What you need to know about Decentralized Finance (DeFi)

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Hi everyone,

After my post on Inflation and Cryptocurrency, I received a lot of requests asking me to analyze other areas of the Crypto market. I figured that I would tackle Decentralized Finance and the two major areas of crypto functionality within DeFi.

What is Decentralized Finance (DeFi)?

The internet isn't any one thing, its a beautiful and incredibly elaborate series of connections between servers. Everything on the internet needs to be stored somewhere, traditionally that meant stored either on a personal computer, a personal server, or as a small part of a massive server farm hosted by a tech company. The issue with this setup is that the owner of the server, if left unrestricted, can determine exactly what is hosted on their hardware. This fear of potential and real censorship has led the push towards a decentralized internet hosted on a trustless foundation. A system that is secure.

This idea has spread throughout the niches of the internet economy. The target of the system is decentralized finance, or how to commodify the internet to allow for a decentralized flow of money. There are two main areas that this overlays with crypto, the first, like Bitcoin, a currency, is primarily an asset, the second, like Ethereum, is primarily a platform for functionality.

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Before we get started, let me quickly run-through some factors that I used to determine the Fundamental Analysis and subsequent Technical Analysis.

Fundamental Analysis:

Fundamental Analysis is attempting to put an accurate price on a item based upon an objective calculation of its worth. This is normally a nebulous number that roughly correlates to its in-kind purchase power if transferred to a universally traded currency. It answers the question of, given the ability to buy its competitors, what is the value of this good in a fair market setting. Fundamental Analysis generally seeks to answer whether the current price is overvalued or undervalued.

Some Fundamental Analysis include:

  • Market Cap:
    • Current Price x number of coins
  • 24 hour Trading Volume:
    • How much coin is being exchanged
  • Inflation Rate:
    • How many new coins are likely to be introduced

Best sources for Fundamental Analysis data: https://research.binance.com/en/projects

Technical Analysis:

Technical Analysis is to Fundamental Analysis as a crystal ball is to a NYSE ticker quote. Technical Analysis is the attempt to predict the market value of an item given all the outside factors that influence it. A technical analysis is generally done when historic numbers are used to predict future trends. Correlation analysis, candlestick patterns, and social media references are ways analysts assess a coins technicals. Technical analysis generally seeks to predict the future price of a coin.

The White Paper

This, often overlooked, gem is the thesis behind the coin. This is the coin's reason for being and the market space that it intends on owning. A coin with an undefined white paper is a coin with an undefined answer, namely to the question, what makes you so special?

It contains:

  • The type of system
    • POS, POW, etc
  • The coin's answer the Byzantine Fault Tolerance (how a coin proofs consensus of trust in an imperfect environment)
  • Tokenomics of the coin
    • How coins can be received or distributed
  • The coin's "why?"

Valuation and Bubbles

A bubble can occur when there is a deviation between the Fundamental Analysis, what something should be worth based upon its own merits, and the Technical Analysis, where the market places the item's worth based upon outside factors. The idea of a bubble occurring is driven largely by projected future value and real future value. Both types of analysis seek to explain the market evaluation of an item.

A quick word on bubbles and bitcoins. This hits on tokenomics, or the inherent value of the coin based on its function as a store of value, unit of account, and medium of exchange. A coin's risk can be determined by its degree of usability, valuations, inflation rate of the coin, information surrounding the design team, and volume of fees (indicating a rough level of willingness for people to trade coin for other currency).

Two major System Types:

Proof of Work (POW): The basis for traditional Cryptocurrency, where a complex equation is solved, providing the equation solver with a unit of currency. The currency gains intrinsic value through the value of the expended energy used to complete the equation. Thus, the tie between energy and currency allows the valuation of the currency.

Examples: Bitcoin (BTC), Ethereum (ETH)

Pros:

  • The first, and most tested, way to ensure decentralized control over a currency.
  • POW provides incentives for miners to behave well and creates a system to settle transactions.

Cons:

  • The process wastes resources, which is unscalable with the current dominance of fossil fuels in our energy production.
  • The transaction time increases as the system seeks to prevent against double spending through verifying against “double spending”
  • Subject to 51% attacks*
    • Miners can technically control 51% of the currencies computational value
  • This allows them to effectively re-write node history and secure bitcoins from other miners, controlling supply

Proof of Stake (POS): The newer version of POW, favoring efficiency over whole-chain verification. Ouroboro’s Genesis-based POS relies on actors providing collateral to verify reduction of tradable coins in the marketplace. Traditionally, verification was performed through a reduced version of POW, where a portion of the blockchain is recorded and used to verify that the owners had not spent the stake. A second method of verification involves creating a lag time between when the currency being un-staked and the ability to spend the coins.

Examples: Zilliqa (ZIL), Cardano (ADA), Polkadot (DOT)

Pros:

  • More environmentally friendly
  • Reduces latency when compared to POW
  • The required code to obtain the currency can be dynamic, allowing for scalable security

Cons:

  • Environmental pollution, latency, and security varies by the coins design
  • No consensus on how the system is verified
  • Requires users to trust the system as a whole and does not allow for selecting verifiers

So lets get to it:

The industry leader:

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Ethereum (ETH) – March 22

Functionality: DeFi Platform

Network: Ethereum

Cryptocurrency: Ether

Market Cap: $203.87B

  • 115.15 million out of No specified Limit

Transaction Count: 1.21M

Average 24 hour transaction fee: 16.07

Tech: Proof of Work (ETH). Proof of Stake (ETH 2.0)

Oversite: Decentralized

Ethereum is the prototypical alt coin. Second only in Market Cap to Bitcoin, but with an amazingly versatile and proven functionality that bridges the gap between currency and utility. It was launched as a type of global computer that allows platforms to build upon it, utilizing its computational capacity for their business functionality. It was made to scale the blockchain technology, and its done a great job so far.

Utilizing smart contract technology that triggers when the outlined terms are met, ETH's smart contract functions as a decentralized broker that eliminates the need for traditional financial middlemen.

Pros:

  • Gradually shifting to ETH 2.0
  • Much of current DeFi system is based upon Ethereum network
  • Does not have a similar DeFi coin that can compete in adoptability
    • Offhandedly referred to as the "worlds computer" due to its ubiquity in its market
  • Strong backing from institutions
  • Proof of concept and proof of team

Cons:

  • Incredibly high fees when compared to competing POS coins
  • Scalability issues with ETH 1.0
    • ETH 2.0 fixes this with the shift to POS
  • Low Latency
    • Due to the limited number of transactions allowed per second the system is bottlenecked
      • ETH 2.0 fixes this by expanding
  • Skepticism regarding its ability to shift to POS
    • Upgrading is more difficult than creating from scratch due to transition time and ecosystem

The competition:

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Ripple (XRP) – March 22

Functionality: Currency (Unit of exchange)

Network: Ripple

Cryptocurrency: Ripple

Market Cap: $59.18 Billion

  • 45,000,000,000 in circulation out of Hard Cap of 100,000,000,000

Transactions:

  • Transaction Count: 1.11M
  • Average 24 hour transaction fee: 0.000609

Tech: XRP Ledger Consensus Protocol

Oversite: Centralized by Ripple

Ripple was founded 2004 by Ryan Fugger. Ripple Protocol, outlined in Ripple’s 2018 Whitepaper, describes its model for using the Byzantine Agreement system in conjunction with decentralized trust.

XRP was started by the folks at Ripple, and finished through open source collaboration. As a coin, XRP does not achieve a traditional system wide consensus and is instead powered by a ledger based consensus. These ledgers are, in part, managed by the company itself through their verification system. Ripple has done a commendable job diversifying their ledger owners, referred to as Unique Node Lists(UNL). Ripple has an extensive list of partners who have adopted their tech, and are growing at an impressive rate. XRP supports a number of functionalities including: Payment channels, escrows, deposit authorizations, a decentralized exchange, amendments, and invariant checking.

Pros:

  • Oldest coin between the three ETH competitors
  • Managed by a team that has successfully transitioned to a new whitepaper
  • The system does not require system wide-consensus, allowing for lower latency
  • Developed within an ecosystem that is currently growing

Cons:

  • Master list system for node selection does not give XRL owners full control of their trusted nodes, unlike XLM
  • Attached to the Ripple scandal, and a for-profit company
  • Similar in benefits to XLM, but lacks extra security features seen through the FBA

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Stellar Lumens (XLM) – March 22

Functionality: Currency (Unit of exchange)

Network: Stellar

Cryptocurrency: Lumens

Market Cap: 44.04 B

  • 22,648,880,607 in circulation out of Hard Cap of 50,001,806,812

Transactions:

  • Transaction Count: 4.49M
  • Average 24 hour transaction fee: $0.000013

Tech: Stellar Consensus Protocol

Oversite: Decentralized nodes

Stellar, was founded by Jed McCaleb, a co-founder of an earlier coin, Ripple. The Stellar White-Paper explains the reasoning for the currency and the market gap it seeks to fill. Stellar seeks to create a word wide financial network, ensured through a Stellar consensus protocol (SCP) built around a decentralized trust model called the Federated Byzantine Agreement (FBA). Through implementing its decentralized trust model, SCP, the Stellar system seeks to ensure:

  • Decentralized Control
    • No gatekeeping or barrier to entry for consensus
  • Low latency
    • Faster processing through spreading work over decentralized nodes
  • Flexible Trust
    • User determined nodes, providing security based upon users predetermined trusted nodes.
  • Asymptotic Security
    • Flexible digital signatures and hash families allowing for scaling for security

Technicals:

Unlike competitors, XLM seeks to fix POW’s latency, trust, and security problems through their SCP model. It’s worth noting that XLM’s SCP model was built before Ouroboro’s Genesis.

XLM allows individual users to select trusted nodes, separating them from Ripple’s earlier attempt to create master sheets with trusted nodes. Rather than individually selected by users, the master sheets employed by ripple ended up transferring the byzantine system of authority from ripple to the sheet owners, leading to sheet owners maintaining control over the term “trusted nodes” within Ripple.

The XLM model diverges from the decentralize admission Ripple attempted in an important way, rather than relying master node lists that are editable, FBA relies on a consensus between decentralized nodes. Turning different nodes into individual owner’s elected officials that verify transactions for them. Thereby allowing for a decentralized consensus along with all the benefits of the Byzantine Agreement. This change, according to XLM, allows their model to create the decentralized consensus that achieves their goals of decentralized control, low latency, flexible trust, and asymptotic security.

Pros:

  • Its tech is consumer focused and better (regarding fees and latency) than current market leaders BTC and RPL
  • Highest transaction count of all coins surveyed
  • Historic ties to ADA and similar functionality may indicate an undervaluation of the currency

Cons:

  • Smaller market cap to XRP, paired with a much higher coin cap, makes % growth more difficult
  • Its tech puts the security onus on the owner
  • Smallest exchange volume of the coins surveyed

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Cardano (ADA) – March 22

Functionality: DeFi Platform

Network: Cardano

Cryptocurrency: Cardano

Market Cap: 37.62

  • 31,948,309,441 in circulation out of Hard Cap of 45,000,000,000

Transactions:

  • Transaction Count: 30,341
  • Average 24 hour transaction fee: $0.258043

Tech: Stellar Consensus Protocol

Oversite: Decentralized nodes

Cardano was founded by Charles Hoskinson, a co-founder of Ethereum, and was launched in 2017. The main goal of Cardano was to solve Bitcoin’s speed and rigidity, while also addressing Caradano’s stated issues with Ethereum’s scalability and safety.

Technicals:

Cardano, unlike Bitcoin, uses a Proof of Stake (POS) rather than Proof of Work (POW). This difference rewards the first rather than the most powerful, a system known as Ouroboros Genesis, where miners can rejoin their chain and continue where they ended. The goal of POS through Ouroboros was to reduce the amount of energy needed compared to BTC and ETH, which both use POW.

Secondly, like ETH’s ecosystem, the second layer of the Cardano is a layer similar to ETH, enabling using the system for smart contracts and applications. Cardano’s POS and computation layer, when combined, offer the benefits of BTC’s security and ETH’s functionality.

Pros:

  • POS tech that connects security, reduced latency, efficiency, and scalability
  • Not reliant on ETH's current market
  • Similar to ETH, ADA has a secondary layer to its code allowing for it to function as a software platform
  • You can end staking whenever you like, with no end period
  • Likelihood that ADA will be completed before ETH 2.0 is fully implemented

Cons:

  • Viability after proposed ETH 2.0 in question
    • Considering the adoption of ETH, and its proven value, ADA is unlikely to unseat
  • Historic tie between ADA:XLM:XRP may indicate an overvaluation
  • Number of transactions is smaller when compared to ETH

Final Thoughts

World Computer:

DeFi has a lot of room for multiple coins. The current enterprise space is littered with blockchain tech supported by the largest tech giants. Unlike ETH, these ecosystems are unlikely to be as secure and are limited by the security of its founder. This security also comes in the form of potential censorship, either by the company or through regulation.

For this reason, its likely that the blockchain functionality through a decentralized currency has real utility. In that light, the functionality allowed through the adoption of ETH and ADA is here to stay. Between the two, there is enough space to support both coins, especially as the ADA model seeks to promote exchanges in developing countries. However, the transition to ETH 2.0 presents an incredible opportunity to reduce ETH's marketshare. ADA's superior latency and fees, paired with its proposed functionality will make ETH's competition market share based. The release of ADA's second tier is likely to come before ETH 2.0 is fully implemented. The impending switch to the POS model will likely keep many ETH users on the ETH network, but the high fees may cause newer adopters to prefer ADA's system.

Either way, ETH has something that ADA does not, a fully functioning system, while ADA does not have a scalability problem and is likely to arrive on market as a full POS. They are both likely to increase in value, as neither coin is the other's Deus Ex Machina.

Currency:

In regards to utility, Ripple and Stellar are likely to continue their battle as a secondary exchange. Ripple, with their recent scandals attached to their network, has an uphill battle to regain trust. Stellar has the advantage in number of transactions, which can largely be attributed to the reduced fee structure. XRP, while supported by Ripple, is not a humanitarian effort, and the efforts to commercialize the coin has landed them in hot water with the FEC.

Ripple's profit seeking nature gives it a higher likelihood of price growth, as they have little incentive to act in the best interest of the system as a whole. Stellar, while a non-profit, is more likely to seek out adoption regardless of the price. This lack of accountability to Ripple owners gives Stellar the ability to plan long term and sacrifice short term gains for long term strategy.

Between the two currencies, I foresee a split in effectiveness. XRP will most likely bring the most profit from holding in the short term. The adoption rate of XLM will continue to surpass XRP and will eventually allow for continued compounded growth. The latency and reduced fees of XLM will entice retail investors, while XRP, over the long term, will most likely attempt another white paper pivot towards hosting on its functionality rather than facilitating exchange.

Any data, text or other content on this page is provided as general market information and not as investment advice. Past performance is not necessarily an indicator of future results.

submitted by /u/Ameri-CantBeWrong
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