A DeFi thought experiment: Part 1
Wednesday, 11 August 2021

A DeFi thought experiment: Part 1

Of course no one knows exactly what is going to happen, all we can do is think of a few core truths that can define our thinking.

  • Liquidity will follow the path of least resistance
  • People like hard money
  • Where there is a trusted third party, a protocol will replace

In the next decade, blockchains are going to overcome the chasm of adoption and start infiltrating every aspect of life.

Disclaimer: This is not financial advice, this is just the thoughts of a man who likes to find signals in the noise. Research all the tokens I mention about and make up your own mind. If I have an * next to a token name it means I hold some.

The thought experiment

Whenever I read about a new technology that I see as practical and is being actively worked on, I think back to Hal Finney's amusing thought experiment in 2009 about bitcoin.

“As an amusing thought experiment, imagine that Bitcoin is successful and becomes the dominant payment system in use throughout the world. Then the total value of the currency should be equal to the total value of all the wealth in the world. Current estimates of total worldwide household wealth that I have found range from $100 trillion to $300 trillion. With 20 million coins, that gives each coin a value of about $10 million.”

I then try to find as much information I can about said tech and come up with my own thought experiment. What impact will this technology have on the world in 1, 3, 5, 20 years?

If I have strong enough conviction and the asymmetric risk is enough, I will make a strong bet on the technology.

This doesn't just apply to technologies that have financial upside. Often it's just enjoyable to daydream about 'what if'.

I was only 4 when the internet became a thing. But in 1993 if you had sat down and asked yourself this:

“What will the effect of virtually instant information delivered to anywhere in the world for almost zero marginal cost have on civilization?”

I think most people would draw the same conclusion. Civilization redefining. It had a bumpy ride while it found its feet (1999), like most dramatic changes to society. I would say we are still on a bumpy ride as we fight the spread of misinformation and bad actors on the internet. But these small negatives are insignificant to the positive gains made by it.

DeFi & Bitcoin

So many people have talked about bitcoin I'm not going to rehash why it is innovative. If you are uninitiated, go and read the bitcoin white paper and do the thought experiment. https://bitcoin.org/bitcoin.pdf


The hottest term in crypto right now. So what is it? If you haven't guessed already - it’s short for Decentralised Finance.

First you have your blockchains, ETH*, BTC* then you get your DeFi smart contracts (AAVE, LINK, UNI) then you get your value transfers on top. (NOTE: there is another layer emerging, which is applications built on top of the smart contracts using protocols like GRT)

These DeFi applications are truly the first blockchain apps to generate real revenue for the token holders. Before this, all value creation was just speculation on the value of the token, and for miners securing the network.

Current traded equity volume on traditional exchanges (CEXs)

2020 - 66 Trillion USD

The first major DeFi case for the early majority - DEXs

Centralised exchanges (CEXs) vs decentralized exchanges (DEXs) will be the biggest battle between the legacy financial system and the web 3.0. The sheer magnitude of this displacement cannot be overstated.

Every financial derivative will eventually be traded on a DEX - it's a matter of when not if.

How do DEXs work?

DEXs allow p2p trading of financial derivatives. No NASDAQ or ASX. Just two anonymous people transacting. They work by using smart contracts called Automated Market Makers (AMM) that hold liquidity of the asset that traders can trade against. Anybody can add liquidity into the pool, and in return can be rewarded with transaction fees on the network. This is where the value is being created. Being an early liquidity provider is highly lucrative, but not without it's risks.

DEX vs CEX in volume

At the time of this article the daily volume of DEXs was around 2.5 billion so around 600-700 billion annually is traded on DEXs.


CEX (non crypto): 66 Trillion (2020)
CEX (crypto exchanges): 129 Trillion (projected 2021)
DEX: 600 Billion (Annualized from todays volumes on DEXs)

Some delicious graphs



Currently DEXs are making up less than 0.3% of value transferred. Ask yourself - How quickly will that 195 trillion be gobbled up into DEXs? And what else can be put on chain to be exchanged via a DEX.

We are very early in this cycle right now, and the DEXs are just finding their feet. For the DEXs to displace the CEXs many problems need to be overcome.

1. Scalability

Scalability is the talk right now, and rightly so. ETH is unusable in its current state due to high gas fees. This makes trading on DEXs right now quite expensive, and not feasible for all assets.

So because of this, alt chains like BNB are being used. However, these alt chains sacrifice decentralisation for cheap fees. They may look appealing, but they really go against the key innovation of the blockchain - decentralised & trustless.

All these alt chains will all run into the same issue ETH has eventually.

Who would have thought creating a scalable, cheap, decentralized network was hard? ETH will solve the scaling problems and become the cheap global settlement layer that we all need. Perhaps with the introduction of EIP1559 we will start to see this emerge.

2. Interoperability

Only crypto assets are being traded on these DEXs right now, and still they are restricted to mostly native tokens of their respective blockchains. UNISWAP, which is the biggest DEX by volume, only allows you to trade eth tokens. This will change as interoperability evolves and allows for AMMs across chains.

See DOT for some big innovations.

It will be sometime before traditional equities are traded on these, because the law will need to change for this to happen - But this will happen eventually, nothing will stop the momentum (check the core truths if you doubt yourself.)

3. Fight the pushback by the old money CEX

There will be massive pushback by centralised institutions in the next decade as we transition away from the legacy financial systems. No one likes getting deleted from a partnership.

Ultimately CEX institutions will have no choice other than to slim down and evolve as generation z choose DEXs natively over CEXs.

What happened with GME shows how rigged the system is towards insiders, whilst simultaneously showing the power of decentralised groups online. The organsiational power of subreddits and discord communities is greater than anything before it. 24/7 pseudonymous groups will reign down on CEXs until they have no choice.

4. Legislation

The polis and our political system can’t seem to handle the basic function of delivering of a vaccine, I don’t have much hope that they will look into DEXs too soon.

So like most technology changes, we will have to wait for the laws to change, which could be 5-10 years.

However, the most likely short term outcome is a group to come up with a solution to trade traditional derivatives on a DEX whilst circumventing the traditional system. The groundwork for these DEXs are being laid right now - See SNX*, PERP*, DyDx

These smart contracts allow you to create synthetic derivatives of any asset linked with their pricing on traditional markets linked via an oracle (LINK). Perpetual protocol has already created a vAMM for derivatives. It's limited to crypto right now but has the potential to trade oil and gold futures in the future.

The initial DEXs trading traditional derivatives will be domiciled in crypto friendly havens until the major cities catch up and realise the talent they are loosing by having outdated laws.

The new demographics

If you talk to a 20 year old today, you will find they are hyper aware of the current political situation, have strong knowledge on climate change and are hyper connected via discord communities. Do you think this generation is going to follow traditional finance? I don’t think so. They are going to be the builders of these next gen smart contracts.

If I was any state government right now, I would be teaching smart contracts at school. These are going to be fundamental in the coming decades as all assets move on-chain.

If schools/states do not do this, they will be left behind, just like how you would be left behind if you didn’t connect your country to the internet.

Other DeFi applications

I have just talked about DEXs but there is a large swath of other DeFi applications being built right now to replace CeFi.

Core truth - “Where there is a trusted third party, a protocol will replace”

Using this truth it’s easy to see what will eventually get replaced.

  • Banks
  • Exchanges
  • Real estate agents
  • Centralised marketplaces
  • ???

The future is bright

At its highest level, DeFi is democratising finance and allowing anyone to participate. The nonsense with what happened with GME, shows the real power of the insiders in the current system. When they are threatened, they will shut the system down.

DEX’s cannot be shut down easily.

We have only stuck our head in the rabbit hole with this topic. We will see how deep the rabbit hole goes in future posts.