---
title: 3.1 Understanding DeFi
description: Decentralized Finance and the Future of Finance
---

# 3.1 Understanding Decentralized Finance and the Future of Finance 

The basis of Decentralized Finance is grounded in the notion of protocol shared liquidity or pooled value. If we think about this on a macro level, especially as compared with existing finance, we need to turn our current understanding up-side-down: 

In the existing financial system, the bank as an entity holds your money for you and issues you credit. Value is locked behind the walls of the financial entity and primarily kept between multiple different financial institutions. 

&lt;> – &lt;> – &lt;> 

When I would like to execute a trade, I am sending the bank's money, labeled as my money, to an intermediary, from which I then exchange that value for another type of value. And here is the interesting, part: 

A third party, usually a market maker or a financial institution itself, helps ensure that the market I trade on is sufficiently liquid. Meaning there is enough underlying value in the market to allow for the quick and easy exchange of value between different parties. 

Notice that in this system, the exchange of value is largely designed around the complimentary dynamics of different centralized entities: 


* A suite of banking institutions or credit institutions. 
* Market makers / liquidity providers. 
* A centralized exchange or an intermediary, designed to specifically facilitate this process. 

The key premise of decentralized finance, is that liquidity for markets can be pooled on-chain, in such a manner that the code handles the accrual of value from which a market or financial service can be created. The specific DeFi primitive is then built around the activity that the user can engage in, with this shared liquidity pool. 

_“For the first time what we have is a potentially digitally native store of value where the bits in the computer are the money, which is very different from the existing financial system where you do have a ledger and the bank has an entry that says you have such and such money. But it is really just an IOU from the bank - if you go to the bank they will give you some cash. It’s not that the bits in the computer are the money. So if you take that one step further and say, if the bits in the computer are the money, why is that interesting? Well it is interesting because now what that means is that computers can own money. Computers and machines and software can take custody of money. And so for the first time, a human can pay a machine without another human in the loop. Or a machine can pay another machine without a human even being involved. And if you play that forward, one step forward, you say, well, ‘why is that interesting?’ Well it is interesting because there is a set of stuff that computers are better than humans at - and strictly speaking there is only one thing that computers are better than humans at - and that is that computers are better than humans at deterministically executing some set of instructions on some future time horizon. That is literally what computer code is: Do this and the same thing happens every time. If you think about the world, a lot of the world is ‘here is a huge pile of money’ and ‘here are a bunch of rules about that money’ - who has access to that money, and when that money can move and on some future time horizon I need you to execute some set of instructions: That’s a will, that’s a trust, that’s an escrow, that’s a mortgage, that’s a heloc, that’s an options contract, it’s a securities contract, like literally a hundred trillion dollars of the world is ‘here is a pile of money and here is a bunch of rules around that money and how that money can move around.’ So now what you have is an infrastructure where money is digital, computers can take ownership of money, and since computers are strictly better at executing instructions, it is such a perfect match for this hundred trillion dollar slice of the world that has previously been untouched because software couldn’t actually solve those problems natively that we think over the next 20 to 30 years this programmable money stack is just going to eat up that 100 trillion dollars of the world. It feels to us a lot like the early 1990s…” - OpenWebCollective_

There are a couple of ways we can look at ‘Decentralized Finance.’ On its most fundamental level, it is the organization of liquidity, behind certain ‘tokenized’ representations of value. On a more advanced level, it is how these already existing primitives are able to interact with one another. 

<center>DeFi 1.0 - Basic Liquidity Primitives. </center>

<center>DeFi 2.0 - Composability between value flows of DeFi 1.0.</center>

<center>Composable DeFi - New building blocks of liquid primitives in the form of tokenized value.</center>

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In its current state, DeFi has existed for less than five years, and has only recently accrued sufficient liquidity to initially ‘stress test’ the fundamental design of DeFi 1.0 products, and a select few DeFi 2.0 products. We stand at the very, very beginning of this industry cluster. In order to properly understand the promise of DeFi and how it relates to the future of finance, we can start by comparing it to existing Centralized Finance, as well as TradeFi: 

## DeFi Compared to Centralized Finance and TradeFi

Compared to CeFi, DeFi purports to do the following: 

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* Automate access to finance based upon smart-contracts on-chain, removing human and institutional bias against past behavior of certain actors. 
* Value and reserves of liquidity are ‘communally sourced’ by different stakeholders as opposed to centrally created or mandated from a Federal Reserve (and then distributed to commercial banks). 
* Access is global and participation is only limited to your access to the internet and your capacity to participate in the ‘rules of the protocol’. 


![](@site/static/img/bootcamp/mod-em-3.1.1.png)


Meanwhile, DeFi in relation to TradeFi diverges strongly in the following areas:


* In DeFi there is continuous revenue accrual, with fully transparent metrics on the growth and success of the protocol. In TradeFi shareholders owning stock are rewarded annually, and are also reliant on ‘earnings reports’ to be released.
* Access to tokens is global with no barrier to entry: Any individual of any age, with an internet connection and sufficient capital can participate in token offerings and purchases. Whereas, in TradeFi individual markets are built around specific rules from different jurisdictions. 


![](@site/static/img/bootcamp/mod-em-3.1.2.png)


**Understanding DeFi in the History of Transaction costs: New Institutional Economics and Theories of Growth.**

The comparisons above of DeFi between CeFi and TradeFi, are especially relevant for attempting to make sense of the inherent value proposition of DeFi to the global economy and financial markets - at scale. This is most easily explained, surrounding the notion of _transaction costs:_

A transaction cost refers to the expenses incurred from the exchange of materials or services between economic agents.[^1] As this exchange is the crucial determinant of marginal utility and supply and demand dynamics within a market, transaction costs are directly related to the health and performance of an economy: low transaction costs, allowing for more frequent and fluid exchange of goods, bolsters economic growth. High transaction costs, resulting in less frequent and more costly exchange of goods, hinders economic growth. 

DeFi offers the world the ability to drastically reduce transaction costs - not only between two humans, but between two software systems, managed by smart contracts! This improvement in how value is managed, holds the promise of: 

1. Increasing the flexibility of transactions - from anywhere, any time, with liquidity already available (no more waiting for liquidity events!). 

2. Increasing the rate and trust inherent to transactions - moving beyond institutions, jurisdictions, and geopolitical interference, to simple self-executing code on massive open, public ecosystems. 

3. Increasing the ease with which users can participate in transactions with one another or code itself - Accessing the internet is the only barrier to entry, no one requires a license, there is no ‘credit check’, or ‘gated community’ and anyone in the world can participate. 

While we are only at the very, very beginning of the emergent world of decentralized finance, from both a practical and theoretical perspective, it is clear that DeFi is well positioned to radically transform the ‘game’ for how money is routed and shared globally. 

## A Broad Look at DeFi Protocols:

Amidst buzzwords and confusing terminology, it is easy to come to a very simple model for making sense of a DeFi protocol, once it becomes clear that the fundamental value proposition revolves around distributed liquidity, and how the distributed liquidity interacts with user behavior and the tokenization of value: 
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When you look at a ‘DeFi’ project, you start by understanding it through the following lenses: 
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* What activity is the user engaging with? In short, the ask - to lend, trade, stake, collateralize, swap, etc. 
* How does that activity impact the liquidity that is supplied on the protocol? From what the user is provided, is a new asset created? The user asset swapped for another one? And so forth. 
* How does the dynamic between user activity, and protocol liquidity change with 1) more users, 2) more liquidity, 3) drastic loss of users, and 4) drastic loss of liquidity? 
* How does the protocol take profit, and where is that profit directed? 
* Is there a token for the protocol and what is its utility or purpose? 

And importantly, it is much easier to make sense of a single DeFi protocol or dApp, once you understand how they may interact with one another: For example, stable coins like USDC and USDT as a mechanism for stable swaps on DEXs. This framework is a simple way of getting a _basic understanding_ on how a decentralized financial system may operate. 

## A Nomenclature of DeFi Tooling

Zooming in even further, when we look at specific DeFi projects, there are certain variables that tend to remain relevant irrespective of the exact design of the product in question. These variables include:

* **Asset Tokenization:** What tokens are involved? How many are listed on the protocol in question? What is the nature of the tokens? Are there different types of tokens? 
* **Protocol Owned Liquidity:** Where does the liquidity come from on the protocol? Are there terms for locking the liquidity? Who sources the liquidity? How stable has the liquidity been over time? 
* **Total Value Locked:** How much value is locked on the protocol in a liquidity pool? 
* **Volume:** How much value is actively utilized on the daily? This could be traded, collateralized, loaned, and so forth. 
* **Transaction Costs:** How much does it cost to operate a transaction on the protocol? 
* **Yield:** What incentives are there for liquidity providers to pool their liquidity on the protocol? How does this change based on the types of tokens pooled as well as the duration of time they are pooled for? 
* **Liquidations / Removals:** Are any positions closed based on market dynamics? Are any liquidity providers removing their liquidity? How frequently and comparative to the amount of inflows? 
* **Fees / Revenue:** Does the protocol charge a fee for participation? How much revenue does the protocol make over different time frames? What impacts revenue of the protocol? 

## The DeFi Matrix

The DeFi Matrix [was coined by Balaji in early 2021](https://twitter.com/balajis/status/1364626032771272706), to refer to the capacity for any type of asset, currency, or token to eventually be tradeable against each other. This would apply first between Fiat systems and stable coins on-chain, and then expand into the larger world of tokenized stocks, bonds, commodities, tokens, NFTs, and so forth. 
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The implications of this DeFi matrix are the following: 
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* **Composability Across Systems:** Fiat / Stable coin pairs, Fiat / Crypto pairs, crypto / crypto pairs, synthetic / crypto pairs, and so forth. To the extent that any type of asset can in principle be paired with another asset for swapping and trading. 
* **Liquidity vs. Currency:** When swaps across different composable pairs becomes more common, the need for ‘cash’ or a specific currency is less relevant or needed. 
* **Constant Liquidity vs. Liquidity Events:** Traditionally, liquidity events would allow funds and participants to open or close positions as they like when there is a liquid market capable of supporting their order. In DeFi, liquidity is constantly open to add or remove from pools, from anywhere at any time. 

## DeFi Today - and the Future Tomorrow?

Before we look into specific examples for these different types of systems, we need to understand what code-secured finance means for the future of financial systems. 

Today, we operate in a curious monetary environment where money is centered around the nation state, and where international finance between institutions is very frequently siloed, slow, and bureaucratic. 

The fundamental question that DeFi proposes is the following: 

_How can contract-based execution of financial activities - built into the very fabric of the internet - alter how we handle value; locally, nationally, and globally? How do new forms of tokenized value moving on-chain impact the development of DeFi?_

While we will revisit these questions towards the end of this module, it is no exaggeration to say that DeFi is an initial foray into this new future of finance. Entities[ like BlackRock already see the writing on the wall:](https://twitter.com/Vic_Vinegar_GMI/status/1598905515253575680?s=20&t=L5w9RT3v_px1pgX0flLNWQ) The future of finance is one that is global, decentralized, operating at internet-speeds, and accessible for anyone. And if you are listening to this, you should pay very close attention because you are going to be building this future over the coming three decades. 

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## Notes

[^1]:
     Ronald Coase, “The New Institutional Economics,” _The American Economic Review_ 88, no. 2 (1998): 72 – 74, 73.