TR；DR
1. DeFi is decentralized finance, an on-chain financial industry built on the blockchain. The current transaction volume is around hundreds of billions of US dollars, with Europe and the United States having the main voice.
2. On-chain finance is the first financial innovation industry in human history to be decoupled from politics. At the same time, many false financial scams and real financial innovations have emerged.
3. Self-custody of funds is a very different point between DeFi and traditional finance. Investors need to be responsible for the security of their own funds.
4. The interest rate of stablecoins is not regulated by a central agency, but fluctuates in real time based on the degree of liquidity shortage, like an inverted financial world.
5. DeFi is a modular and interoperable financial world that makes it easy to stack various financial products and generate high leverage returns.
6. The prosperity of BTC and ETH is closely related to the prosperity of on-chain DeFi, and they influence each other.
7. DeFi is still in its early stages. Compared with the asset side, the financial clearing network on the capital side is more developed and is also the main asset that currently carries various types of funds.
1. DeFi and Onchain-Fi
DeFi stands for Decentralized Finance. It is a financial industry that uses blockchain and smart contracts as underlying clearing technologies. In my opinion, DeFi has a basic threshold, which is that you must have a cryptocurrency wallet as the entry point for interaction.
So, from an investor’s perspective, there is a very simple definition: “When you use a cryptocurrency wallet as a tool, all industry objects related to financial asset transactions on the blockchain can be unified as DeFi, that is, decentralized finance.”
The birth of DeFi can be said to have started with the DeFi Summer event in 2020. At that time, the verification mode of the Ethereum network had just switched from POW to POS. Everyone earned transaction GAS fees by staking their ETH to the Ethereum network, making ETH a purely on-chain interest-bearing asset that does not rely on any external factors.
This interest-bearing asset has become the cornerstone for the crypto industry to launch DeFi summer. With the birth of a series of on-chain protocols around interest-bearing assets, such as lido\Eigenlayer\pendle, on-chain decentralized exchange uniswap, lending protocol AAVE, etc. The entire decentralized finance is based on various public chains, and a group of on-chain financial institutions with similar functions to traditional finance have been born, forming the so-called on-chain financial ecosystem, Onchain-Fi.
Judging from TVL (total value locked, which can be understood as the scale of funds deposited in on-chain financial projects), DeFi is going through its second cycle, falling from the previous scale of 160 billion US dollars to the current scale of 100 billion US dollars. In general, DeFi is currently an on-chain financial industry based on blockchain with a transaction scale of hundreds of billions.
As some people with traditional financial backgrounds in the crypto community hope to embrace compliance and regulation, the anti-censorship, decentralization, and distribution advocated by DeFi are gradually seeking a balance and compromise between KYC compliance and centralized efficiency. DeFi is moving from a small circle culture to a larger population market.
In particular, as it moves closer to the European and American legal systems, it will introduce more compliance and supervision to expand its usage scenarios. Compared with the previous cycle, more financial-oriented DeFi projects have emerged (such as some financial derivatives agreements), and the voice of the entire circle is gradually shifting to the European and American circles led by the United States.
The above is an industry-level description of DeFi, a financial industry built on the blockchain. From a more specific perspective, DeFi has many differences from traditional financial institutions. I try to explain my understanding of the current situation of DeFi based on my own understanding.
2. Fertile Ground for Financial Innovation
DeFi blockchain finance is an industry that is highly innovative in finance. It may also be the first time in human history that the financial industry is completely decoupled from political regulation.
Throughout history, the financial industry has been highly linked to the political power. Every innovation and collapse in the financial sector cannot be separated from the deep involvement of regulators. This is undoubtedly a good thing for protecting some investors, but on another level, it has been suppressing the atmosphere of financial innovation.
Because financial innovation is a very cruel thing. In the financial industry, money itself is no longer money, but a kind of inventory. As an industry, every cycle is accompanied by the elimination of obsolete production capacity, the disappearance and transfer of inventory. In traditional industries, it may only be the annihilation of service and commodity value, but in the financial industry, it is the annihilation of individual finances. The excessively heavy cost of innovation and the destructiveness to social stability have led to the government's sovereignty leading and regulating financial innovation. To some extent, financial innovation has never been in an extremely loose environment, even in the United States where capital projects are very free.
With the emergence of on-chain finance, a financial model that is free from government control has emerged. DeFi has six distinct characteristics.
1. Blockchain technology and smart contracts are used as account clearing functions.
2. Circulation of information and funds based on Internet technology.
3. By exchanging real funds for cryptocurrencies as circulation agents, a global financial system based on cryptocurrencies is realized. At the same time, cryptocurrencies themselves have the dual attributes of currency and securities.
4. Operating across regions, the DeFi financial system is theoretically not subordinate to any national institution.
5. The overall state of the industry is close to being unregulated, and most of the time it can only be constrained by industry self-governance. With the advancement of compliance, some projects have gradually begun to meet departmental and national compliance requirements.
6. It operates 24/7. Due to the lack of supervision and legal constraints, it is in a state of free and wild growth, with real financial innovations and false financial scams growing at the same time.
The relaxed and free financial environment, efficient blockchain clearing network, and globalized market have led to an extremely developed financial innovation atmosphere on the chain. However, behind the relaxation is the more cruel law of the jungle.
Due to the lack of supervision and legal constraints, the chain is full of traps, scams, fund loss, etc., and even 100 times leverage can be used for financial investment without any threshold. However, on the other hand, it is relatively more inclusive financial services. There are about 1.7 billion people in the world who do not have bank accounts, but they can apply for a cryptocurrency wallet through a mobile phone, and then use the financial services on the chain to enjoy interest rates higher than the US Treasury level. Relaxation and freedom always have both good and bad sides.
The loose environment and the imperfect system in the early stage have caused the DeFi industry to experience many ups and downs in the past, and a large number of investors have to bear their own gains and losses. However, this volatile cycle has also created a number of financial innovation projects, which are simpler and lower cost than traditional financial institutions. Taking Ethereum, the largest public chain at present, as an example, the current TVL is 60 billion US dollars. The top three DeFi protocols have TVLs of 33 billion, 16 billion, and 11 billion US dollars respectively. At the financial function level, the top ten protocols cover functions such as liquidity pledge, liquidity re-pledge, mortgage lending, decentralized exchanges, and interest rate swaps.
On-chain financial companies with these functions do not rely on any government-backed clearing agency, but can provide financial services through blockchain and computer networks. They can also serve people all over the world through the popularity of cryptocurrency wallets. They are a self-contained financial industry and may also be a financial clearing network that has never appeared in human history.
This clearing network has many advantages in terms of technology, the most obvious of which is the transaction fee. Calculated based on the cost of paying $100,000, the payment cost based on blockchain technology is far less than the cost of the entire set of traditional financial clearing currently used.
This superiority in technical efficiency is the key to on-chain finance's traversal cycle, while the loose financial environment and the almost jungle-law-based profit and loss are two sides of the same coin that allow this financial system to grow freely. DeFi has only gone through four years, a cycle, since the DeFi Summer in 2020. The last cycle had high returns, but there were also more traps. With the passage of time, this system has become more self-consistent, secure, and inclusive.
3. Self-custody of funds
Self-custody of funds is an often overlooked blind spot when entering on-chain finance from traditional finance. In the traditional financial world, all our funds are deposited in government-backed institutions such as banks and securities firms, and are backed by insurance institutions (except for some institutions). The risk of custodial funds is often assumed to be a risk-free state. However, in the crypto ecosystem of on-chain finance, funds are in the form of self-custody, and you are responsible for your own fund custody risks.
SlowMist: Blockchain security incidents in 2021 caused losses of more than $9.8 billion - BlockBeats: https://www.theblockbeats.info/news/28403
SlowMist: There have been 275 hacker attacks in 2022, with losses exceeding $3.5 billion - BlockBeats: https://www.theblockbeats.info/flash/111703
SlowMist: A total of 464 security incidents occurred in 2023, causing losses of up to US$2.486 billion - BlockBeats: https://www.theblockbeats.info/flash/21244
In the past few years, a large amount of funds in the crypto industry have been stolen every year due to various problems, such as phishing websites, arbitrary authorization, theft or absconding of project parties of depositary funds, etc.
As an industry that integrates computers, cryptography, and finance, on-chain finance has an extremely high threshold for use. At least at this stage, I believe that compared to financial risks, the understanding of fund custody and risk management are the most important things for participating in on-chain finance.
In short, the risk of traditional finance lies in the judgment of the fair value of an asset in the market. However, the on-chain finance in the crypto industry currently introduces very few real-world assets and does not require too much judgment of fair value. In terms of capital flow, most capital flows are clearly visible on blockchain records and are relatively controllable.
On the contrary, the risks at the code level are relatively tricky, and it is a process that the industry itself needs to continuously improve. Usually, old players in DeFi tend to trust old DeFi projects with stronger financial strength and longer duration, which are more secure. 4. Stablecoins and interest, an inverted financial world In the on-chain financial world of DeFi, stablecoins play an extremely important role. Most of the interactive funds on the chain exist in the form of stablecoins, and the current overall scale is around 160 billion US dollars.
Stablecoins are basically pegged to the US dollar in a one-to-one exchange rate by some means. These means usually include USDT\USDC, which is issued with a 1:1 guarantee reserve of the US dollar, Dai of makerDAO, which is generated by over-collateralization of excess cryptocurrencies, and stablecoin USDe, which is generated by building BTC and ETH spot and contract hedging.
What are the costs of using these stablecoin on-chain financial services, i.e., the interest rates? They vary.
There are two main reasons for this interest rate difference:
First, the differentiated services provided by various financial project parties on the chain.
Second, there is no central agency to regulate the long and short interest rates of stablecoins, which are determined by the degree of liquidity shortage.
The first point is not discussed for now. The second point is an important reason why on-chain finance has become an inverted ecosystem with the real world. In the world of traditional finance, legal tender is guaranteed by government credit and the central bank regulates interest rates. In today's Keynesian world, a large number of legal tenders are in a state of low interest rates and over-issuance. Legal tender is in a state of inflation relative to other goods and services.
In the crypto industry, all stablecoins are collateralized, overcollateralized or hedged, and no central agency can adjust the long and short interest rates of stablecoins. The interest rate of stablecoins is completely determined by whether liquidity is scarce. It is usually a real-time floating rate, which is automatically determined by a simple product formula X*Y=K.
Therefore, compared with the monetary environment of the traditional financial world where fiat currency is over-issued and leads to inflation, the on-chain finance in the crypto industry is more like an environment of fiat currency deflation.
This is because all stablecoins must be made from collateral, and at the same time, a large number of other types of virtual currencies are over-issued without control, causing stablecoins to be in a deflationary state relative to other currencies.
Secondly, there is no centralized institution like the Federal Reserve to adjust the overall interest rate level of stablecoins. The interest rate is determined only by whether there is liquidity shortage or not. This is a point that is very different from traditional finance, making it look like a financial world that is inverted from traditional finance.
5. DeFi Lego and Leverage
In the world of DeFi, the various financial projects on the chain are not completely isolated from each other, because each project can achieve interoperability by calling each other's API interfaces.
It is very likely that the tokens issued by project A can continue to generate new benefits, interactions, gameplay, etc. in project B. This has formed a nested financial ecosystem that looks like a Lego building block.
The essence of all financial innovations is to use less collateral to leverage greater capital.
Therefore, DeFi Lego also achieves this goal through various modular interoperability. The benefit of doing so is very obvious, which is to improve the utilization rate of funds. In the traditional financial world, due to compliance, technology, risk preference and other reasons, the utilization rate of funds is often likely to be very low. In on-chain finance, the loose financial environment leads to extremely efficient utilization of funds and also brings a higher leverage ratio.
Of course, this leverage ratio is not mandatory, and participants can choose it. At the same time, the clear flow of funds on the chain can clearly track the flow of funds. For those with professional financial knowledge, they can better distinguish the financial benefits and risks.
6. BTC and ETH, the lenders of last resort
Any financial system must have a lender of last resort, similar to the Fed's role in the US dollar. The lender of last resort is both the issuer of currency and the backer of liquidity. Their role is to provide the final buyer liquidity for financial assets in any system, just like during the subprime mortgage crisis, a large number of financial bad debts were indirectly backed up in the form of quantitative easing by the Fed, and the actual subject of this backing is all holders willing to hold US dollar assets.
Similarly, in the on-chain financial system based on DeFi, the role of the last lender is actually the buyer of the two major mainstream currencies, BTC and ETH.
Taking on-chain mortgage lending as an example, investors holding BTC and ETH can borrow other cryptocurrencies, such as stablecoins, by mortgaging BTC and ETH. If a default occurs, a large amount of mortgaged BTC and ETH will flow into the hands of creditors, who will cover their losses by selling them on the open market.
Therefore, since BTC and ETH have assumed the role of important credit collateral in on-chain finance, their buyer market depth has also become similar to the role of the last lender in this financial system. The market capitalization levels of these two cryptocurrencies with the largest market capitalizations largely determine the prosperity of on-chain finance, and they influence each other.
7. Crypto Industry from a Financial Perspective
From the perspective of traditional finance, finance is an industry with a very short industrial chain. It has only two links, one is capital and the other is assets. Most of the work done by the financial industry is to efficiently use funds on the capital side and then output funds to assets with high returns.
When we observe the crypto industry from this perspective, we will find that the crypto industry, due to compliance, technology and other reasons, does not serve as many companies that provide goods or services as traditional finance, such as Apple, Tesla, Nvidia, etc.
In on-chain finance, although the industry has been pursuing mass adoption and enriching the asset side, its stronger point lies in the development and richness of its capital side and its leading technological advantages.
All kinds of cryptocurrencies on the chain can generate higher leverage and returns through various on-chain financial services, improve capital efficiency, and in order to make the entire on-chain finance run more smoothly, the crypto industry uses this on-chain financial clearing network as the asset end, so that the logic of the mutual operation of funds and assets in on-chain finance can be achieved.
This self-growth state constitutes the main logic of the development of the crypto industry at this stage. With the introduction of compliance and scale, more and more people hope to introduce real-world assets to use this financial clearing network, or apply blockchain technology to the real world to achieve mass adopiton, which is the long-term goal of the industry.
at last
Recently, Trump, the popular candidate for the US presidential election, gave a speech about Bitcoin.
In the speech, he expressed that the United States will fully embrace the crypto industry and lead the development of this industry. From this speech, we can also see that the on-chain finance of the crypto industry is gradually integrating with the mainstream government and the real world as the scale of the industry grows, from a technology-oriented native community to a mass adoption financial ecosystem, and this change will gradually accelerate in the next few years.
