Day63.md

Connecting TradFi and DeFi

It's how we connect traditional finance with decentralized finance. Traditional finance mostly begins with the banking system. People who have money either invest it or use it to make more money. There are also people who don't have enough money but want to start with their ideas so they can make more money. So the bank fulfills both their demands. A person with money deposits who needs money gets a loan from the bank and pays the interest to the bank. That's how lending and borrowing are done.

We have the same thing in decentralized finance. We've got protocols like AAVE, COMPOUND, and more, and they do essentially the same thing. They take deposits and give loans to the people. These loans are "collateralized" because it's still a developing system and we haven't figured out uncollateralized loans yet. But it's completely trustless; you don't need any KYC, and it really cuts out the whole banking system's risk. For example, in the current banking system, if the bank starts to make unreasonable demands like KYC, you just have to comply because the bank holds all control over your funds. In defi, you have complete control because you know what the smart contract and code are doing. You can deposit 100 ETH and get a loan for, say, 50 ETH worth of a different crypto currency, like chainlink. If you have collateral, you can get a loan for anything you want, pay interest on that loan, and get your collateral back.

Traditional finance exchanges are known as stock exchanges or currency exchanges, and they involve exchanging one asset for another or converting one asset into another, as if you were exchanging money for Meta stock. We have the same in decentralized finance, called DEX. They exchange one type of crypto currency for another type of crypto currency. If you have ETH and you want to exchange it for BTC, you can go to UniSwap, send them your ETH, and the UniSwap smart contract will give us BTC back at the price you agree upon. The way this is different from traditional finance is that you don't have to trust the exchange. Uniswap is a bunch of code that everyone can see on the Ethereum blockchain, and you can make sure you won't be cheated. In traditional finance, you have no such guarantees. You send your money to your broker, and your broker might run away with it, or your broker might not even open an account for you. You need the permission of the broker, which might get rejected, and you have to trust them.

The next are derivatives, which are futures and options. Just as you have futures and options in traditional finance, you have them in DEFI as well so that you can have trustless, collateralized trades, and they're still figuring that out. There are protocols like Synthetix that allow you to trade auctions in a decentralized way.

Asset management is the next big thing. Let's say you're a rich person. You can give your money to your fund manager, and this fund manager is going to invest the money on your behalf and give you the return on the investment it has made. In exchange for his work, he's going to take a small fee. We've got products that essentially do the same thing in decentralized finance. The advantage of DeFi is that you don't have to trust a fund manager to do this thing.You can take a protocol that's doing the strategy of investment and have it trustlessly do that strategy over and over again through a smart contract. The protocol for this is a set protocol.

Next are decentralized payment technologies. The aim here is to make transactions fast and cheap and to add more features to them. Sablier has developed a technology called "payment stream" that allows people to be paid in real time. In traditional terms, if you hired a consultant, you would have to pay them by the hour. But let's say that in the first 15 minutes you realized that the guy didn't know about the work; you'll pay him for that for an hour. Wouldn't it be nice to have a system to pay someone by the milisecond? You can start paying them in miliseconds, and after 15 minutes, you can decide not to continue the session. All these innovations are happening in Defi, and they're there to make payments smoother, cheaper, faster, and give you all sorts of features that are not possible in TradiFI.

Stablecoins

Volatility

It's an up-and-down market movement. Let's assume you want the stock to be at one price  but over a short period, it drastically goes down or up. Calculated as a standard deviation from expectations, such movements reflect volatility. If a position goes through remarkable changes in value, we call it highly volatile. vice versa; low volatility means a position is stable. High volatility brings uncertainty and scares people. At the same time, highly volatile positions can generate a lot of profit if you're willing to take a risk.

How to determine the crypto volatility?

Trace the trend. Look at the volatility of the crypto chart and analyze the severity of a crypto market price fluctuation. The more voilent the ups and dows of the crypto, the more volatile it is.

Volatility helps you realize whether a crypto fits your portfolio or not. It's up to you to decide whether to take an extreme ride or an easy slide.

Liquidity

It's the availability of liquid assets to a company, market, or trader/investor. Consider it an infinite series of intermediate stages such as 10/90, 30/70, and so on. Assets can be fully liquid, like water, fully frozen, like ice, or anywhere in between.

Company liquidity

If you review a company's financial statements, liquidity means the ability to pay short-term obligations. An example is the CFO stating that his company has ample liquidity of $3 billion: $2 billion in cash and $1 billion in a revolving loan (also called a revolving credit facility: a loan where the funds are drawn and repaid as needed by the borrower.) If you want to review the liquidity of a company from its financial statements, the current ratio is a very useful financial ratio.

For US reporting purposes, the assets of the company are listed from the most liquid at the top to the least liquid at the bottom. Cash is very liquid. In most cases, you can use it to pay your obligations immediately. Accounts receivable are very close to cash. Once the customer pays you, you can use that cash to pay your own bills. Inventory is still reasonably liquid, but you have to sell it first and collect the receivables for inventory to turn into cash. Fixed assets are not very liquid. To convert them into cash, you will need to produce product on them, sell the product, and collect the receivable. Goodwill is an example of an intangible asset that is very illiquid.

Market liquidity

When I look at the most active crypto in Coinbase, I see bitcoin and Ethereum.These are heavily traded cryptos with billions of dollars of transaction volume on normal days. That's the first version of defining market liquidity: having lots of buyers and sellers available, forming an active market. A second version is the ability to buy or sell something without causing a large price change. If I need to liquidate my portfolio today, will I be able to do so at stable prices, or will my selling cause a price drop, which would decrease the amount of cash I get in return for selling my stocks?

Trader/Inverstor liquidity

Suppose Jim has invested directly in private companies, real estate, and vintage cars. Jane has invested in blue-chip stocks and bonds and holds cash. You could say that Jim's portfolio is largely frozen or illiquid, while Jane's portfolio is relatively liquid. We're not looking at their returns here. We're only judging how flexible the investment portfolios are in exchanging assets for other assets. If Jim and Jane both love art and go to an auction, who is in the best position to bid? Most likely, that would be Jane. She can pay in cash or quickly sell stocks or bonds on the day of the auction.

Collateral

It refers to an asset that a lender accepts as security for a loan. Essentially, collateral is an item of value used to secure a loan. It acts as a form of protection for the lender. If the borrower defaults on the loan, the lender has a legal right to seize the collateral and sell it to recoup its losses.

Floating and Fixed Interest Rates

Fixed exchange rates mean that two currencies will always be exchanged at the same price, while floating exchange rates mean that the prices between each currency can change depending on market factors; primarily supply and demand.

The benefits of a floating exchange rate are:

• It reduces the need for currency reserves. We know that large amounts of currency reserves are required by central banks or governments to maintain fixed exchange rates.With a floating exchange rate, there is no need to mess around with holding lots of currency reserves.

• Freedom for domestic money policy     -          Some fixed exchange rate systems will require the manipulation of interest rates in order to keep an exchange rate fixed to a certain currency, whereas in a floating exchange rate system there's no need to worry about changes in interest rates to keep an exchange rate fixed. You can use monetary policy to deal with domestic issues in the economy, whether it's inflation, low or high employment, etc.

• Partial automatic correction for a trade deficit    -     Consider a country with a large trade deficit, implying negative net exports. There's more supply of the currency in terms of buying imports than there is demand for that currency. So on a very simple currency diagram, supply is shifting to the right, which is lowering the value of the exchange rate as a result of imports being greater than exports, but in a floating exchange rate, increasing the supply of the currency will reduce the value of the currency, making imports more expensive and exports cheaper, which in theory can help partially correct the trade deficit.

• Useful instrument for macroeconomic adjustment    -     Reduction in the value of the exchange rate can help prop up an economy. So if the exchange rate fell for some reason, that could help prop up export growth in the country, which can help increase general growth in the country. So, for countries that rely heavily on exports, the fall in exchange rates may increase export demand and exports. So it can be very useful to just help solve potential low growth issues in the economy.

• Reduced risk of currency speculation     -     A floating-point exchange rate reduces the possibility of a currency being overvalued or undervalued. In a floating exchange rate system, the exchange rate should reach an equilibrium that reflects purchasing power parity; in this sense, the currency is perfectly valued, rather than over or undervalued.Therefore, the risk of speculative attacks, especially when the currency is overvalued, is less likely to occur. Hence, more stability is likely in that sense with the exchange rate at its correct level.

However, there are some issues with floating exchange rates.

• Volatility     -     There's no guarantee that floating exchanges will be stable. They're left open to the forces of demand and supply, and everyone knows the exchange rate can go up and down. It can be very volatile. The problem with that is that it can reduce the incentives for foreign investors or foreign companies to actually invest in the domestic country, where the exchange rate is very volatile. It puts off trades as well, so for exporters domestically, it becomes harder to trade because foreign countries don't really know what they're getting in terms of currency with the domestic currency constantly going up and down.

• Self correction of trade deficits is unlikely   -     When we discussed sub-corrections in Point 3, it was primarily theoretical; in practice, it is unlikely to occur because imports and exports are only two of the factors that can affect the demand and supply of a currency. There are loads of other factors that are way more dominant, like speculation. In fact, speculative flows are way more likely to affect demand and supply and change the exchange rate's value than a current account deficit is. So in that sense, the demand for imports and exports is fair enough to have an impact on the exchange rate, but nowhere near as big as speculation, which can actually stop the number 3 point.   -     We can also bring the concern about inflation rates.Think about an economy that's suffering because of high levels of inflation  and as a result, it's struggling to export, which maybe means that net exports are negative, but we've already said that that's going to  put downward pressure on the exchange rate because the supply of the currency is going to be increasing more than demand for the currency, which lowers the exchange rate. While trying to correct the trade deficit problems, the lower exchange rate will actually push up inflation again. So if high inflation is causing a problem, reduce export competitiveness. A lower exchange rate could worsen the inflation problem through higher import prices and through high demand-driven inflation as well. As a result, there is a risk associated with a floating exchange rate that includes inflation.   Fixed exchange rate

• It had the benefit of lowering exchange rate uncertainty.

  • Exporters and importers know that with this exchange rate, it's going to be fixed at a certain level. It's going to be stable, which promotes foreign investment in the country and also makes trade a lot easier.

• Some flexibility is permitted.

  • In reality, countries that adopt a fixed exchange rate will often have a band within which the exchange rate can very simply move up and down within the band.It doesn't stay at one specific point. So there's some flexibility there. Also, if a government wants to reduce the exchange rate value, it can just devalue the currency, or if it wants to increase the value of the currency, it can revalue as long as other countries agree with it. But the problem with doing this, even though in theory it seems fine, is that politically it's not really accepted. It's a sign of weakness if the government has to revalue or devalue a fixed exchange rate.

• Bringing down the cost of doing business

  • People in the trading industry who want to protect themselves from volatile floating exchange rates may invest in the future exchange rate market. So let's say a foreign country wants to buy domestic goods, which may have a floating exchange rate. Foreign countries that are not sure about the value of that country's currency might hedge against whether that country's currency increases in value, which will make buying imports more expensive for the foreign country. So they might buy in the future exchange rate market by now, even though they actually want to buy the imports or exports to hedge against the rise against that currency. That's very costly to buy and get involved in the futures exchange rate market. So if you have a fixed exchange rate, there's no need to hedge. There is no need to purchase any currency in the futures market, lowering the cost of trade for everyone, particularly importers.

• discipline on domestic products

  • They know they can't rely on the exchange rate falling in value. They know that their exchange rate is fixed. As a result, the only thing they can do to maintain competitiveness is increase efficiency by investing in or participating in R&D.

But there are major issues with fixed exchange rates.

• Interest rate effects
  • If the interest rate is being used to maintain a fixed exchange rate, let's say the fixed exchange rate is set at a level below the current exchange rate, then the exchange rate needs to rise to meet the fixed exchange rate, which may mean raising interest rates. While raising interest rates may well get the fixed exchange rate back to its fixed level, it may come with major negative consequences such as reduced growth, higher employment, etc.
• A large level of foreign currency reserves is needed.
  • We need to question whether large levels of foreign currency reserves can actually be held by central banks and governments to maintain a fixed exchange rate. Can a government hold large amounts of foreign currency if currency reserves are not led and maintained by interest rates, which is often the case? Maybe not if it's too expensive, in which case the whole system will collapse.
• If the exchange rate is set too high or too low, speculative attacks may occur.
  • With a fixed exchange rate, there's no guarantee that the exchange rate that's decided is actually going to be the correct purchasing power value. Maybe it's going to be overvalued or undervalued, in which case speculative attacks that can really destabilize the whole system are quite likely.

What do we tend to see in the world?

Well, most economies now agree that the merits of floating exchange rates outweigh the merits of a fixed exchange rate, but there are still major concerns about some of the issues with floating exchange rates. So, the majority of the time, you will see a floating exchange rate, but if there are issues with the exchange rate, the government allows itself room to intervene and solve potential issues. So that kind of gives them the best of both worlds, really. China is a good example of intervening if they're not happy with the floating exchange rate.

Currency pegs

Let's think about a yatch on a sailing race.Usually you want to win ofcourse but on this race, you've decided that you want to stay level with another yatch for the whole duration of the race.You may move a little bit forward or backward but essentially if you want to remain pretty much level.Your yatch slightly built different than the other yatch so you got to be careful with the weather because that yatch gonna be faster than yours or your faster than that other.So you have to compensate for that.How do you do that?

Well you hold on the ropes of the yatch called the sheets.So if you're falling behind, you pull in hard on the ropes which tightens up the sails and you go forward a lot faster.If you're going too fast, you'll just do reverse, let go of the rope and then you slow down.

What does this have to do with the currencies?

It's essentially the same thing.One country decides that it wants to peg its country's currency to another to move as the same speed as that country.It does that because the currency that it's pegging itself to is the currency of the large trading nation or one of the biggest trading partners.Obviously with all sorts of variable in trade, one of them is currency fluctuations.So in order to get some stability in your trade with that country, you can peg your currenct.So the exchange rate is always going to be the same and it takes out lot of uncertainity in the dealings with that country.

How does that actually work?

Well it's kind of like pulling on the rope or letting go of the rope.If you're slowing down or your currency is being devalued, you basically pull your currency out of the market.You decrease the amount of supply of your currency that's in the open market and ofcourse we all know the supply and demand imbalance that means if there's less supply, the price is going to go up and you're going to drawback level with it. Well most smart countries have foreign reserves and they'll spend that in order to buy their own currency out of market to bring them up.

What happens if their currency becomes too expensive in comparision to other currency?

They let the rope go.They sell their currency into the market.When you got too much supply, it brings the price of the currency back down.

So you can see the advantages of having a currency peg for a trade but of course there's big disadvantages.The biggest of which probably is you're pegged to the fortunes of the economy.Once you pegged your currency to it, if that econoy runs into trouble, you too will get affected by it.If it drags you all the way down, leave you and your crew very badly.

**What are Stablecoins? **

Most crypto currencies were meant to serve as a medium of exchange and not just a store of value.The problem is that due to relatively small market cap, even popular crypto currencies like Bitcoin tend to experience wide fluctuations in price.Usually the small market cap an asset has, the more volatile it's price will be.This creates a major issue since you can't enjoy the benefits of cryptocurrencies which includes the decentralization of money and free for all payment system without the value volatility that accompanies it.

Imagine how hard it it to use Bitcoin or any other crypto currencies for day to day transactions and trading purposes when one day it's worth X and the next day it's worth half of that.That's exactly where stable coins come in.

Stable coins are an attempt to create a cryptocurrency that isn't volatile.A stablecoin's value is pegged to a real world currency, also know as fiat currency.For example the stable coin known as Tether or USDT is worth 1 US dollar and is expected to maintain this peg no matter what.Stable coin allows for the convinence of cryptocurrency which means fast settlement and fewer regulatory hurdles along with the stability of fiat currencies.Like most coins the most obvious use case would be to use them as a medium of exchange for day to day purchases.

The main usuage of stable coin today is actually on crypto exchanges.Using stable coins, traders can trade volatile crypto currencies for stable crypto currencies when they want to lower their risk.For example if I have invested on Bitcoin and I don't want to risk the price of Bitcoin falling against US dollar, I can just exchange my Bitcoins for USDT and retain my dollar value.Once I want to get back into the game and hold Bitcoins, I can just exchange my USDT back to BTC.This method is extremely popular with crypto only exchanges that don't supply users the option to exchange Bitcoin for fiat currencies due to regulation.

Another great advantage of stable coin is that you can move funds between exchanges relatively quickly since crypto transactions are faster and cheaper than fiat transactions.The option for such a fast settlement between exchanges makes arbitraging more convinent and closes the price gaps that you usually see between Bitcoin exchanges.

For now stable coins are more of a utility coin for traders than an actual medium of exchange.But how are they made possible?What keeps their price from the volatility that other cryptocurrencies experience?

Well, there are several ways a company can try and maintain its stablecoin’s peg to a fiat currency.The first way to maintain a peg is by creating a trust that the coin is actually worth what it is pegged to.If the market doesn't believe that the one USDT is really worth $1, people will immediately dump all of their USDT and the price will crash.In order to maintain this trust, the company backs its coins with some sort of asset.This collateral is basically proof that the company is good for its word and that its coin should actually be worth the pegged amount.For example in Tether case, each USDT is said to be backed by an actual US dollar that Tether holds as a collateral.A different example is the DGX token that is said to be backed by gold.Another version of a collateralized stable coin is one that is backed by one or more cryptocurrencies.This form of collateral is much easier to audit since a company's balance can be viewed  on the blockchain.

The second way to maintain a peg is by manipulating the coin supply on the market, also known as algorithmic peg.It means the company writes a set of rules also know as smart contract, that increases or decreases the amount of stablecoin in circulation depending on the coin's price.Imagine we have a stable coin that is pegged to US dollar through an algorithmic peg.Assuming alot of people were to start buying the coin, it's price would rise and the peg will be broken.To prevent this from happening, new coins are issued.This increase in supply alleviates the price pressure created by the demand and maintains the coin's value.If one the other hand many people start selling the coin, coins are reomved from the overall supply in order to hold the price peg to one US dollar.To be clear algorithmically pegged stablecoins don't hold any assets as collateral.The smart contract that manages the coin acts as a central bank.It tries to manipulate the price back to the peg by changing the money supply.

There are pros and cons of each pegging method.Fiat collateralized peg transmit the highest degree of certainty  to stablecoin holders that the coin is indeed worth the asset it is backed by.However fiat collateralized pegs have some major cons.From the company standpoint, the asset is frozen and can't be used for anything else.Also there's always the risk of embezzlement or the closing of the company's bank account which can ruin the trust in the stablecoin.Another issue is that it's hard to actually prove that the company owns the enough of the asset to really back the amount of coins in circulation.Tether for example has suffered severe criticism and audit requests from skeptics claiming the company doesn't have enough collateral  to back the USDT in circulation.

Crypto collateralized coin on the other hand may have the benefit of viewing collateral on the blockchain, but the collateral itself is extremly volatile.That's why a premium is needed.In many cases that company will hold 150% or even more of the collateral needed, to make up for possible drops in the crypto prices.

Algorithmic pegging benefits from the fact that the company doesn't need to hold an asset on hand.However many will argue that algorithmic pegging theory doesn't really work in real life since manipulating the money supply isn't a gurantee the peg will hold.with all the complexities in maintaining a stablecoin's peg, what's the incentive to create a stablcoin in the first place?

Well for each company there's a different incentive.Some company can charge a fee for trading their coin.Other comapnies use their stablecoin as a marketting channel to raise awareness to the company and other services it offers.Coinbase have created it's own stablecoin in order to attract more users to their trading platforms and allow easier transition of funds within and between exchanges.

Are stablecoins really cryptocurrencies?

Stablecoins are considered by many to be centralized.Due to the fact that there's a company behind them that maintain the peg, whether it be algorithmic or collateralized.Therefore stablecoins aren't really cryptocurrencies in the sense they aren't decentralized.

Are stablecoins solving a real problem?

Once a cryptocurrencies achieve a higher market cap, their volatility will reduce dramatically and there will be no real use for stablecoins.

Stablecoins are trying to get the best of both worlds, the stability of an established currency with a large market and a flexibility of a decentralized, free for all cryptocurrency.The problem is that they also get the worst of both worlds.A centralized coin with a sort of central bank controlling it and a questionable ability to maintain the public's trust in it.

Types of stablecoins and comparison

USDT

This is the most widely used stablecoin. The owner is IFINEX, the same owner as BitFinex, which is an exchange. They're based in Hong Kong, but the parent companies are in the Virgin Islands. Virgin Islands companies don't want to be audited by a strong government. It is backed by the US dollar, but not in the usual way. 65% of the USDT is backed by commercial paper, which is a kind of debt. Then 24% by fiduciary deposits, 3.87% by real cash, 3.6% by reverse repo notes, and 2.94% by Treasury bills. Commercial paper is debt, and what if at some point the market crashes? You might want to sell crypto and buy dollars, but when that happens, if a lot of people are selling their USDT, they will not have enough dollars to pay you back. That's the main concern. They will have to sell the commercial paper, but when the company is selling the commercial paper but not paying their debt, USDT won't be paying your dollars.

• Availability : 5 This token is available almost everywhere. It is available at every chain and exchange.

• Fully backed: 3 We've discussed that the commercial paper is not actual dollars. If the commercial paper seller defaults on its loans, you will not receive fully backed USDT.

• Transparency: 3 They do attestations every month, which means they tell us what they are backing the USDT with, but it's not an audit.

• USD peg: 5

It keeps the USD pegged at one to one most of the time.

• Risk: 3 We've discussed all of our concerns with USDT.So three for it.

USDC

This is the second-most-used stable coin. Its market capitalization is significantly lower than that of the USDT. The owners are Circle, Inc., and Coinbase. It's backed 61% by cash or cash equivalents, which is more solid. It is also backed by 13% in Yankee certificates of deposit, 12% in US treasuries, 9% in commercial paper, 5% in corporate bonds, which are debt, and 0.2% in municipal bonds and US agencies. Municipal bonds can be risky depending on who or what CDs (Certificates of Deposit) are backing them.

• Availability : 4 It's not available everywhere compared to USDT.

• Fully backed : 4 We just discussed what it's backed with, and it's a lot stronger than USDT.

• Transparency : 4 It's audited every month. Between months, they can do anything, but at the end of the month, they get audited, which is better than attestation because there's a third party. So they're pretty transparent.

• USD peg : 5 They're really pegged to the US.

• Risk : 4 It's less risky because it's backed with better resources.

BUSD

Along with BUSD, we're going to be talking about Paxos Standard, which is another stable coin. The reason that we're discussing these together is because BUSD is administered by Paxos, and they have their own stablecoin, but it's basically the same thing behind both. They're backed 96% by cash and cash equivalents and 4% by US Treasury bills. T-bills are solid unless the US government falls on their debt. This is a really, really solid stablecoin.

• Availability : 3 BUSD is not available in many chains, nor is Paxos standard.

• Fully Backed : 5 It's fully backed by 96% of cash and cash equivalents.

• Transparency : 5 They're fully audited, and the audits are also by the government, which is looking into what they're doing.

• USD peg  : 5 It's strongly pegged to the dollar.

• Risk : 5 This is one of the less risky options for stablecoin.

DAI

DAI is a special stablecoin because it's not backed by crypto. The owner is Maker, but it's basically owned by Dao. This is basically a smart contract based token. If you want to get DAI, you would loan your BTC or ETH to Maker, and then you'd get DAI back. You have to overcollateralize by 150%. If you want 1 DAI, you have to give 1.5 dollars' worth in crypto. What happens if you have DAI when bitcoin crashes? If Maker wishes to keep the 150% collateral, those who purchased DAI will be liquidated and will lose their BTC or ETH. That's really a bad scenario for those who are lending their crypto to DAI. If you have DAI because you got it somewhere else, this is a good scenario. They don't depend on central banks. USDT, USDC, and BUSD all depend on the US dollar and what the Fed does, which is kind of tricky sometimes and might ban stable coins, at least those backed by US dollars. So with this being pegged via other crypto, the Fed really doesn't have any way to change this.

• Availability : 4

It is available in many chains and exchanges, but not everywhere.

• Fully Backed : 5 It's fully backed by other crypto, and it's overcollateralized.

• Transparency : 5 It's all on the blockchain.

• USD peg : 4 Most of the time, it'll be $1.

• Risk : 4 Because of the variation, it's not always pegged one to one.

Use USDT when you need to make transfers. For saving or storing value over the long term, use USDC or BUSD. DAI can be used if you fear that the Fed will interfere with stablecoins, and it's decentralized.