The Rise of Decentralized Finance


“The older generation of bankers would probably be completely unable even to imagine how the new system would operate and therefore be practically unanimous in rejecting it.

But this foreseeable opposition of the established practitioners ought not to deter us.

I am also convinced that if a new generation of young bankers were given the opportunity they would rapidly develop techniques to make the new forms of banking not only safe and profitable but also much more beneficial to the whole community than the existing one.”

So said Friedrich Hayek, after studying money all his life, to then tell this generation in no unclear terms in The Denationalization of Money:

“If we want free enterprise and a market economy to survive (as even the supporters of a so-called ‘mixed economy’ presumably also wish), we have no choice but to replace the governmental currency monopoly and national currency systems by free competition.”

If we were to build the financial system from scratch, Bill Gates said in 2016, we would build it on a digital platform. We do not have the luxury of starting from scratch, he said, but we have to manage this transition to digital finance.

What can you do with a bitcoin? They used to ask and still ask. Hodl, of course. Maybe buy something, or speculate, or exchange it for eth. And what can you do with eth? Well here is something interesting an etherean said:

“Presumably the value of Eth would go up if the purchasing power of USD goes down. So the value of my collateral goes up and I can get more Dai from my CDP to account for that change.”

That’s presumably in some sort of lab setting because ethereum doesn’t easily correlate with any other asset, including the dollar, as it has its own factors that affects its value whether at a fundamental level or more speculatively.

However, that dynamic between tokenized dollars and the collateralized eth that created them, appears to be quite interesting if we limit ourselves just to the question of dollar inflation.

When you create dai, you’re basically locking the current dollar price of eth at the cost of 33% of your locked assets being non utilizable. If the price moves against you, then the contract sells the eth to cover the dai dollars unless you have paid back the dai or you send more eth to now account for the lower dollar/eth value. If the price goes up, then you can get more dai or unlock some of your eth.

Since eth has been practically turned into dollars, while not converted into actual dollars, then this presumably can be used as a hedge of sorts in both directions.

If the dollar gets stronger, let’s say from $1,000 per eth to $100, you’ve locked your dollars at $1,000 by collateralizing say $1,500 eth. Now eth’s price falls. As long as it does so by more than 33%, you’re in profit, but a special kind of profit.

Eth has fallen a lot more than 33%. Your 1.5 eth, turned into 1,000 dai, is now worth 10 eth. Obviously, had you plainly sold, that 1.5 eth would have given you $1,500 which are now worth 15 eth.

So you lost five eth, but realistically that’s only if you had a crystal ball and you knew what was going to happen. Eth could have doubled and it could have even gone up 10x. It has done so before. Had you plainly sold and that 1.5 eth became say $15,000, you would have “lost” quite a bit of money.

So making it a special kind of profit because while technically if price goes down you would have lost 33% more than had you plainly sold, you would be quite a bit in profit than had you plainly held eth and you expose yourself to the upside of a potential price increase.

You’d think that the only way you can really lose in a sea of unpredictability is if price goes down by precisely 33%. In that instance, your $1,500 worth of eth has become $1,000. The price of eth has become $670, and you’ve lost $500 of eth value.

As you’ve borrowed $1,000, and as you need 1.5x collateral, we now get into a bit of complex maths which we’re not very good at, but let’s see if we can manage.

Lets say 33% of your eth is sold, ◊0.5, at a price of $670. That gives us $335 of dai, which is paid back, turning our borrowed $1,000 into $665. That would have been it if you had put in 2eth, leaving you with 1.5. But we started with 1.5 and now we’re left with 1 which is worth only $670, so basically your entire 1.5eth has to be sold.

That can be fine if price then goes down further presuming your intention is to increase the amount of eth you have as you would have lost $500, but you can now buy 2.5 eth if say price goes down to $400.

Obviously had you sold the eth when they were locked in this scenario you would have been able to buy slightly more than 3.5 eth. So you did in the absolute sense lose some money, but had you held the 1.5 eth, then you’d still have 1.5 eth. Hence the hedge, you won one eth and you lost one paper eth.

Does this make sense? Well, we’re talking sort of out of a napkin. In due course there will probably be studies and models with their complex formulas and so on with plenty of smart men and women probably doing that right now, not for studies but for their own financial management.

Now obviously there are scenarios where you lose in eth as well because price can increase before you buy and so on. Making dai not quite a sure thing. Instead fairly risky if one doesn’t quite know what they’re doing and if you don’t do all the maths and so on.

However, let us now suppose that this $1,000 dai we borrowed we are now lending perhaps on Compound once it gets up and running after the recent bug and it proves itself or on some other financial dapps that are now rising.

We’re tempted to suggest 20%, but let us be nice and lend this at 10%. After a year, we’ve only made $100, so it’s not much of a dent towards “neutralizing” this $500 of potential loss, which is now $400.

So what if we do something stupid. What if we go to a new dapp we haven’t yet reviewed, we will in due course, and enter a 1x margin short of 1.5 eth.

Half long half short as traders call it. Price goes down to $670, we make $330 on the short, we lost $5oo on the collateralized long, but this $400 has now become just $70.

The problem here with the short is what if price goes up, we’re cancelling the long, but would that matter? Maybe.

Let’s say for simplicity price goes up to $10,000. We now have $15,000 in eth, $1,000 in dai and we lost $14,000 in the short. We started with 1.5 eth which was worth $1,500. We’re now in the plus by $2,000, so we made $500 after all this effort.

Meaning you can tell how great a financier twastnodes is, but looked at it from another perspective this is a 30% gain. Had we started with $1.5 million, for example, we would have made $500k at the risk of losing $70,000 except that obviously that $1,000 in dai has to be returned at some point, so we kind of lost that $500 whether up or down. Hence the half long half short meme.

But this somewhat absurd example illustrates the fairly complex calculations that can now be made through natively digital financial dapps which are currently holding about 1.5 million worth of eth.

You might hedge your risk by 1x margin shorting with just 1eth for example, or 0.5eth. That means your gains would be lower, but then so would the risk.

With the point of it all in a way being that if you buy say $1,500 worth of eth, you don’t have to just sit on it. You can do stuff with $1,000 or $750 worth of it, while obviously taking into account the risks and the potential gains.

In a way, all these instruments are nothing new. Margins and options and borrowing money on collateral have been around for quite some time.

The difference being that its open finance, easily accessible, highly efficient with just one click, pretty much instant, and fully transparent.

It is basically opening up Wall Street to the ordinary man and woman, or more correctly, to the smart guy and gal who is sufficiently intelligent but can’t be bothered with the arcane paper processes of the old financial system.

It doesn’t look like much. You know, why bother with the telephone you can just send a fax. But it’s just better.

And its available to a Ugandan smart man or woman, to a Chinese math wiz, to the American student of finance, to everyone with an internet and a means of getting eth really.

Not quite earth shattering, the slow replacement of intermediaries. The one click efficiencies of the digital age. The opening of Wall Street guilds. The availability of sophisticated tools to the ordinary smart ones.

Yet we might look back one day and see the arcane paper world, full of exploitation and abuse of trust, and perhaps wonder just how on earth one could go back to that.

For candles did their job perfectly well, yet bulbs do it better. Nothing earth shattering, just nicer.

We’ll still go on demanding more, satisfied never, but it is difficult to see how this new digitally native financial world is not the future.



Leave a Reply

Notify of