Crypto Research

Defi 101 — Part 2

In my previous article, I mentioned Defi has a problem with volatility compared to traditional finance.

Do you think traditional finance (TradFi) is stable? ?

The answer is: probably not! ?

Let me show you why ?

✊ The Market When The Fed Trades 

The Fed has two jobs: control inflation and bring down the unemployment rate. 

In the past, when the Fed brought down ⬇️ interest rates, it reduced the return on interests paying assets. It means the opportunity cost of holding securities is higher than holding on cash. And from this perspective, a low-interest rate brings more opportunities to invest and expand the job market. However, big money institutions do not think about expanding the job market. They got a handful of cash to burn ?. Unlike retailer investors who got cash to invest in Bitcoin ?, they trade with the Fed.

? Repo Markets

A Repo market or repurchase agreement is a short-term secured loan. How short, may you wonder? ? It is one day!

Wait a minute! So you are saying the Fed is a day trader?! ? 

Pretty much! And we all screw! ?

More interestingly, they had been doing day trading since the 1980s. The daily volume is about $4 trillion. 

Here is how a repo (day trading) sets up:

1️⃣ Barrier of Entry is High

Who trades with the Fed? They will not trust you to jump into their trading unless you are a big-money guy ? because you cannot afford to lose the game. 

2️⃣ Rules are Pre-setted

If you want to play this game, you must follow the rules. It is a simple rule.

3️⃣ A Win-Lose Game

The game is Win-Lose. The Fed has to be consistently winning the game.

4️⃣ The Fed is the Dealer

The Fed is the dealer of the game. Players are banks, financial institutions, and hedge funds. 

Financial institutions got lots of securities to borrow cheaply to loan lots of money with little earned interest. They don’t want to hold large amounts of cash to lose opportunity costs. So the Fed will supply US Treasury securities as collateral and buy securities from sellers. 

Sellers agree to sell securities and repurchase those securities later (the next day) at a higher price. But sellers do not need to repurchase at higher prices. Instead, they buy from the broker with lower price securities and earn the differences. 

Here is how a repo (day trading) works:

Assumes that you got US Treasury securities on hand and want cash today. So you go to the repo market to sell your US Treasury securities and sign a contract to buy back tomorrow at a higher price (including interest rate payment – repo rate). Now, you got cash ? that you can spend and transfer the obligation of bonds (US Treasury securities) to buyers. You do not need to buy back the bonds you just sold. Instead, you can go to the market to buy a cheaper bond.

All these operations work depends on the assumption that US Treasury securities are risk-free!

Everything works well under normal economic conditions until mid-September 2019.

The volatility in the repo market is suddenly spiked! And nobody knows why ?!

Should you worry about how the financial market has been done so far? ?

©️ Mimic the Operation! 

Can anyone operate such a similar cashy washy scheme? 

Nope, you can not! Because no one trusts your obligations! ?

Behold to the trustless and permissionless blockchain technology. ?

Defi becomes a repo market that is accessible to everyone! ?

Heard about the liquidity pool? Let me explain from a repo perspective ?:

Image credit: https://docs.uniswap.org/protocol/V2/concepts/core-concepts/pools

You have a liquidity provider who is a seller similar to the repo market. However, instead of US Treasury securities paired with the dollar, you have cryptocurrencies paired with stablecoin!

Instead of the Fed being a dealer, you got an Automated Market Maker (AMM) bot. 

Stablecoin is to mimic the dollar to stabilize the market. Other liquidity pools use native tokens, as Sushi Swap did ?. 

People think a token is equal to a currency. But the above ☝️? example makes Sushi token a debt!

People also think stablecoin pools guarantee high APY returns. 

No way! It depends on the market conditions. Even the Fed cannot guarantee that! ?

When you enter the liquidity pool, you purchase debts to exchange for your cryptocurrencies. The crypto market is more volatile than the dollar. As a result, your profits depend on market conditions. Also, likely your funds are substantially smaller than the whale did. Therefore, your impact on the pool is significantly less. And you will pay gas fees, resulting in your profits being substantially smaller than you can imagine. ?

There you have it. ?

? Stay tuned for part 3.

? Follow me here

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