May 2022 – Muthu’s Musings

4b: Decentralized Finance (DeFi) – Cryptocurrencies

“If you don’t believe it or don’t get it, I don’t have the time to try to convince you, sorry.” – Satoshi Nakamoto

We continue our journey into Decentralized Finance (DeFi) with the discussion around Cryptocurrencies and Blockchains. In the past several posts, I have provided background on the various aspects of the Web 3.0 ecosystem.

Part 1: Web 3.0, What is it and Why it matters
Part 2: Web 3.0 applications – Community managed applications
Part 3: Decentralized Autonomous Organizations (DAOs) – Community owned governance
Decentralized Finance (DeFi) – Community Finance
- Part 4a: Intro to DeFi
- Part 4b: Cryptocurrencies
Stable-coins and Central Bank Digital Currencies – Fiat collateralized and Government issue digital coins
Creator Economy & Non-Fungible Tokens (NFTs) – Community creations
Blockchain based games – Community built, created and owned Games

The timing of this post comes in the heels of the recent development in Terra Luna and UST which in itself is terrible but not a death knell for cryptocurrency. I approach the cryptocurrency subject as a technological innovation rather than a speculative asset class. If you recall the dot com boom, there was innovation and fraud that permeated the system and eventually some companies came out of it successfully. We can see similar situation here. Let’s get back to our learning on the Web 3.0 and focus on cryptocurrencies.

What is Cryptocurrency?

According to Wikipedia, Cryptocurrency is a digital currency designed to work as a medium of exchange through a computer network that is not reliant on any central authority, such as a government or bank to uphold and maintain it.

There are three key characteristics that makes it difficult to dismiss the importance of cryptos.

1. 1. Trustless – Since the system is peer-to-peer, no trust between the sender and recipient is required. In addition, the incentives for the miners is adequate enough to not defraud the users but to add it to the blockchain resulting in the integrity of the environment.
  2. Immutable – Transaction cannot be reverted since it is permanently recorded in the ledger and transmitted across all nodes.
  3. Decentralized – No central agency that controls the creation of the new coins or transfer of the coins from one entity to another. Granted exchanges facilitate those transfers but there are multiple exchanges and a user can go to any exchange to get the task completed without having rely on only one.

Let’s take an example of sending money from one country to another country through wire. The processing has the following steps and it will take at least five business days (may change depending not the recipient country) for the recipient to get the payment.

The central banks/correspondent banks act as intermediaries to oversee the payments to or from the senders/receiver. Now let’s review how Cryptocurrency works.

In this peer to peer system, because there is no central agency, the entities easily transfer their resources (currencies) to make an entry or exit on the positions. As a result, the payments are near real time. Bitcoin transactions can take place within 10 to 15 minutes, Ethereum within five minutes and so on. The quickness of the transfers is unbelievable and liquidity is instantaneous.

Another benefit would be to prevent corrupt and oppressive governments intervening and siphoning off funds from the citizens. By using cryptocurrencies, the citizens can protect their wealth since it will be stored in their wallets with the private keys that is not accessible by the governments. They can migrate to other countries and liquidate the cryptocurrencies without any issue.

Requires just internet and anyone can begin transacting with the cryptocurrencies. Today there are over 300+ million users and this is huge considering there were zero users a decade ago.

Courtesy: Small business blog

The adoption rates are comparable to the internet growth

Courtesy: Small business blog

Numerous brands and companies are accepting the crypto payments. Here is a list that may not be exhaustive for Bitcoin payments.

Courtesy: Spendmenot

Why do they matter?

- - Cryptocurrencies allow low cost, nearly instantaneous, borderless, peer-to-peer transfers of actual value
  - Low barrier to entry and not subject to business hours in mainstream financial institutions
  - Payment blockchains open up access to financial services to unbanked/underserved people worldwide
  - Mobile wallets make it cheaper for immigrants to transfer money to their homeland
  - Can provide safer store of value in countries with hyperinflation

The market cap as we speak is hitting $1.3 Trillion which is no joke and of course, the volatility is not for faint of heart. It went up to $3 Trillion last November before coming down to the current levels. Comparing this withUS Stock Exchange that has the market cap of around $53 Trillion, we are at the early stages of a financial asset.

In our next installment we will review other aspects of DeFi like lending, farming etc., Meanwhile I will be taking few weeks off this summer and resume the posts in July. Happy Summer everyone!

Part 4a: Decentralized Finance (DeFi)

DeFi boom is very near equivalent of an apocalyptic event for the traditional financial institutions. – Mohith Agadi

We have reviewed the overall landscape of Web 3.0 in Part 1, reviewed the Web 3.0 applications in Part 2 and Decentralized Autonomous Organizations in Part 3 We will focus on Decentralized Finance (DeFi) in this post.

Web 3.0 applications – Community managed applications
Decentralized Autonomous Organizations (DAOs) – Community owned governance
Decentralized Finance (DeFi) – Community Finance
Stable-coins and Central Bank Digital Currencies – Fiat collateralized and Government issue digital coins
Creator Economy & Non-Fungible Tokens (NFTs) – Community creations
Blockchain based games – Community built, created and owned Games

DeFi is an umbrella term to define building a new internet-native financial system using blockchains to replace traditional intermediaries and trust mechanism. Before we go deeper into DeFi, let’s review what prompted this technology to evolve.

Let’s travel back in time to 2008 and look at some numbers.

Courtesy: The Balance

We all know how the banks leveraged the housing derivates to over extend and eventually fail to meet their obligations resulting in the monumental financial market downturns. There were many reasons including the greed and lack of oversight but one of the primary reasons which prompted Satoshi Nakamoto to think about a solution is the lack of electronic trails in the banking transactions. There were paper trails for the transactions but nobody can look up to see how a particular real estate has been leveraged, what kind of derivates were issued, who owned them etc.,

While decentralization may be a solution, it had trust and permissionless issues. In centralized transactions, there is one authority that oversees and approves the financial transactions. However, in a decentralized situation, there is no single authority. All the concerned parties may not know each other and by default assumed to be bad actors. There is no reliable way to confirm if the information is factual or fraud.

This brings us to the Byzantine General’s problem. Roman Empire has ordered its generals to occupy a castle which has enough supplies to last for a long time. The generals are camped in various directions and there is physical distance between them. Each general acts an independent decision maker but will comply with the messages to attack or hold. It has to be coordinated among themselves. Therefore, trust and communication play an important role. In a centralized network, the central authority ensures that the information is accurate which ensures the dissemination of information across all the nodes. So, the centralized agencies don’t suffer from Byzantine Generals problem but they can become corrupt.

For a long time, decentralized solutions didn’t solve this Byzantine Generals Problem until Satoshi presented the Proof of work mechanism. Simply put, the mechanism had the following,

- The miners in the blockchain acted a generals

- Each node must try to validate the transactions which are sent like messages to the generals
- The enemy can be thought as bad actors (hackers) who can maliciously write transactions or spend the currency twice
- The miners will compete to write a next block by solving cryptographic puzzle and whoever solves it first will get the right and the reward to write the transactions in the block. This is proof of work and has built-in mechanism to reward the work done by the miners.
- The blockchain is also decentralized and copies of the ledger is available in all the nodes and the blocks are hashed for security.
- The blockchain infrastructure paved way for peer-to-peer transaction in a trustless and permissionless environment.

As long as there is 51% of node validators accept the truth, it will be approved as valid block for any payment transactions. In order for someone to maliciously insert a transaction, they need 51% control of the network which is nearly impossible because of the geographic spread as well as the unparalleled growth of networks. Even if some nodes go rogue, there is no impact to the overall infrastructure.

So Bitcoin was created with this and other security measures to kickoff the decentralized technology evolution. In the next post, we will dive deeper into cryptocurrencies. before we pickup the next topic.

Part 3: Decentralized Autonomous Organizations (DAOs)

DAO is an entity that lives on a network and exists independently, but also relies heavily on the human person to perform certain tasks that it cannot. – Vitalik Buterin

Let’s continue to explore further in our journey. Check out Part 1 and Part 2 before reading this post.

Web 3.0 applications – Community managed applications
Decentralized Autonomous Organizations (DAOs) – Community owned governance
Decentralized Finance (DeFi) – Community Finance
Stable-coins and Central Bank Digital Currencies – Fiat collateralized and Government issue digital coins
Creator Economy & Non Fungible Tokens (NFTs) – Community creations
Blockchain based games – Community built, created and owned Games

Decentralized Autonomous Organizations (DAOs):

Before we review the merits of DAO, it is important to review the challenges in a centralized system. Every publicly traded companies are centrally organized with a CEO at the top. As such, it is important for the CEO to be ethical, trustworthy, and showcase a flawless image to the public. Otherwise, we have seen how Elon Musk’s interview while smoking marijuana evaporated $4 billion Tesla stock. Or how Lukin Coffe’s revenues catapulted the company stock to $24 and fell down to $2.40 after it was identified. In addition, when the central head dies or leaves there’s an impact to the stock price and company. Is there a way to fix this dependency? DAOs emerged to address this issue.

Decentralized – Power lies in the community not with a single individual. Rules cannot be changed by single individual but by the community voting.

Autonomous – With on-chain governance, there is no human intervention, votes are tallied and decisions are implemented through smart contracts.

Organizations – entities that coordinate activities among stakeholders

The following captures the differences between the centralized and decentralized organizations.

Source: BlockchainHub

DAOs are fundamentally changing the ways the work is done. They remove the capital and human resource limitations by converting them to community ownership and machine contracts. The resources can reside anywhere in the world to contribute and get rewarded. There is no central authority and everyone has an equal say in the future or operational aspects of the project. While there are benefits of adopting the decentralized organizations, they also come with some challenges.

1. It may be challenging to coordinate multiple decisions to be made initially when the project is kicked off. However over a period of time these will reduce and will be more manageable.
2. Governance conflicts between shareholders, company managers and creditors. These cannot be resolved through the current legal framework and there is no entity that validates the smart contracts.
3. There is a tradeoff done between scalability, security and decentralization for the blockchain. Security and decentralization may have some impact on scalability of the blockchain
4. Security and economic are the biggest blockers for the growth of DAOs as the combined security and economic attack would render them useless.

However, there are tools like Discourse, Tally, Snapshot, Cybill etc., have emerged to solve the above challenges. The DAOs are great solution to mitigate the ills of centralized organizations but it is still in its infant stage. The tools, regulations and security breakthroughs will help grow DAOs and eventually be adopted across the board. One of the areas that has blossomed is the Decentralized Finance which we will review in detail next.