Decentralized Finance: an explanation for the non-accountants and the non-economists.

shortsegments (77)in #decentralized-finance • 5 years ago

Mr. Justin Sun, CEO of Tron and recent purchaser of Steemit Inc and the Steemit Inc stake or Steem, just announced the opening of a Credit Facility on the Tron blockchain similar time the MakerDao on the Ethereum blockchain. This brought a lot of publicity to Tron and to Steem , along with a 25% jump in Steem’s price. For most investors or users of Steem this is just background noise, but if you are interested understand what these entities are, how they work, definitions of their terms in plain language and my opinion on why they benefit your Steem investment in terms of raising the price and increasing your income from your Steem investment you should read the rest of this post.

I have been researching Decentralized Finance and the MakerDao Credit Facility because I want to understand why the MakerDao is doing close to 2 billion dollars in transactions per month in the first quarter of 2020, a multiple of over 10 times the volume of previous quarters. When I first started reading about Decentralized Finance I didn’t understand why it was important, and more importantly I couldn’t learn much about it from reading the articles written on it because I didn’t understand any of the terms. This area of finance is new, it’s where finance and technology meet, a space called Fin-Tech and this space is filled with what I call Techno-babble. When a baby first starts to talk it makes sounds or noises that it thinks are words, but to everyone else it’s just noise. We call those noises babble. The purpose of this post is to hopefully change that noise into words, so you can understand Decentralized Finance.

First let’s look at common economic terms. When people purchase things they pay cash or credit. Cash is fiat or currency like Dollars, Euros, Yen. Credit is of course the use of credit cards and for larger purchases you get a loan. The loans have terms which include length and a fee for borrowing money called interest. There can also be fees or charges for making the loan called origination fees or loan fees. The loans like car loans or home loans are made by a bank. A bank provides you “credit” in the form of credit card use, which is a loan, specifically an unsecured loan. A bank is essentially a “Credit Facility” , it provides “Credit” which allows commerce, buying goods like cars and homes, plus consumer goods. The bank makes money by loaning money and charging fees.

Security or Collateral

A bank provides you “credit” in the form of credit card use, which is an unsecured loan. This is different from a secured loan like your car or home loan. A credit card is secured by your “promise to pay” but not secured or backed up by any asset. Your car loan or home loan is secured by the car or the home. The car or loan are the “security” the bank needs to make the loan. You promise to give them the car or home, if you can’t pay back the money you borrowed to buy the car or loan. The other word for security is collateral. The loan is a contract between you and the bank. The bank agrees to loan you money, you agree to pay it back, you agree to provide security to the bank for this loan by agreeing that the bank can seize and sell your home or car if you can’t pay the loan back. The home or car is called security, so the loan is called a secure loan. The home or car is also called collateral, so the loan is also called collateralized. The loan you get from the bank is also called a debt.

Now if you take a step back from this you see where the terms credit, credit facility, loan, security, collateral, secured loan and collateralized loan come from. And now you know what they mean.

Stability Fees & Collateralized Debt Products
Let’s take this process a few steps forward and explain stability fees and collateralized debt products. A car factory makes cars, a bakery makes bread and a bank makes loans. In other words the the product of the car company is cars, the product of the bakery is bread and the product of a bank is loans.

We have learned above that a bank makes secured and unsecured loans. We also learned that the loan is secured when it is backed by a promise to turn over the car, home or other asset to the bank if the borrower of the loan can’t pay the loan. This asset which secured the loan through the loan contract is also called collateral. The loan secured by collateral is referred to as a secured loan, but also as a collateralized loan.

CDP
Now take a deep breathe. First, remember above when we said a loan you have for your house or car was called a debt? Yes it’s a contract which says you owe money to the bank every month until you pay back the money you borrowed to buy the car or house. It’s called a Debt. Remember above when we said the product of a bakery was bread and the product of a bank was loans? Well now you understand loans are considered secured and secured loans are called also called collateralized loans. Well let’s put all that together:
Loans equal Debt
Loans equal a Product.
Loans are secured or Collateralized.
Loans are called Collateralized Loan Products.
Collateralized Debt Products are called CDPs.

We are almost done. Congratulations to those who read this far.

Loan to Value Ratio
Traditionally, a bank doesn’t loan you $10,000 USD on a new car selling for $10,000. They only loan you a percentage of what the car or home is selling for and you pay the rest. It’s usually 10-40 percent. The loan however is secured with the entire asset, not just 60%. So although the bank may only invest 80% of the assets value, if you stop making payments the bank seized and sells the entire asset. 100%.

The bank takes some risk, loaning you $$8000.00 USD on a vehicle worth $10,000, but you also risk $2000.00 and you lose it if you stop paying on the loan. The bank decides how much to loan you based on a standard loan to value ratio, which depends on what type of asset the loan is for, such home, car or securities. This loan to asset ratio could be 80%. Which means the bank will loan you $8000.00 on a $10,000.00 dollar car.

Collateralization Ratio
In decentralized finance their are no banks, but there are Credit Facilities. These credit facilities make loans called CDPs or collateralized debt products. They don’t use a loan to value ratio, they use something called a Collateralization Ratio. It is the inverse or opposite of a loan to value ratio. In a loan to value ratio you create a fraction with the loan value on top (numerator) and asset value on bottom. (Denominator). I remember this by reminding myself that banks slwsys have the advantage, thus they are always in top. LOL.

In a Collateralization ratio the value of the asset is on top, and the loan is on the bottom. I can remember this because in decentralized finance the borrower is suppose to have the advantage or be on on top. The top is a the value of the asset in fiat, like dollars and the bottom is the value of the loan. The fraction usually is greater then one. For example in the MakerDao it’s 1.5. This fraction by current convention referred to as a percentage and currently it is usually 150%.

So this means the value of your collateral in a Collateralized Debt Product must be 150% of your loan. So if your loan is for $100 your collateral must be worth $150. That’s a 150% collateralization ratio. Next we shall tackle liquidation.

Liquidation
The final thing we need to understand in decentralized finance is called liquidation. This is to me a fun term. It’s fun because it is a term which “distills this entire process down to its very essence”, or “lays bare the bones”. But I digress into idioms, another form of babble, so please forgive me.

Now as we saw above, due to the loan to value ratio in traditional banking and the collateralization ratio of decentralized finance, the bank in traditional banking or the credit facility in decentralized banking the bank loaned you around 75-80 percent of the collaterals value. But it is allowed to seize and sell the entire collateral if you fail to pay. If you don’t pay your loan, the bank takes your asset, the car or your home. This process is called repossession in America in the case of a car or foreclosure in America the case of your home. And they sell it at a below market price to get their money back.

The bank loaned you cash. Cash has a property called liquidity, which means amongst other things you can buy anything with it. Or you can loan it to people to buy things with. The bank isn’t in the real estate business, they are in the money lending business. They lend money out and money comes back to them in the form of loan payments. If you can’t pay, they seize the security and sell it to get their cash back. Your asset be it a car or home is valuable, but it isn’t liquid. You can’t take your ownership papers to the store to buy food and you can’t send your child ownership papers to pay her bills in an emergency. You need something liquid like cash.
So the process of changing your liquid asset into liquid cash is called Liquidation.

So now you know the terms and how they were derived. So What is the MakerDao?

The MakerDAO is basically a credit facility that issues loans with a certain interest rate called the stability fee against a collateral called Ethereum. The loans are called Collateralized Debt Priducts is CDPs and are paid to borrowers in Dai. The MakerDao issues new Dai to find each loan. It is like a country printing currency yo pay its debts. Each Dai is worth one dollar USD. The stability fee or interest rate is raised to reduce selling pressure on the Dai and help keep it pegged to the dollar and vice versa. The DAI stability fee or interest rates for borrowers was 1%, but later the stability fee increased from 1% to 3.5%.

What does the MakerDao do and why are there so many transactions? The MakerDao provides loans in Dai, against assets, mainly Ethereum and in some instances Bitcoin held by Bitgo.

For Example
If you deposit one Ethereum worth $150 USD in the MakerDao you can ask for a 50 Dai loan and 50 Dai is worth 50 dollars USD. Your asset, the Ethereum, is held as collateral and you get it back when you repay the loan. This process of depositing your Ethereum as collateral and getting a loan is known as collateralization.
The ratio of collateral to loan is $150/$50 or 3:1. This is called your collateralization ratio. The minimum ratio is 1.5. If the price of Ethereum falls, your ratio will fall. Once the dollar value ration of your Ethereum collateral gets to 1.5 your Ethereum collateral will be liquidated or sold to pay back your loan.

Why Collateralize your Ethereum
As an investor your rate of return on Ethereum is variable, for example if the price for Ethereum increased 5% in one month your ROI was 5%.
If you owned $100 worth of Ethereum your 5% ROI was worth $5 USD. But what if you owned 10 times as much Ethereum? $1000 worth of Ethereum at a 5% ROI would mean $50 USD.
If you had 100 times as much Ethereum your 5% ROI would be worth $500 USD. So to make more money, you need to buy more Ethereum. But with collateralization you can buy more Ethereum without having more money.

For Example.
You buy and hodle one Ethereum worth $150 USD. In one month if your ROI was 5%.
150/100 =1.5 x5 = $7.5 USD

But if You deposit your $150 worth of Ethereum in the MakerDao, you can borrow 75 Dai, using your $150 worth of Ethereum as collateral. You then exchange 75 Dai for $75 USD on the exchange and buy $75 dollars worth of additional Ethereum. Now you own $225 dollars worth of Ethereum. So if in one month you get a 5% ROI on $225 USD or 225/100=2.25x5=11.25$.
So by using the MakerDao you were able to increase the amount of Ethereum your hodling from $150 to $225, a 50% increase, but without investing any additional capitol. While you pay 3.5% interest on the additional $75 worth of Ethereum you still get 1.5% ROI without increasing your capitol invested.

Discussion
You didn’t use any additional capitol to increase your ROI, you used a “Credit Facility”, which is called MakerDao. This allowed you to earn money from the appreciation of your asset and to borrow against your asset to buy more asset and earn more money. That’s why this is popular and that’s why the MakerDao has increasing volumes as more people collateralize their assets to make more money. In some ways, this is a win-win situation as the MakerDao gains 3.5% stabilization fee and the borrower gains addition ROI.

But there’s more.
Bitgo is currently offering a service which allows people to Tokenize their Bitcoin and get Ethereum. Then those Bitcoin owners can deposit their “Ethereum loans” at the MakerDao and borrow against it. Then they can earn off the appreciation of Ethereum and the appreciation of their Bitcoin.

And even more
You can also deposit the Ethereum you bought with your MakerDao loan in the MakerDao to increase both the amount deposited and the amount you can borrow. So if you deposited $300 worth of Ethereum and borrowed $100 in Dai, which you changed to dollars and bought Ethereum. You could deposit this additional $100 worth of Ethereum in the MakerDao for a total of $400 dollars worth of Ethereum in your account. Now you could borrow an additional $100 to bring your total borrowing to $200 and use this second $100 loan to buy $100 worth of Ethereum and deposit this also, for a total of $500 of Ethereum deposited and $200 borrowed.
Now your $300 worth of Ethereum has grown to $500 worth of Ethereum using the MskerDao credit facility and your collateralization ration is 500/200 or 2.5, well above the 1.5 liquidation market and requiring a 40% drop in the Ethereum Price

Are losses possible?
Certainly. But they are very similar to your possible losses HODLing Ethereum.

Example
You buy and hodle $150 worth of Ethereum. In one month it drops 50%. Now the value of your $150 has fallen to $75. You lost 50%. If you sell now, you get $75.00.

If you take the same $150 USD investment, deposit it in the MakerDao and borrow 75$ ( 75 Dai, exchange for $75 dollars, but $75 dollars worth of Ethereum and now hodle 225$ worth of Ethereum for one month. If Ethereum falls in value 50%, your Ethereum collateral deposited in the MakerDao will be liquidated or sold for 75 dollars to pay back your loan. You are left with the $75.00 worth of Ethereum you bought using the loan. Basically the same position you would have been in, if you had just hodled your original $150 worth of Ethereum. So technically there are losses, but in reality your ROI is zero in both scenarios.

Decentralized Finance
The MakerDao doesn’t care about your race, religion, sex or country of origin. There are no financial qualifications other then having Ethereum. This is permission-less, as in you don’t need anyone’s permission to do this. It is also trust-less by design as the smart contract locks up your Ethereum when you enter the agreement and releases your Ethereum when you repay the loan.

This is the future, and because we have a stable coin here, we could do this here.

✍️written by Shortsegments.

Shortsegments is a blogger or writer on the Steemit social media platform, which is an decentralized application hosted on the Steem blockchain.

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