Decentralized Finance or DeFi is a prominent use case of blockchain and crypto technologies. It is a rapidly growing sector and new business models are coming up every day. The dynamism of the sector makes understanding and tracking the sector challenging. Apart from that, most discussion around the sector is very technical in nature and can be hard to decipher. There is a need for learning materials that cover the fundamentals of DeFi in simple language without becoming esoteric. This book is trying to create a general framework for DeFi platforms by presenting complex concepts around DeFi in simple language with case-studies from various DeFi Platforms - How does the Instadapp platform work? How does the Maker platform work? How does Uniswap mine liquidity? How does the Matic token create value for Polygon? How does governance work in Curve Finance? Tokenomics of Shushiswap? Cash-flows in Convex Finance? …..Apart from giving a taste of real DeFi platforms, these case studies will help you compare different technologies and business models. This book is for techies who want to get into DeFi but are struggling to understand the business models and for business folks who want to understand DeFi but are struggling with the technical vocabulary. This book does not assume any prior knowledge of blockchain and crypto technologies and contains a primer on these topics. Get the book on Amazon Kindle USA : https://www.amazon.com/dp/B09T2ND42B UK: https://www.amazon.co.uk/dp/B09T2ND42B Germany: https://www.amazon.de/dp/B09T2ND42B France: https://www.amazon.fr/dp/B09T2ND42B Spain: https://www.amazon.es/dp/B09T2ND42B Italy: https://www.amazon.it/dp/B09T2ND42B Netherlands: https://www.amazon.nl/dp/B09T2ND42B Japan: https://www.amazon.co.jp/dp/B09T2ND42B Brazil: https://www.amazon.com.br/dp/B09T2ND42B Canada: https://www.amazon.ca/dp/B09T2ND42B Mexico: https://www.amazon.com.mx/dp/B09T2ND42B Australia: https://www.amazon.com.au/dp/B09T2ND42B India: https://www.amazon.in/dp/B09T2ND42B This book is a derivation of the popular Udemy course with the same name. https://www.udemy.com/course/business-of-decentralized-finance-defi/?referralCode=A642642AEFE52E7BAB6E

2. SAM GHOSH
Business of Decentralized Finance

3. First published by Sam Ghosh 2022
Copyright © 2022 by Sam Ghosh
All rights reserved. No part of this publication may be
reproduced, stored or transmitted in any form or by any
means, electronic, mechanical, photocopying, recording,
scanning, or otherwise without written permission from the
publisher. It is illegal to copy this book, post it to a website, or
distribute it by any other means without permission.
First edition
This book was professionally typeset on Reedsy.
Find out more at reedsy.com

4. Contents
Preface ii
Acknowledgement v
1 Primer on Blockchain and Crypto 1
2 Fundamentals of Decentralized Finance 25
3 Workings of DeFi Platforms 55
4 Economics and Finance concepts for DeFi 71
5 Value creation in DeFi 79
6 Token Economics 96
7 DeFi Project Cash Flows 127
8 DeFi Governance 142
9 DeFi Growth Challenges 158
10 Strategizing a DeFi Platform 178
About the Author 192
Also by Sam Ghosh 193

5. 1
Primer on Blockchain and Crypto
Before we talk about Decentralized Finance, let us take some
time to review some basic blockchain and crypto topics. If you
are already conversant with these topics please take some time
to just skim through these concepts before moving to DeFi
topics.
What is a Distributed Ledger?
A ledger means where we store data. A distributed ledger
means data storage is distributed across various data stores
called nodes.
When we access a centralized database we need to access a
server and the server returns the requested data stored in the
connected database. Only specific entities can access and edit
the database i.e. control of the database is centralized. This
may seem secure but it is only as secure as the entity that is
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6. BUSINESS OF DECENTRALIZED FINANCE
managing the database. The authenticity, and in turn, the
value of the data is tied to the trustworthiness of the entity
controlling the database.
A distributed ledger i.e. distributed database does not operate
on trust but on consensus.
What does it mean?
If every copy of the database i.e. if all the nodes of the ledger
are compared and found identical then we can trust that all the
nodes know all the transactions that happened in the database.
So, we do not need to trust one specific entity but the process
of matching all the data nodes i.e. the consensus creates trust.
Distributed ledgers can be classified into Permissioned and
Permissionless - based on whether they require verification
and permission from any central entity to become a node of
the network.
Blockchain is just one type of Distributed Ledger. Other types
are Hashgraph, DAG, Holochain, etc. They differ in how data
is stored and the consensus is reached.
2

7. PRIMER ON BLOCKCHAIN AND CRYPTO
What is Blockchain?
A blockchain is a type of distributed ledger.
But, why is it called a blockchain?
In the case of blockchains, the consensus and data additions
involve the creation of blocks. Blocks are basically a set of
transactions that happened during a particular time period.
The nodes initiate new additions to the database through the
creation of a new data ‘block’ which includes the records of
different transactions. Then, the information about the new
data ‘block’ is shared across the whole network in the form of
encrypted information.
If we consider a blockchain as a file used for bookkeeping,
blocks are pages in the file containing records of, say, a
particular business day.
Say, in an organization instead of trusting only one bookkeeper
for recording all transactions, multiple bookkeepers record the
transactions simultaneously. We can think of each bookkeeper
as a node of a distributed ledger. Now, at the end of each day,
all these bookkeepers come together and tally their records.
If all the records match, the day’s records are settled and the
settled values are carried forward to the next day. Once a day’s
record is settled, it is locked and cannot be changed without
the permission of the majority of the bookkeepers.
A blockchain works somehow like this - records are matched
between nodes at predetermined intervals and become part
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8. BUSINESS OF DECENTRALIZED FINANCE
of the blockchain. The process involves calculating the Merkle
Root which is a hash of all the transactions in a block and is
carried forward to the next block. Once a record becomes part
of a blockchain it is nearly impossible to modify it.
Blockchains can be classified into public and private
blockchains based on who can access the blockchain.
What is Mining in Blockchain?
If you follow the crypto news, you probably have heard of
mining and how many people are earning a ton of money by
mining cryptocurrencies. It gives the impression as if miners
are digging the ground to dig out cryptocurrencies. The reality
is nothing like that.
Mining is the process of adding a new block to a blockchain. As
the process of adding blocks to a blockchain involves intensive
computations, the nodes adding a block to a blockchain get
rewarded with cryptocurrencies - say Bitcoin in the case of
Bitcoin (BTC) Chain and Ether in the case of Ethereum.
As this is how cryptocurrencies come into circulation in many
blockchains, this process of getting rewarded for adding blocks
to a blockchain is called Mining.
4

9. PRIMER ON BLOCKCHAIN AND CRYPTO
What is a Consensus Mechanism?
Consider an organization where instead of trusting only one
bookkeeper for recording all transactions, multiple bookkeep-
ers record the transactions simultaneously. We can think of
each bookkeeper as a node of a blockchain.
Now, at the end of each day, all these bookkeepers come
together and tally their records. If all the records match, the
day’s records are settled and the settled values are carried
forward to the next day. Once a day’s record is settled, it
is locked and cannot be changed without the permission of
the majority of the bookkeepers. The process of matching the
records and agreeing on the end-of-the-day values is analogous
to a Consensus Mechanism.
Before a block is added to a blockchain, nodes need to reach
an agreement on which transactions are valid - the process of
matching and verifying the transactions is called the consensus
mechanism of a particular blockchain. Different blockchains
use different consensus mechanisms.
Apart from adding blocks, consensus mechanisms also secure
the blockchain networks against various cyberattacks such as
51% attacks.
There are various kinds of consensus mechanisms -
5

10. 2
Fundamentals of Decentralized
Finance
What is Decentralized Finance?
Decentralized Finance involves the process of disintermediation
- removing intermediaries who do trust and risk intermedia-
tion.
Consider the case of banking - savers deposit their money in
time deposits, savings accounts, current accounts, etc. Then
the banks pool that money and lend it to the borrowers. The
banks do trust and risk intermediation - the banks decide
whom to lend and at what terms.
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11. BUSINESS OF DECENTRALIZED FINANCE
Banks assess risk with the help of different tools such as ‘Know
Your Customer’ or KYC, credit risk assessment, etc. These
processes create friction for borrowers and make accessing
credit difficult for borrowers who do not have required
documentation and/or do not have much credit history.
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12. FUNDAMENTALS OF DECENTRALIZED FINANCE
The KYC and other requirements make financial services
restricted by regulatory jurisdictions. This makes financial
services closed and a slow process.
Another aspect is that intermediaries often make it difficult
for fund suppliers (depositors in the case of a bank) to take
advantage of market opportunities such as increased yield due
to higher loan demand.
Decentralized Finance removes the need for such intermedi-
aries with the help of distributed ledgers. Blockchain is a type
of distributed ledger.
Similar to the intermediaries like banks, liquid assets are
also pooled in the case of DeFi platforms. DeFi platforms
pool liquidity with the help of various algorithmically defined
incentive mechanisms. Apart from that, the need for trust and
risk assessment is replaced with collateral requirements.
* * *
27

13. BUSINESS OF DECENTRALIZED FINANCE
AAVE is one of the largest decentralized lending
platforms with more than 30 markets in which assets
of more than US $20 billion are locked at the time
this book is being written.
AAVE primarily deals with crypto assets such as DAI,
Binance USD, Ether, Ampleforth, Basic Attention
Tokens, etc. but recently they have partnered with
Centrifuge and started offering tokenized real-world
assets such as invoices, real estate, and royalties
with their rwamarket.io platform.
So, how AAVE and other DeFi lenders are
disintermediating financial institutions?
Consider traditional borrowing from a bank or other
lenders. The banks act as intermediaries connecting
lenders and borrowers. Banks and other lenders pool
money deposited in savings accounts, current
accounts, or time deposits and lend to retail and
corporate borrowers. Now, Banks and other
centralized lenders retain most negotiating power.
They decide what interest rate to offer to the
depositors and they decide how much to charge from
the borrowers. Even when demand for credit increases
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14. FUNDAMENTALS OF DECENTRALIZED FINANCE
and the lenders can hike the lending interest rates,
they seldom pass on the increased interest rates to
the depositors.
Apart from that, these lending intermediaries
require various identity verifications, credit
assessments, and various other kinds of
documentation from both borrowers and depositors.
Now, coming to the lending process of AAVE and other
DeFi lending platforms. The requirement for
intermediaries is replaced with liquidity pools and
algorithms or protocols. Depositors can deposit
their assets in the liquidity pools and borrowers
can borrow from the liquidity pools. Interest rates
vary based on borrowing demand and supply of
liquidity. The lending and borrowing interest rates
are transparent.
The need for credit assessment is replaced with
collateral requirements on the DeFi lending
platforms. Although some platforms such as TrueFi
are offering uncollateralized lending.
In the case of AAVE, all borrowing is
overcollateralized. For example, the maximum Loan to
Value Ratio (LTV) for the DAI liquidity pool is 0.75
i.e. the loan amount cannot be more than 75% of the
collateral provided.
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15. BUSINESS OF DECENTRALIZED FINANCE
DAI Market on AAVE
* * *
Characteristics of DeFi systems
DeFi systems are trustless, permissionless, and automated
systems designed on blockchain networks.
Trustless means that DeFi platforms do not need trust to
function. Tradition financial system is based on trust and
unless you prove your trustworthiness you cannot participate
30