BTC & DeFI

Blockchain and DeFI intro

Before cryptographic currencies emerged as a viable alternative for transactions, the two prevailing payment methods has historically been cash and credit. Currently, the cash based system has an advantage over cryptos when it comes to relative valuation of goods and services as prices of fiat currencies like dollars are more stable. However, a well-known flaw with a cash based system is that it needs bootstrapping meaning that someone needs to create cash in the system in the first place so people can transact. Another issue with cash is that sometimes people do not hold enough of it to make expensive purchases. For example, to buy a house most people need a mortgage, which is a form of credit. However, the drawback of credit is counterparty risk because taking on a mortgage means having a debt obligation that needs to be paid back to a bank or someone else in the future. If the borrower defaults, lenders like banks may have lost part or all of their investment, which can create systemic risks in our society including the financial crisis in 2008. Today, the developed world uses a blended system by combining cash and credit to facilitate transactions in our economy. For example, in the US most customers use credit cards for online purchases. They must therefore provide credit card details either to an intermediary such as PayPal or to a merchant like Amazon for their payments to be completed. The process of having a middleman like PayPal is called intermediary architecture within financial payments. By providing credit card details to PayPal, customers improve credit card and perhaps personal information security, but it prevents direct communication with merchants. Blockchain and Decentralized finance (DeFI) has a small probability of solving issues arising from the blended payment system through cryptography. In addition, cryptography can also be used as a tool for proving ownership and timestamping actions. Ultimately, the blockchain optimists claim that cryptographic currencies have the potential to revolutionize our payment and economic system, while pessimists believe that cryptos will collapse either because something is wrong with the technology or because government inability to regulate the crypto market will ultimately force a crypto shut-down. From an investment perspective, the asymmetric nature and potential network effects of investing in blockchain and DeFI is for me enough to allocate a small amount of my portfolio to projects based on these two concepts. In the end, we shall see if pessimists or optimists will prevail.

Fiat printing press is hot

Solving the Credit Card problem and the invention of Crypto as cash

Widespread adoption of crypto currencies around the world might revolutionize our global payment system. That is because crypto based transactions solve both privacy and security issues common to credit card users while at the same time maintaining direct merchant interaction like cash. Functionally, cryptos are more similar to cash than credit cards so they enjoy some of the benefits enjoyed by cash. These cash benefits include information privacy and allow for offline transactions directly between counterparties without third party involvement. The typical third party is a PayPal like institution or a bank so cryptos would cripple their ability to extract consumer information, which might explain the negative view of traditional institutions about the crypto space. Important to note is that Bitcoin users do not enjoy the same level of anonymity as with cash because it is possible to trace Bitcoin spending based on user pattern in the public ledger. However, the crypto space is evolving quickly and there might be other blockchain protocols that can technologically circumvent this issue. Unlike cash, bitcoin is also not completely offline, but it is worth noting that Bitcoin relies on a peer to peer network, which is fractally resilient like the internet and not based on some sort of central database.

David Chaum and Blind Signature

In 1983, American computer scientist David Chaum came up with perhaps the first known method to use cryptography as a technological foundation for digital cash. A physical example of his idea is described in a Bitcoin textbook taught to students at Princeton University and proceeds according to following logic. If you write on a piece of paper – “if given to someone this note is worth 1 USD “ - and sign it, you have effectively created cash as long as people trust that the note is worth 1 USD and that the cash has not already been spent, which is exactly how fiat currency works. The difference is that fiat currencies are backed by governments and monitored by the central banks, while this 1 USD note is not. The process of creating a promissory note with a signature can be recreated digitally by using hash functions instead of handwritten signatures. Obviously, signature problems remain even with digital notes as the note could already have been spent. This is called the double spending problem. Chaum solved the double spending problem by using cryptography based on the following logic. The first step is to digitally put a unique serial number on every crypto “note”. The next step is to add your signature to verify the note’s worth. Finally, a server is used to prevent double spending by monitoring signatures and serial numbers, which is cumbersome if done by hand, but not when the process is digital. To prevent the serial number from being tied to a person, Chaum created a blind signature, which means that note recipients got to pick the serial number. The numbers picked by the recipient should be long and secret so that the number is impossible to guess and unavailable to the note signer. The problem is that this type of digital currency needs a central server ran by trusted third party like a PayPal. Unlike Chaum’s original cryptographic idea, Bitcoin is peer to peer and no central server is needed, but the bitcoin network still utilizes the basic principles of Chaum’s idea of a cryptographic digital currency.

David Chaum

The Ledger

The second special component of bitcoin and other cryptos is the blockchain ledger. The idea behind the ledger is derived from time stamping legal documents. The reason legal documents get time stamped is so that the person viewing a specific legal document knows when the document came into existence. Like reviewing legal documents, the bitcoin ledger records the time of a transaction, which establishes the order of transactions in its blockchain. In addition to creating order, the ledger also creates a hash pointer to the previous transaction to make transactions more secure. If someone messes with the data of this pointer or so called hash function to the previous transaction then the current transaction becomes invalid, which means that a previous transaction ensures the integrity of the next one: there is no screwing with the blockchain. The bitcoin ledger is more technical than a linear pointer to the previous transaction and instead collects transactions in blocks and trees. This reduces the amount of time needed to certify the previous transaction and speeds up the network. Basically, the ledger creates a decentralized system for authorization of peer to peer transactions.

Blockchain

Ledger Ideas

There are more use cases for a blockchain ledger other than for transactions. One of these ideas is called decentralized cryptographic truth. I first heard about this idea from Balaji Sirinivasan and it blew my mind. He says that cryptocurrencies have made it possible for people to agree upon the state of the bitcoin blockchain. This is an important truth as large players in the world tend to fight over money so if everyone will agree on who owns the BTC and how much they own then it might decrease fighting. Once you develop consensus algorithms on BTC ownership then that means we can agree upon ownership of other resources. For example, the blockchain will make it possible to determine ownership over properties such as bonds, stocks and real estate and the exact time when that ownership occurred. Finally, you can extend this idea to what events happened at what time. For example, the device that recorded the kind act of a good Samaritan, the document a hospital uploaded to the medical records or the crime that was reported by the police officer. All of these feeds happening right now are put into separate silos. However, with the blockchain these events can be added together in a ledger of records that is immutable to corruption just like BTC ownership. This would be an example of a global feed of cryptographically time stamped records. Cryptography and digital signatures are not perfect, but it will help distributing truth!

The truth will set you free!

Yield Farming

An interesting way to make money in cryptos is yield farming, which is a way to maximize the rate of return by leveraging different DeFI protocols. This is accomplished by switching between different strategies using different protocols including Avee, Compound, Synthetix and Uniswap. These yield farmers move their funds from low yielding to high yielding protocols and swap existing coins for new ones with higher yields. The concept of yield farming comes from crop rotation in actual farming. Three well known yield farming strategies is lending/borrowing, supplying capital and staking LP tokens. Lending is an easy way to earn an APY and it involves supplying stable coins such as DAI and USDC to one of the lending platforms and start getting a return on capital with liquidity mining and leverage super charging this APY. Compared to savings accounts generating around 0.1% APY, the yield farming world can deliver over 100% APY; what is the catch? Well, any form of investment that delivers a high rate of return comes with lots of risk including liquidity mining, leverage and risk. Liquidity mining is the process of distributing tokens to protocol users. One of the first protocols was synthetix where liquidity miners got rewarded for adding liquidity to seth/ethpool on uniswap with SNX tokens. The liquidity mining process doubles the reward because in addition to the yield generation, you also get rewarded with increased values of tokens. These incentives can be so high that farmers may be willing to lose on initial capital to get rewarded through the distributed tokens. The Compound protocol for example incentivized farmers to borrow high yielding assets because they provided comp tokens as a reward, which was higher in return than the borrowing cost. Leverage is another way to generate high returns, which basically means you use borrowed money to increase return. The farmers can use their coins as collateral to borrow new coins and then repeat that procedure. Leverage is also the biggest risk, but all the loans are overcollateralized. If the collateralization ratio drops below a certain threshold, the loans are liquidated. In addition, there is smart contract risks like bugs, platform changes, systemic risk and admin keys. Most of these protocols run on Ether so there is a risk that Ether would drop sharply in value. Finally, there is DeFI specific risks such as an attack on liquidity protocols.

Yield Farming

Conclusion

Through iterations of collective imagination, our society have agreed upon rules for language and money. Written language increased access to information to solve problems and internet decentralized sourcing of information and labor talent. Historically, a few journalists subsidized large newspapers basically paying coworkers salaries, but with internet these gatekeepers are no longer necessary to inform readers. B-chain and DeFI may transform money similarly to how internet revolutionized information. Currently, fiat cash and credit are used to facilitate economic transactions. The benefit of cash is privacy, but flaws include bootstrapping and large purchases. For example, to buy a house a mortgage is often needed, but this form of credit leads to systematic risks if banks are careless. Another flaw of credit is that customers must provide sensitive information for online purchases. That is why third parties like PayPal sometimes handle credit security, but this intermediary payment architecture prevents direct merchant communication. In 1983, US Computer scientist David Chaum used cryptography as base for digital currency. His idea was simple as he recreated the equivalent of fiat by digitally writing on a piece of paper “if given to someone this note is worth 1 USD”. If the digital note is immutable then people may trust its value more than a central bank controlled fiat dollar. Also, the technology behind DeFI will regulate the global payment system without middlemen similar to how our central nervous system regulates our bodies by setting up rules for lending & borrowing, fractional finance and supply of capital.

//Stay Adaptive!!