CRYPTO-4-BEGINNERS

Welcome to Crypto-4-beginners, our topic is Decentralized Finance, also called DeFi.

In this section we'll cover staking, compound, Uniswap, Binance SmartChain, and briefly touch on a more advanced topic of Double-Layer-Solutions.  Buckle up, here's where stuff gets interesting!  

DeFi is a form of finance that is independent of a central authority.  It is permissionless, meaning that anyone can participate, and doesn't require an official middle-man like a broker or bank.  Its a decentralized, peer to peer network that is able to exist because of a unique idea first brought to life by the Ethereum blockchain, and that idea is "Smart Contracts".  

Before we can discuss Smart Contracts, its important to understand concepts like "mining", "proof of work" and "proof of stake", which I cover in the section titled "An Introduction to Important Concepts".  But, i'll go over it again here.  

Earlier cryptocurrencies such as Bitcoin, Litecoin, or even Ethereum use "miners" to "mine" newly minted tokens.  "Miners" use computer software to solve complex cryptographic algorithms that secure transactions.  For example, every time a transaction is made on the Bitcoin blockchain, miners work to solve the cryptographic algorithm that secures the transaction.  Once a miner 'solves' the puzzle, the transaction is verified, a new block is added to the blockchain's history, and the miner is rewarded some newly minted Bitcoin.  This process is called "Proof of Work" or PoW.  

Unfortunately, PoW, is time and energy demanding, and a new consensus mechanism is replacing PoW.  This new consensus is called "Proof of Stake" or PoS.  

Under PoW, miners were required to run expensive equipment that consumed a lot of electricity.  Under PoS, miners are replaced by validators, and instead of operating expensive equipment that uses a lot of electricity, validators must "stake", or lock up a portion of their tokens to use a collateral, which incentivizes the validators to be honest.  If a validator was to verify a fraudulent transaction as legitimate, the rest of the users on the blockchain would see the fraudulent transaction and the validator would be punished by losing all or a portion of their stake.  The larger the validator pool, the greater the chance of solving the cryptographic puzzle associated with the transaction's security.  

Validators can operate stake pools.  Which allows holders of their crypto, to stake their crypto-savings.  One could think of this as similar to a savings account that gains interest on your savings.  

For example, lets say you have some crypto and its sitting in your digital crypto wallet. You don't plan to sell it anytime soon.  So instead of the crypto just sitting in your wallet, you can stake it can earn interest on it.  That means that not only is there potential for the value of your crypto to increase, you also gain more of that crypto just by staking it.  

I'll show you a few ways you can start staking using the Exodus wallet.  

If you have these following crypto's, you can stake them in the Exodus wallet and receive an Annual Percentage Yield (APY) higher than most banks.  

Algorand, pays 6.03%
Cardano pays 6.97%
Cosmos pays 10.02%
DAI pays 5.7%
NEO pays 3.52%
Ontology pays 7.72%
Tezos pays 5.48%
VeChain pays 1.7%
*** Rates change sometimes, but on average are better than most banks.

So, for example, if you had 100 ADA (Cardano), and bought at 0.20$, waited a year, at the end of the year, the price of ADA (Cardano) has increased, so you made a profit there.  But also, you gained an extra 6.97 ADA (Cardano), so now you have 106.97 ADA at a higher price than when you purchased.  Now, of course the price could also go down, but you still gain your staking rewards.  

This is all possible because of the PoS mechanism.  But there's more to it.  Smart Contracts.  

Smart Contracts are computer programs that execute a set of parameters.  If any of the parameters are unable to be executed, then the entire contract fails.  You can think of smart contracts as a contract that is enforced by code, instead of a central authority. 

One way you can imagine this is to imagine you're buying something off of Amazon online.  You have no problem sending Amazon your payment first, and then receiving the product you purchased after the payment has been verified because you trust Amazon to send you the product.  But what if you just met someone online in a forum.  You've never met this person and have no reason to trust them.  If you want to buy a digital item from them, but you're reluctant to send them payment first because you don't know if they will take your money and not send you the item you wish to purchase.  Well, smart contracts locks in the agreement, and unless all the parameters are fulfilled, the contract fails.  This means that if you send payment to the random person online for a digital product, and they don't send you the digital item, then the entire contract fails and the payment never reaches them and is returned to you.  That's a smart contact... pretty smart eh! 

With the use of smart contracts, decentralized liquidity pools became the foundation of DeFi.  Liquidity pools are places where a person can borrow or lend crypto - and because of smart contracts, it doesn't require any centralized authority, it doesn't require any permission or even identification to participate, anyone from anywhere in the world can borrow or loan their crypto, and in some ways completely risk free.  

I'll elaborate.  If you wanted to borrow crypto, you can use the crypto you have as collateral and borrow up to 75% of your collateral.  So for example, if you have 1000$ worth of Bitcoin, you can use that as collateral and borrow up to 750$ worth of Bitcoin.  The lenders don't worry about you defaulting on the loan because the collateral is locked in a smart contract that will either return the 1000$ worth of Bitcoin to the person that put it up for collateral upon paying off the loan (plus interest) in a specific agreed duration of time, or the collateral is absorbed by the lender.  With smart contracts, the lender can loan risk free, and does not have to worry that the borrower will default. 

This makes liquidity pools attractive to lenders.  They can put any amount of their crypto into a pool with others, and earn interest.  At any time, a person can withdrawal their crypto from the pool.  

This all can be done on a website called Compound Finance.  Users can connect their MetaMask wallet to the platform and begin lending or borrowing.  It's not suggested that newbies rush into this.  You should definitely do more research on how to use Compound Finance, especially if this is the first time you're learning about it.  

There are risks.  Smart contracts are somewhat of a new technology, and because they are computer programs, they're susceptible to attacks from hackers.  In the past, hackers have exploited smart contracts of liquidity pools and made away with millions of dollars stolen from the pool.   When this happens, since its decentralized and no CEO to blame or hold accountable, all the lenders of the pool lose whatever was stolen from the pool.

DeFi is certainly just getting started, and there are some obstacles in the way.  To understand these obstacles, we have to discuss Uniswap and Binance SmartChain.  

Uniswap is a Decentralized Exchange (DEX).  Its similar to Coinbase, Binance, Gemini or Crypto.Com, except it is decentralized.  This means that there is no central authority that is able to halt trading, or ban a user.  Uniswap operates on the Ethereum blockchain, and the only tokens that can be traded on Uniswap are ERC-20 tokens that exist on the Ethereum blockchain.  There are many popular crypto currencies that exist on the Ethereum blockchain such as; BAT, LINK, UNI, etc... This makes Uniswap a popular choice for traders.  Since its on the Ethereum blockchain, and ETH is the main currency of that network, every time a transaction is made, there is a fee paid to the miners in ETH by the sender of the transaction.   So if a person wants to make a trade on Uniswap, let's say they want to use ETH to buy BAT, they would pay a "gas" or transaction fee to the miner that secures that transaction.  

Unfortunately, there's one tiny problem.  The more popular Uniswap gets, and/or the more people that use the Ethereum network, the more congested the system gets, and this causes the transaction fee's to increase.  Today, (March 5th 2021), the transaction fee's are so high it is discouraging small and medium sized traders from using the system.  

I'll give you an example.  The other day I was going to make a trade to put 200$ worth of ETH into a liquidity pool, and the transaction fee was 143$.  As you can see, this might not be an issue for someone putting 2,000$ or 20,000$ into a pool.  But for 200$, its not feasible.  So, because of these transaction cost, many are moving over to Binance SmartChain, which has all the same features of DeFi - except its centralized.  

The benefits are you can do trades with very low transactions fees, but thats because it doesn't have the same security features as Ethereum's blockchain.  Ethereum's security is protected by 8000+ nodes, where as Binance SmartChain has only 29.  

Fortunately, Layer Two or Double Layer solutions are coming to the Ethereum blockchain, which is promised to reduce transaction cost.  I won't go into what double layer solutions are here, I only wanted to mention them so that you do not get discouraged from DeFi due to current high transaction fees.