What Happens If You Want To Lend or Borrow in Crypto?In the world of Web 3.0, the borrower is anonymous, so collateral is a must
In this second part of “Staking and Liquidity on Web3”, the fifth episode of the podcast series between computer engineering prof Robert J. Marks and engineers Austin Egbert and Adam Goad, the discussion centers on making and taking loans in cryptocurrency. In the first part, we looked at changes in how cryptocurrency is produced: Ethereum is moving from mining to staking this month. In Episode 4, the discussion centered on what a decentralized financial system would look like and on challenging new concepts like flash loans and smart contracts. Dr. Marks is the director of the Walter Bradley Center.
A partial transcript of the first part, notes, and Additional Resources follow:
Robert J. Marks: Now there’s something in staking [providing assets] called market maker algorithms. What is a market maker algorithm?
Understanding liquidity pools and market maker algorithms
Adam Goad: Market maker algorithms [are focused on] providing liquidity. Let’s say that I have Ethereum but want Bitcoin. I want to trade my Ethereum into Bitcoin. I would need to go to someone who wants my Ethereum and can give me Bitcoin. I could go to a centralized exchange — Coinbase, Kraken, or any of the other ones that have gained popularity — or I could go to one of these decentralized exchanges known as DEXs. They provide liquidity to these various pools. Then I could go to one of these pools and put my Ethereum into it. It would give me some amount of Bitcoin equivalent to it, minus a fee, of course.
What you could do is you could say, “Okay, here’s $10,000 worth of Ethereum and $10,000 worth of Bitcoin. And I’m going to take this liquidity pair and put it into a liquidity pool so that anyone who wants to transact between those two can come to the pool and they can transact with it, and they would give me a small fee. And then for whatever portion of the entire pool that my input to it was, I would get a portion of that fee as a reward for providing this liquidity.”
Adam Goad: This is another way that you can sort of invest with your cryptocurrency and you can get very high returns on this. Like Dr. Marks mentioned earlier, you can get somewhere around half a percent, if you’re lucky, with a savings account in a bank. With these liquidity pools, if you’re providing in a good one, especially one that’s in high demand, you can get anywhere from four, five, to up to thousands of percents of annual return on your money. All of that’s due to the volatility of the crypto market and all sorts of other factors as well. You have to watch out for scams, of course, when doing this. But there is plenty of people out there that have millions and millions of dollars put into these pools that are making very good annual returns on them.
You asked, “What is a market maker?” I didn’t really answer that. I jumped to “What is a liquidity pool?” In a traditional exchange, like the New York Stock Exchange, there is an order book. This book lists all the transactions. People have said, I am willing to sell my stock in, say, Apple, and I’ll sell it to you for $500. And then someone else puts an order into the book saying, “I’m willing to buy Apple and I’ll buy it for $400.” Whenever there’s a pair that match, a transaction occurs. Centralized cryptocurrency exchanges — Coinbase and the like — often have order books as well.
But these decentralized exchanges have automatic market maker algorithms. These algorithms control the liquidity pool. So if I come up to this liquidity pool that’s going to transact my Ethereum and turn it into Bitcoin, I would just say, “I’m going to give you 10 Ethereum.” And then this algorithm will say, “Okay, you have given me 10 Ethereum, I am going to give you this much Bitcoin.” One of the most common ways for this algorithm to implement currently is as a constant product market maker algorithm. That means that the product of the amount of Bitcoin and the amount of Ethereum must be … a constant number.
Robert J. Marks: The multiple of what two numbers? The number that you own or the dollar amount?
Adam Goad: I believe it is the value, but different places could implement it differently. Rather, when the pool was started, it had $100 worth of Ethereum and $100 worth of Bitcoin. So the product would be 10,000. If I want to add in some Ethereum, there will be more Ethereum. So to keep a constant product, there would have to be a smaller amount of Bitcoin. So then, the difference between the current amount of Bitcoin and that smaller amount of Bitcoin required to have that constant product is the amount of Bitcoin it would give to me.
Robert J. Marks: In a way it sounds like in derivative trading, kind of like a swap. For example, the president of Apple talks to the president of Microsoft and they say, “Today I’m going to give you a million dollars worth of my stock, you give me a million dollars worth of your stock, and then in three months we’ll settle up whatever the difference is. If yours goes up more than mine, then we’ll make a transition in order to make the amount the same.” Is there any similarity in that?
Adam Goad: It sounds like there might be some similarity there, but that also sounds somewhat similar to how loans and borrowing work in cryptocurrency.
How loans work in cryptocurrency
Robert J. Marks: Tell me about loans in cryptocurrency. I want to take out a loan. I want to buy a house or a car or a new flat screen television. How do I get a loan from crypto?
Adam Goad: With loans in centralized finance, of course, you have to identify yourself. They will perform an extensive background check on you; they’ll check your credit score and such. And if you fail to pay back your money, they will send debt collectors, and perhaps the court and stuff after you to try and recoup their funds.
But in the world of Web 3.0, you are, of course, anonymous. So if someone wants to lend you money, they can’t come track you down. What you have to do for loans in cryptocurrency is overcollateralize them.
Let’s say that you have 10 Ethereum. You believe in Ethereum and you think its value’s going to go up. So you want to keep it. But you want to be able to use that money. So you could come to me and say, “I want a loan from you for $10,000.”
And I’ll say, “Okay, if you give me your 10 Ethereum, I’ll give you 10,000 USD coin (the stablecoin worth $1 a piece. Then you could go off and use that $10,000 USDC as you please.
And we could have terms for our loan, of course. You could owe me some interest or perhaps there was a limited term on our loan or something. Then if you fail to pay me back my interest or if you reach the end of the term and you don’t want to give it back or you can’t, for whatever reason, then I get to keep the Ethereum you gave me.
Of course, there is some risk there on both sides. If you … can’t pay back the loan, you’ve lost your Ethereum. But I also take on risk because if the Ethereum you gave me goes down in value, then I gave you more money than the collateral I now hold is worth. So there would be very little reason for you to come and get it back, and now I have lost some money.
Robert J. Marks: Interesting. I don’t know if I’m ready to refinance my house yet using crypto, but I’ll keep my ear to the railroad track, as they say. So what advice would you give for people that want to learn more about this? That want to learn about flash loans, liquidity, crypto facts, how crypto works and how to invest in crypto and how to do staking. Where’s a good place to learn about this? I would suspect that they have entire courses in this.
Adam Goad: Oh, yes. So a common saying in the Web 3.0 community is, “Do your own research.” DYOR is the abbreviation you’ll often see for it… Everyone knows there’s all kinds of scams out there for everything. So whenever someone gives you advice on something, they don’t want to be seen as a scammer trying to trick you into anything, so they’ll say DYOR, do your own research.
To get started with this, I think one of the best places to go to is YouTube, honestly. That’s how I got started with it, I just started watching YouTube videos. There’s lots of good educational YouTube channels out there that can teach you about any aspect of this really. And you can spend hours and hours learning and getting ready for any kind of adventure into Web 3.0 you want to take.
But then when you want to get down into: Should I invest in this particular project or not?, that’s where things get a bit more complicated with your research. So when you’re looking at different cryptocurrencies, there’s a term that’s been coined, tokenomics.
That’s looking at the economics of a particular cryptocurrency token. You look at things like when a new block is added, it adds in a certain amount of currency, when transaction fees are paid, a certain amount of that fee is destroyed. Is the currency inflationary, deflationary? How is it run? Just all those different things. And it can take a while, of course, to understand what all those are and also, even more, to know what you should do based off what they say.
I am also leery of course, of providing advice here and you should do your own research. But yes, there’s plenty to look into here. And there is tons of people talking about it online. but of course you should always be wary of anyone trying to sell you something and saying, “It’s a good thing to buy.”
Robert J. Marks: Got you. I know that there are people that call themselves wealth managers and finance advisors. It seems to me that there would be a market opening for crypto finance advisors. Do those exist, do you know?
The role of the alpha caller
Adam Goad: They do. I know there are some more traditional organizations trying to get on this and a lot of banks and investment companies are getting into crypto. They’ve been mainly sticking to the larger currencies, Bitcoin, Ethereum, as far as I know, I don’t think they’ve ventured too far into the lesser known parts. But there’s what is known as an alpha call and an alpha caller.
Adam Goad: Now, that term kind of started as someone who will tell you, “Hey, I know this information and something’s about to happen and you should get in on this.” It still mostly means that, but it has kind of also become more of a broad term for someone who provides advice: “Hey, I like this NFT project, they’re doing good things.” Or, “Hey, the tokenomics on this new coin look really good. I’m going to invest in it myself,” or “Looking at the market, I think that Bitcoin is going to drop in the next week and you should sell now and buy on Thursday.” Or whatever. Anyone who wants to try to provide that kind of advice is known as an alpha caller.
Robert J. Marks: I see. Okay, so those are the financial callers. And I’m sure that they set up things like portfolios and distributed finance in order to spread out your risk. I think we’ve just touched the tip of the iceberg here, and I really want to thank Adam Goad and Austin Egbert for sharing their expertise.
Robert J. Marks: And I suspect that distributed finance, just like maybe electric and hybrid cars, are something which everybody doesn’t have today, but I think they will in the future. And I think that decentralized finance is just going to be dominant in the future. Fascinating stuff.
Here’s the first part of this (fifth) episode: Ethereum moves from mining to staking this month. As there came to be more and more “eth” in the world, the puzzles computers had to solve got very much harder, consuming vast energy resources. Robert J. Marks discusses with engineers Adam Goad and Austin Egbert the energy-saving transition Ethereum is making in how the coin is produced.
Here are the two parts of the fourth episode:
What would a financial system based on blockchain look like? Adam Goad talks about key differences between banks and blockchains in what creates trust and privacy. Hackers don’t steal cryptocurrency by breaking the encryption but by getting by getting users to reveal information that makes them vulnerable.
The futurist finance world of flash loans and hypernodes. In the cryptocurrency world, you could float a loan for ten seconds and make good money — but you and your computer must be very fast indeed. Adam Goad explains to computer science prof Robert J. Marks how decentralized finance works in a world where milliseconds make or break you.
Note: If you want to read or listen to the first three episodes, you will find links to all parts at the bottom of this page.
- Adam Goad at IEEE Xplore
- Dr. Austin Egbert at IEEE Xplore
- ”Just As Cryptocurrencies Went Mainstream — a Huge Collapse!” by Jonathan Bartlett at Mind Matters News
- Ethereum 2.0