DeFi 101: All About Crypto

DeFi 101: All About Crypto

Let's talk about crypto tonight. The last three months have been a crash course for me as I've increasingly experimented in the DeFi space. I thought it might be useful to do a short primer on some of the many confusing concepts that baffled me on first contact here.

I want to give a high-level overview on some of the weirder terms and concepts you'll see get thrown around: pools, farms, NFTs, staking, liquid defi, and margin trading.

It's not as complicated as it looks at first. The UX in this space is really bad. I'll also touch briefly on DAOs and what I'm seeing there, beyond what I already discussed here.

One of the interesting things about this space is it's so incredibly new. Extremely veteran experts have a few years of experience at most. You can become an expert fast just by jumping in and playing around. Blue sky, green field, tons of opportunity. Very very early days.

I'm going to assume that you have a basic understanding of what crypto is here. If you don't, the story is that a bunch of computers mutually agree on number balances in a ledger. You can write code to create circumstances under which these balances change ("smart contracts").

You can interact with established versions of these smart contracts on websites by "connecting your wallet" to them, which basically opts you in to their smart contract that allows exchanges to happen (which you consent to).

Usually this is done by connecting a browser-based wallet (MetaMask, SolFlare, etc) to the site in question by clicking a button and approving it. Then you're allowed to take actions to interact with that site using the coins you've sent to that wallet address.

So you have a wallet in your browser, you sent some coins to it (from Coinbase or wherever), and you're ready to jump into DeFi. What can you do, and why would you do it?

The most basic use case is simple swaps: trading one currency for another currency on sites like Uniswap.

There are tons of these around, and you can only trade on the protocols that support the wallet and currency you want to use. Solana and Ethereum and Binance all operate on different protocols, and you can't directly trade coins across them.

There are mechanisms called "bridge protocols" from established providers that can be used to swap currency across chains, and they basically work by taking your currency on one chain and sending it to a wallet address on a different chain that you specify.

Some wallets like MetaMask support multiple chains and you can operate across multiple networks by switching your network on the dropdown at the top. You still need to use a bridge to swap your coins over though.

By using these decentralized finance portals, or DeFi sites, you can quickly and directly trade coins on your own without going through a third party service like coinbase, which is "custodial." They hold coins on your behalf, which means you really need to trust them.

Custodial services can be great for security, but you run the risk of them disappearing with your coins (Mt. Gox anyone?) and you can't do anything if they have technical issues (I spent a week not being able to send SOL I bought on Coinbase due to tech issues).

The flipside of this is that your personal (MetaMask/Solflare/etc) wallet is only as secure as your personal risk management is. Do your research, consider using a cold wallet, and don't put all your doge in one wallet.

This feels scary at first but you get over it fast.

So Uniswap and Pancakeswap have been two of the historically most popular sites for DeFi, on the ETH and Binance chains respectively, and I'm going to use them to explain the next few DeFi concepts.

Every time you swap coins on these sites, they take a small fee.

Usually when you're trading in a market, the market matches people who want to sell at the current price with people who want to buy at the current price.

But what if there isn't someone who wants to trade with your coins at the current market clearing price on this site?

This is where pools and farms come in. Pools are liquidity pools, which is a defi innovation where people put up an equally valued amount of Coin A and Coin B in a locked pairing in order to facilitate trades between those coins.

This means that you don't actually have to be matched with another human who wants to sell in order to make an exchange between those coins. The pool itself facilitates the exchange by always having both types of currency in the pool.

So a USDC-ETH pool, for example, would have 1 ETH for every 3000 USDC in it right now because 1 ETH is roughly equivalent to that dollar amount. The pool is constantly rebalanced to keep this mostly even.

Because these pools are supplied by the coins of individuals who voluntarily put them up by locking them into the pool's contract, you need people to want to do this.

The incentive is you get a variable amount of the fees from the swaps made by this pool by contributing.

To represent your ownership of the coins you have locked in the pool, you receive a fixed number of coins back from your position in the pool that are usually represented by a pairing of the pools coins. Put in 3000 USDC and 1 ETH, and get back 3001 USDC-ETH tokens.

These live in your wallet until you decide you want to exit the pool, at which point you go back and trade them in to receive the same number of tokens back that you put in. However, the pool is always being rebalanced to maintain the relative value of the pool's coins.

So if there are large price movements in the RELATIVE value of the two coins you have paired (in either direction), you may lose money if you cash out at that point. This is called Impermanent Loss and you should read about it if you want to play in this space.

You can either hold these liquidity pool tokens to collect the fees you've earned when you eventually redeem them or in some cases place the tokens into a "farm" offered by a provider for an additional rate of return. A farm is a separate smart contract from the pool.

Farms expose you to additional risk by allowing someone to take your liquidity position and use it for whatever DeFi activities they'd like (lending your position) in exchange for this additional APR that varies by the amount of capital in the farm.

When you remove your tokens from the farm, you should always get the same number of liquidity tokens that you put in (3001 USDC-ETH is still 3001 USDC-ETH), but you need to trust the provider you're handing your coins to. Most major exchanges are as safe as anything here.

In theory, these compounded gains (in general) should offset any impermanent loss you incur unless you paired a very unstable coin in a relatively stable coin for the liquidity pool. You'll see very high return rates on stablecoin pools and farms (USDC-any for example).

This is necessary because you should EXPECT movement of most assets in either direction from stablecoins given the historical volatility of crypto markets. Coins that move tightly together or are more stable offer lower rates (less risk).

So when you're pairing coins for liquidity that don't move tightly together (like ETH and a random dog coin) you need to factor in your risk due to impermanent loss from the price movement and your willingness to ride that movement out (or risk it never recovering).

Farms usually reward you with tokens issued by the managing site which represent your portion of the rewards and which rise in value as those sites earn more from in fees from exchanges on their protocol (so PancakeSwap awards "CAKE" and Uniswap awards "UNI").

All of this is just 2 layers of lending levels designed to offer you a return on your position, and you need to compare the total expected APR against the likelihood of any particular coin raising or lowering in value (just hodling your coins).

You also need to compare this against Staking your coins, which is a lending alternative to all this liquidity and farming stuff by doing a direct lend of your coins to a smart contract in exchange for a fixed APR, usually used by a validator node to facilitate the network.

Unlike these other options, "staking" your coins often involves a lock-up period where you can't pull your coins back out until the end of the lock up period. The returns you earn come from the rewards of validating blocks instead of enabling coin swaps.

Your coins are fairly safe if you stake with a reputable validator, and you still technically own them in most cases via a smart contract claim (though they're not in your wallet). The rates for this tend to be lower than liquidity farming, because the risks are lower.

All of these are lending instruments that allow you to earn additional gains on your coins over holding and you back out of your position by going to the site with the contract and exiting your position once the lock-up period is over. Some wallets also offer direct staking.

Increasingly, staking providers are now offering you tokens in exchange for your stake which offers you a way to access the coins that are locked up in the stake by giving you a tradeable token representing your "stake" with that contract.

You can send, sell, or trade these tokens like any other currency, and anyone holding the token can redeem it from the provider for that tokens share of the stake pool. These tokens increase in value based on the validator fees collected by the stake pool.

Liquid staking is a newer concept used by some protocols like Solana where you can sidestep the staking lock-up period entirely by offering your coins to a provider who spreads them across validators and operates kind of like a staking exchange. Marinade is one example.

You want lots of network validators active on the chain for complex technical reasons related to network health, and liquid staking allows someone else to manage that while issuing one central token to you that increases in value while you hold it.

Anyone can put their SOL up on Marinade (and sites like it) and let Marinade manage the network health while taking their promissory tokens and going to go do other DeFi stuff with them (like the aforementioned liquidity farming).

This gets very tricky when you do stuff like this because you're now operating through THREE levels of lending if you dump your liquid staking tokens in a liquidity pool and then farm them. Kinda gotta do some complex financial wizardry to figure out if it's worth it.

This is also where things start to get kinda wild wild west and fun, though. Basically all of these things are risk and return management tools. You can take on as much risk as you're comfortable with for ever-increasing returns (and oh boy can it get risky).

Because now we get into lending and margin trading. There's yet another thing you can do with your coins (or any of the secondary tokens from any of these positions): You can put them up as collateral for margin trading on sites like Solend.

Because all of these tokens have immediate market value and uses in lending and borrowing via the markets and instruments we've already discussed, sites like Solend will let you lend these coins and instruments to other people who want to borrow them for fixed rates.

Note that this differs from the previous scenarios in that your coins (when lending) are relatively safe through a lending broker because they often have automated liquidation of borrowed positions that get out of balance to ensure they can return your coins when you want.

This is more like peer to peer lending via a brokered pool of currency, and the rates for lending tend to increase as more of a particular currency in demand. There are still risks here, and you should read about them. But it's more like staking with no lock-up.

Many of these sites allow you to use your lent currency as collateral to borrow other kinds of currency, up to 80% of the coins you have put up as collateral. So if you have 1 ETH staked in their pool, you can borrow up to .8 ETH of value in any currency you like.

Why would you do this? Well one reason might be if you have a short term need for currency but don't want to realize gains on a coin you hold. Putting it up as collateral (at this time) does not trigger a taxable event.

So you can borrow against ETH that you hold, which locks it in the smart contract, and borrow USDC that you can use for whatever you like without triggering a taxable event on your underlying ETH (no gain for using borrowed funds). You do have to repay the loan.

Again, this is the wild wild west, so this might change at any time with new guidance, but right now this works the same as putting up your house for a bank loan (which you know as a mortgage). You get taxed when you sell your house, not on the money you borrowed against it.

And this also unlocks new kinds of uses for tokens that couldn't otherwise be easily converted for trading or lending.

Some sites, like Parrot Protocol, will take your liquidity tokens (which you'd normally farm) and allow you to mint tradeable stablecoins from them.

If you're dizzy at this point, I'm not surprised. This is a lot and it's hard to wrap your head around until you actually see it in action.

Remember that this is just layers upon layers of lending activity. Each step is increasing your risk for a return you need to calculate

The bottom line is that if you want to margin yourself to the hilt for 3000% annual returns that you have to watch on a hair trigger for flash crashes, you can do this. Stare at charts to your heart's content with your finger over the "withdraw" button.

If that's not your jam, take your ETH and lock it into a stake pool on Coinbase for 5% annual returns until they let go of it.

There's a risk level and playground to suit anyone looking for a particular use case or return on their coins.

What's interesting is that these are tools and strategies that aren't normally available to the average Joe and most people have no idea WTF we're doing here for both complexity and novel tech reasons. But people in finance have done this stuff forever.

Play at your own risk!

But even the most paltry and risk averse staking play is offering returns comparable to or better than the "historical average" 7% safety situation of the stock market index, and potentially many multiples of that if you increase your risk a bit.

Yes, you're taking on underlying risk by even leaving money in the crypto market anyway (which is what people will be quick to point out), and also if you're playing around with ETH or newer coins like SOL or FTM or BNB, which are more volatile.

But if you're long and hodling on those coins anyway, all of these instruments are ways to let your coins work for you via investment tools instead of just having them sit in a cold wallet somewhere, and it's worth looking at if you want to maximize returns.

Finally, I want to take one sec to explain NFTs and DAOs a little bit. I plan to do an entirely separate thread on NFTs at some point, because I want to follow up my last thread on them this spring, which was much more bearish because I didn't understand them as well.

The NFT market is ablaze with hype at the moment, and if you wanna trade while the trading is good, by all means play there (I am, badly, and still learning the market). But the real value of NFTs is not just ponzi trading on jpegs even if it looks like that right now.

NFTs are exactly what they're labeled on the tin: they're uniquely identifiable tokens which can have their ownership validated on the block chain. There actually are a myriad of uses for them, and ecosystems are already springing up around them.

I touched on this a little bit in this thread, and I want to follow up on the potential future use cases in a separate thread later, as I said. But for now, just trust that there IS real utility beyond the excited hype of the moment.

As for DAOs, this is probably the least-well understood concept in crypto right now because it's one of the newest. DAO stands for Decentralized Autonomous Organization. It's an extremely flexible way to pool resources and organize with other individuals on the blockchain.

DAOs are governed by smart contracts whose rules are specific to the DAO, but usually has a coin/resource pool and a voting mechanism that allows members of the DAO to decide how to allocate those resources in the service of a shared mission.

This can be anything from a small art project to a fully resourced organization attempting a digital replacement for an incorporated co-op (or even potentially a virtual, decentralized nation). I unpacked the co-op vision a bit in this thread.

The most interesting aspect of DAOs is that they're a way to pool funds for shared goals in a way that doesn't actually require knowing one another or even having trust. The contract is published. The votes are visible. You can check the smart contract code.

It remains to be seen how useful this ends up being or how they'll evolve in coming years, but they're so very new and this space is so fresh and fast moving that I'm SURE I'm missing things about them just like I did before I wrapped my head around every other part of crypto.

I'm sure I'll write about these more in coming months too as I become more familiar with the space and novel and interesting use cases present themselves. But there's a LOT of cool energy here and it's one of the most cutting edge tech spaces you can operate in.

When you combine NFTs, ICOs, and DAOs, spinning up and funding a new project with people from all over the world has never been faster or easier than it is at this moment. It's moving so fast that legislation can barely track it right now (let alone keep up).

It's fascinating to watch. It feels like the very early days of the internet when it was first catching pop culture's imagination. Anything could happen, and we're just getting started.

Money makes the world go round and this space is rolling in it.

If you're a young, tech-savvy person looking to make their mark on the tech scene, here's my advice: if you're not learning everything you can about AI/ML, you should be participating in a DAO and working on a Web3 application.

Yesterday's Jobs, Gates, Zuckerberg, and Bezos were building on the back of Web 1.0 and Web 2.0.

Tomorrow's version of those guys is working on Web 3.0 right now.

Pay attention.