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Is DeFi Rewriting Wall Street Into a Code?

Convert your fiat to cryptocurrency, and you suddenly emerge in a world where you can use your crypto to perform a large number of functions that are traditionally performed by the financial infrastructure but in a completely humanless way.

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In a normal world, you would expect everyone to earn money based on the work they do that is needed by others and that others are willing to pay for, something along the lines of economics 1.0, i.e., “making an economic contribution.”

However, people in the Philippines and Vietnam are leaving their day jobs to play a blockchain game.

“It sounds shocking and maybe even funny, but this is the reality: An average player can earn around…$1,200. As a result, people in countries like the Philippines and Vietnam are quitting their day jobs to dedicate themselves to playing Axie,” writes Evan Luthra for CoinTelegraph. “When players play the Axie Infinity game, they earn the native token Small Love Potions (SLP), and these tokens are needed by the players to breed new Axies, which are charged by Axie. Axie also charges a 4.25 percent fee for buying and selling Axies on the platform. Players can also decide to sell SLP tokens to other players on an open marketplace if they decide to cash out these tokens.”

Right, this makes sense, sort of. Massive multiplayer online (MMO) games have been a huge business for over a decade now, with gamers in countries like Venezuela selling their digital assets to Western gamers sometimes as their primary source of income. Only now, the money for the gamer is better. Why? Well, blockchain, of course. Before, trading of digital assets was controlled by large gaming companies. Now, thanks to blockchain it is direct transaction between individuals.

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So…more money to the people?

First, we should talk about this—earn-to-play is only a small fraction of the decentralized finance (DeFi) environment that is absolutely booming right now for pretty much the same reason: high returns. To put it simply, DeFi is rewriting financial infrastructure into code on blockchain with no human involvement or control whatsoever. So, convert your fiat to cryptocurrency, and you suddenly emerge in a world where you can use your crypto to perform a large number of functions that are traditionally performed by the financial infrastructure but in a completely humanless way (i.e., by sending your crypto to smart contracts, which are themselves just lines of code on blockchain with certain rules embedded).

OK, this needs an example: Say, you have $10 of Ethereum in a MetaMask wallet saved on your browser. You can go to Compound and lend your crypto for a rate that far exceeds what’s available in a traditional bank (like 2 to 3 percent on USDT vs. 0.1 percent in a bank). You can go to Uniswap and contribute some of your crypto to a liquidity pool to then earn a fraction on each trade in it—nice, you are essentially now one of the owners of what in the old world is called an exchange. Or you can enter Nexus Mutual and contribute your crypto towards a common insurance pool, which is used to insure investors for certain types of risks (like a smart contract malfunctioning) in exchange for a premium—great, you are now a co-owner of an insurance company. All of this is done on the level of code with no human involvement—just records on blockchain sent in and out of smart contracts.

You can see why this is the internet moment for finance.

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So, just how much should you care?

You can maybe make an argument that people are only interested in DeFi due to the attractive returns and that often their understanding of it stops somewhere at the level of practical utility—i.e., “how do I plug in my Ethereum wallet”—and I would generally agree. DeFi is exciting right now because the math is easy: it is 0.01 percent (bank deposit) vs. 2 to 20 percent for DeFi depending on your level of risk aversion.

There is a good and a bad reason for why DeFi currently offers such high rates. The good is obvious and very true. If things like loans, trading or insurance can be done by computer code without humans and institutions in the middle, then costs are saved and split among people. Great.

The bad is less obvious, but also very true as we’ll see over time. Anyway, here it is: New money pays for the old money.

The DeFi space is large and divided. As Brady Dale explains here, each DeFi startup is trying to attract more capital because the more of it they have locked in their smart contracts, the more robust (read less prone to bank runs) they get.

For example, Uniswap is a decentralized exchange that works on the basis of pools. Someone puts 2 USDC and 2 Dai into a pool. Someone else comes and exchanges their 1 Dai for 1 USDC. Now, there are 3 Dai and only 1 USDC in the pool. This immediately attracts arbitrage because a third person can now come and exchange 1 USDC for 1.5 Dai, making a free profit and putting the pool back into balance. Now, if the pool were larger, it would be much harder to push it out of balance.

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This isn’t important due to some attempts to weed out the arbitrage, but because small pools can lead to fraud. A rug pull describes a situation when someone makes up a token X, creates a liquidity pool attracting investors in it and then drains it for a more valuable token Y, leaving investors with a meaningless made-up token they cannot trade.

Because liquidity is so important, to attract more of it, DeFi startups began giving out their own governance tokens to people in exchange for them using the platform. So, for example, Compound gives out a token to both lenders and borrowers on its platform. And because you are dealing with a code, not a human system, you can do weird things like lending and then borrowing the same amount, while receiving the Compound token, which has a market price that is, by the way, rising because (I guess?) it has limited supply and everything that is seen as scarce in this strange YOLO market has to go up?

But this is it. DeFi is rewriting the high-finance speculation of Wall Street into code and making it available to anyone in the form of a game. That is why it is exciting. When you take that speculation out, we might find that we are left with just savings from automation and disintermediation, and those are not likely to be very exciting.

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