not something you need to rush to come into.

As I mentioned, I think part of what makes it powerful is that the sandbox right now has its own natural barriers to entry that are allowing for meaningfully sized and real experiments to happen without creating the sort of systemic risk that could set it back years or just kill it entirely. So to me, that's a really good thing. But hopefully this episode has given you a little bit more of an understanding about the underlying concepts. And I'm sure over the next few weeks, few months, we'll do more deeper dives where I think they're relevant and probably more with guests who are real experts in this space. For now, guys, I appreciate you listening. And until tomorrow, be safe and take care of each other. Peace.