Beyond Bitcoin

Decentralised Finance and the End of Banks

Simon Dingle, Steven Boykey Sidley

• Publisher: Icon Books
• Year: 2022
• ISBN:
  9781785788314
• Topic: Business
• Subtopic: Business General
• Index: Business

After over a decade of Bitcoin, which has now moved beyond lore and hype into an increasingly robust star in the firmament of global assets, a new and more important question has arisen. What happens beyond Bitcoin? The answer is decentralised finance - 'DeFi'. Tech and finance experts Steven Boykey Sidley and Simon Dingle argue that DeFi - which enables all manner of financial transactions to take place directly, person to person, without the involvement of financial institutions - will redesign the cogs and wheels in the engines of trust, and make the remarkable rise of Bitcoin look quaint by comparison. It will disrupt and displace fine and respectable companies, if not entire industries.Sidley and Dingle explain how DeFi works, introduce the organisations and individuals that comprise the new industry, and identify the likely winners and losers in the coming revolution.

1

CHAPTER 1

Introduction

A man in Johannesburg wishes to send his daughter studying in The Netherlands some money to spend on an upcoming long weekend. He decides that R1,000 (about $75) seems about right. He goes to his banking website to transfer the money to his daughter’s bank account in Amsterdam. On the site he is confronted with an array of forms and questions that seek to shoehorn his intended gift to his daughter into a set of arcane and opaque requirements.

The man gives up at the point where the system attempts to assign a regulatory code to the transaction. He has been on the site for ten minutes. He does not even get to the point where the transaction might have been approved and where the transaction fee would be revealed. Had he done so he would have found out that it was over 15% of his intended gift.

He then opens an application on his phone, a crypto-wallet called Metamask. He transfers $75-worth of a cryptocurrency called ETH from Metamask to his daughter’s crypto-wallet, accessed via an app called MyEtherWallet which she had downloaded the previous week in Amsterdam from her laptop. It takes fifteen seconds to enter the transaction. She receives the funds five minutes later. The  2 transaction fees are a fraction of what her father’s bank would have extracted.

The man fills out no forms to do this transaction. He does not need an ID. The transaction, although having been viewed by thousands of anonymous computers, will never be tied to the father or the daughter. Unlike the bank transfer, the South African government and Dutch government will not ever identify them as the parties to this transaction, even though they would wish to do so.

It is a private matter between father and daughter.

It is simple. It is fast. It is cheap.

The scenario above is not new. It has been around for a few years, certainly longer than the main subject of this book, DeFi. It is in daily use by millions of people. It is trivial to initiate and conclude.

But buried in this little story is an important matter, the crux really.

It is the matter of trust.

The man wishing to send his daughter a payment had two options. One required a ‘man-in-the-middle’ and the other did not. In this example, the ‘man-in-the-middle’ was his bank. Not only was the experience frustrating (although, to be sure, while this example is real, not all bank experiences are this bad), it was also expensive. And in this example, accompanied by a usurious rent extraction, both by the bank and the state.

In the man’s second attempt to pay his daughter, there was no one sitting in the middle of the transaction. No institution with employees and forms to fill in. Just a few lines of code of little interest to the man who initiated the transaction, or to his daughter. A transaction fee may have been charged to compensate for 3the expense of the computing resources which shepherded this transaction to its conclusion. But it was much lower than that of the bank.

Bitcoin arrived as an idea in 2008, launched in 2009, and is the last common ancestor of all that has come after (Bitcoin itself still rules the roost in terms of scale and total value but decreasingly so).* It has spawned many offspring, some spinning off into historical footnotes and others surviving and conquering. It is Darwinian in its unfolding, having evolved in its entirety in a little over a decade, as though in a petri dish. And it has turned out to be antifragile, adapting and surviving over time.

One of the evolutionary lines has resulted in the family of projects and applications collectively called DeFi, which started appearing in 2018. There is a famous August 3rd, 2018 screen grab from Telegram, a chat with early innovators in the field – some people from projects called dYdX, 0x, Set Protocol and Dharma. The names on the chat are Blake and Brendan, but there were others, like Felix Feng from Set, who has related the story and shared the screen grab. Names for their new passion were bandied about. OFD – Open Financial Protocols. DFD – Decentralised Finance Developers. Open Lattice, Open Horizon. And then ‘DeFi’. I like it, says Blake, it comes out as ‘Defy’. And that was it.

And therein lies the core of this book, DeFi. We will describe a big idea, its implications still evolving and ill-understood, and its commercial instantiations appearing daily, not only in finance (where we will spend most of our time) but across myriad other human endeavours.

4This idea had its roots in maths first, and then cryptography, and then the aspiration of a few techno-zealots to build a new financial system, a better one than had existed for centuries.

It was an idea that fed off the perhaps cynical view that the world would be a better place if we trusted no one. Or, rather, that we didn’t have to trust humans, institutions and governments, but rather mathematics and logic, protected against politics, change or misinterpretation.

We will describe a set of technological and commercial developments which are, by design and with brutal precision, targeting industries that outsource trust – banks, insurance companies, exchanges and brokers and other trustees across numerous other industries, whose fees are estimated to consume 6% of global GDP, to say nothing of the profits which some of them accrue beyond the selling of trust.

We will briefly and lightly explain the underlying mathematics, and point out the organisations, projects, individuals and services that together comprise this new industry, and we will show exactly where their collective arrows are likely to find their marks in the financial world.

DeFi is coming. Quietly at first. Tentatively at first. Softly at first. And then not.

* For the uninitiated, we describe how cryptocurrency and blockchain actually work at various points in the following pages.

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​CHAPTER 2

A matter of trust

Before launching into the Wild West of blockchain and smart contracts and DeFi and banks and metamorphosing financial landscapes, it’s worth taking a short look at trust and the role it has played, not so much in financial matters, but everywhere.

It could be argued that human beings start their lives with a surfeit of trust, giving themselves over completely to the protective embrace of their mothers. We have been taught to trust those in our immediate proximity, and authorities. Trust your family, trust the tribe, trust the police. Automatically distrust strangers. And if one has a darker view of nature, one can argue that the older we get, the more our trust in the world leaches away until it is exhausted.

Perhaps that is partly true, or a matter of degree. What is certainly true is that in human interaction, from business to politics to language to the entanglements of intimate relationships, trust is the lifebelt which seems to keep us afloat. Where we find a lack of it, often through bitter experience, we try to take action to enforce it. Contracts. Promises. Threats. Shame. Laws. Police.

Trust inhabits how we operate in the world, from our families and loved ones and friendship circles where layers of trust are 6assumed, to delegated representatives and authorities in politics and institutions (where trust never seems to last for very long), and on to the wider and unknown world in which we require a little more assurance, and sometimes a lot more. In the circumstances that we address in this book, we find that the best strategy is to have no trust at all.

Google fairly bristles on this topic. Scholarly articles go on for many pages and across decades. This is a big subject, well-trodden, continuously debated, worried over and analysed.

There is one analysis that caught our eye, from a paper entitled ‘Information, Irrationality, and the Evolution of Trust’ by Manapat, Nowak and Rand, from ScienceDirect.com. The authors discuss trust in the field of investing. They talk about the context of trust evolving under the influence of two important questions. One is knowledge of the trustees. And the other is whether the trustees are in an environment where they need to compete for investors’ trust. We will see this directly affecting the matters discussed in this book. The financial organisations that we trust with our valuables are increasingly unknown to us – their brand may be known, so might the employees with whom we interact, but not the inner workings of the products they sell to us, the machines into which our funds are thrown. And they are increasingly monopolistic, not because there are no competitors, but because there is inherent friction in moving from one to another. Anyone serviced by multiple products at one bank, like a savings account, current account, credit cards and a mortgage would balk at restarting with a new bank.

This brings us to one of the core pillars of DeFi, that of trustlessness, a term bandied about since before the birth of Bitcoin. And the other piece of related jargon, decentralisation, often ill-understood.7

A simple explanation then.

A trustless economic system means that participants need not trust anyone in that system. Not even a little. Not the people who built it, not the people who use it, not the people who abuse it. This is true of most of the DeFi projects we will discuss. Trustless architectures are designed around assumption of the worst-case scenario (i.e. everyone is equally liable to be dishonest). You do not even need to trust the system itself.

This is achieved in more than one way. The first is to use maths to ensure immutability in the data stored on the system. It cannot be changed, ever. Not by people and not by malware. It is locked down by mathematics. We will learn a little bit about how that is achieved in the next chapter.

The other is through the mechanism of the decentralised system.

A story is illustrative here. There is a small undiscovered island somewhere in the Pacific, with no access to the outside world. There are, say, 150 families on this island. They all reside in the only village, and live bountiful lives, eating coconuts from palm trees and getting shade from their leaves. Each family has one tree. One day, a storm comes over the island and lightning strikes, destroying the tree of the Wok family. That night a meeting is called. Wok’s neighbour, the head of the Kek family, says: ‘No worries, Wok, I’ll lend you leaves and coconuts, and when your tree grows back you can repay me.’ So two years later, the tree is back. Kek comes to Wok and says: ‘Dude, it’s payback time.’ Wok says innocently: ‘What are you talking about? I don’t owe you anything.’ A meeting is called. Kek asks: ‘Who heard Wok promise to repay me?’ 149 families raise their hands (not the Woks, of course); they all heard the same thing. Wok has to pay. The same promise was heard 8by everyone. It cannot be refuted. Because the transaction was … decentralised.

This is how decentralisation works in the here and now, only better (imagine if everyone hated Kek because he was a meanie – it could have gone the other way). In the case of cryptocurrencies such as Bitcoin and Ethereum the same transaction can be viewed and checked by hundreds, thousands, even tens of thousands of anonymous computers, the operators and owners of which are all unknown to each other. There i...

Table of contents

• Praise
• Title Page
• Contents
• Epigraph
• Acknowledgements
• Timeline of major events
• Prologue
• 1: Introduction
• 2: A matter of trust
• 3: Ethereum and the rise of the smart contract
• 4: Financial institutions – targets on their backs
• 5: A short note to our banker, our friend
• 6: ICO mania – aspirants, chancers and crooks
• 7: Bridging DeFi and TradFi – stablecoins
• 8: Depositing and lending: reinventing the core – Compound
• 9: Yield farming and Yearn
• 10: Decentralised exchanges (DEXs) and Uniswap
• 11: Oracles!
• 12: Reinventing insurance – Nexus Mutual
• 13: The scalability trilemma and its discontents
• 14: Derivatives
• 15: NFTs – beyond WTF
• 16: Mutants and strange creatures – WeirdFi
• 17: Risks aplenty
• 18: Into the thicket – Wyoming
• 19: Fintech – lipstick on a …
• 20: The great crypto energy debate
• 21: Who will benefit, who will get hurt?
• 22: Central banks and stablecoins
• 23: The future
• Postscript
• Breaking news
• Index
• About the Authors
• Copyright