‘Decentralisation' is a word you constantly hear throughout the crypto world. And there's a good reason for this…
It forms the foundation of everything in crypto.
The idea you don't need to rely on a central authority to make things work - be they financial transactions, contracts, proof of ownership, proof of identity… anything - is what crypto is all about.
In traditional finance, you need to either trust the person you're exchanging money with, or you need to trust in a central authority (like a bank) to oversee the transaction.
For example, if you send money to someone through your bank, you're trusting your bank to make sure the money gets there.
If the person denies the money reached them, your bank can step in and prove it did.
With bitcoin, you can prove the money reached them without any need for a bank. You simply look up the transaction on the bitcoin network, and there it is, for anyone to see.
While this is fine for basic transactions, our financial world is much more complicated than simply sending set amounts of money from one person to another.
And that's where DeFi or ‘decentralised finance' comes in.
Just as bitcoin allows you to make payments without a bank, DeFi allows you to create an entire financial system without banks or central authorities.
And this could overtake every area of traditional finance, because it makes things cheaper and more efficient.
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So how does DeFi work?
Right now, the biggest branch of DeFi is lending.
In traditional finance, a bank takes money from person A and then lends that money out to person B.
It pays person A interest for using their money, and person B pays the bank interest for lending out person A’s money.
The bank makes money because it pays person A less interest than it collects from person B. A lot less.
The main idea of DeFi lending is you cut out the bank – and its ridiculous cut – and match lenders directly with borrowers.
For example, on what’s probably the most well-known DeFi platform, Compound, you can currently lend out your money using the DAI stablecoin at 8.07% interest, or borrow against it at 8.48% interest.
So, instead of getting barely no interest with an overseas bank, you could be getting over 8% with DeFi.
The reason DeFi rates can be so much better than banks are because lenders are matched directly with borrowers. There is no bank taking a ridiculous cut.
Is DeFi lending safe?
The main reason people put up with banks is because banks are “safe”.
If you put your money in a bank, it’s highly unlikely you’ll lose it. Of course, it is possible… such as in a fraud or a Greek-style debt crisis. But it is extremely rare.
In DeFi lending, you’re not relying on anything other than computer code. So long as the computer code is written right, there can’t be a DeFi debt crisis.
The way DeFi lending works, is you have to put up collateral if you want to borrow. With Compound, for instance, you can only borrow up to 75% of your collateral.
This means there is always money in the system if the lenders ask for it back.
This is great for lenders. They can get more than 80 times the interest they could in a traditional savings account.
But what about DeFi borrowers?
On Compound, you can also lend out and borrow against an array of different cryptos.
Some, like DAI and USDC, are stablecoins – their value will remain stable against a fiat pair, in this case the US dollar.
But some are not.
For example, you can borrow against Ethereum at 2.08% per year.
So, if you hold Ethereum and think Ethereum will go up by more than 2.08% in the next year, you could make money by borrowing against it.
I’ll show you how with a very basic example.
Say you had 10 Ethereum, worth R100 each. So R1,000 of Ethereum.
You could lock up your 10 Ethereum in Compound and get R750 back for it.
You could then go buy another 7.5 Ethereum for R750 with that money.
Then if Ethereum doubles in price, you can trade 3.75 of your new Ethereum for R750 and use that money to get back your original 10 Ethereum that’s locked up.
So, in the end you would have 13.75 Ethereum, worth R2,750.
If you’d just held your 10 Ethereum over that time, you’d only have the same 10 Ethereum, now worth R2,000.
So by using leverage, you’ve gained 3.75 Ethereum, or R750. And it cost you nothing.
But here’s thing…
Let’s say if in that example the price of Ethereum dropped by 50% instead of doubling.
If you didn’t add any money into your loan, you would get liquidated. Your Ethereum would be returned to you, minus what you borrowed and minus a liquidation fee.
To avoid being liquidated, you would need to keep adding Ethereum back into your loan, as the price dropped.
So if the Ethereum price dropped, you could end up very out of pocket.
This is why most people won’t borrow anywhere near the maximum 75% amount.
The less you borrow against your money, the more Ethereum has to drop before you need to top up your loan. And the less at risk of liquidation you are. It’s all about balance.
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The possibilities for this kind of transaction are endless!
That’s why it’s got so many people so excited.
And given that the actual money you’re using for this – most of DeFi is built on top of Ethereum – is programmable itself, it means you can create any financial instrument you want on top of it.
As well as loans, DeFi will eventually be used for everything like… mortgages, bank accounts, savings accounts, stocks and shares, insurance… you name it.
And eventually major financial systems could move over to DeFi, because it’s a much more efficient, and cost-effective way to do things.
In fact, over the last 12 months, the total amount of money locked up in DeFi has ballooned from $330 million to over $1 billion. And Compound alone, has over $223 million of assets in its system.
See you next week.
Managing Editor, The South African Investor