DeFi: A Paradigm Shift in the Financial Industry
Original title: "The Way of DeFi 丨 St. Louis Federal Reserve DeFi: A Paradigm Shift in the Financial Industry"
Original source: Babbitt
Note: The original author Fabian Schär is a professor of distributed ledger technology and financial technology at the University of Basel, and the article was published in the United States St. Louis Federal Reserve, In this article, Fabian Schär introduces the fundamental components of a decentralized financial (DeFi) system and provides an objective analysis of the associated opportunities and potential risks. The author believes that if the underlying problems of DeFi can be solved, it may lead to a paradigm shift in the financial industry and may contribute to the establishment of a more robust, open and transparent financial infrastructure.
The term Decentralized Finance (DeFi) refers to an alternative financial infrastructure built on top of the Ethereum blockchain. DeFi uses smart contracts to create protocols that replicate existing financial services in a more open, interoperable, and transparent manner. This article highlights the opportunities and potential risks of the DeFi ecosystem. I propose a multi-level framework to analyze the underlying architecture and various DeFi building blocks, including token standards, decentralized exchanges, decentralized debt markets, blockchain derivatives, and on-chain asset management protocols . My conclusion is that DeFi is still a niche market with some risks, but it also has some interesting properties in terms of efficiency, transparency, accessibility and composability. Therefore, DeFi may contribute to a more robust and transparent financial infrastructure.
1. Introduction
Decentralized finance (DeFi) is a block-based The financial infrastructure of the chain, which has received extensive attention recently. The term generally refers to an open, permissionless and highly interoperable protocol stack built on a public smart contract platform such as the Ethereum blockchain. DeFi replicates existing financial services in a more open and transparent manner. In particular, DeFi does not rely on intermediaries and centralized authorities, instead, it is based on open protocols and decentralized applications (DApps). Protocols are enforced by code, transactions are executed in a secure and verifiable manner, and legal state changes persist on the public blockchain. Thus, this architecture could create an immutable, highly interoperable financial system with unprecedented transparency, equal access, and little need for custodians, central clearinghouses, or custody services, as most of these roles are Can be assumed by "smart contracts".
DeFi already offers a wide range of applications, for example, people can buy USD-pegged assets (so-called stablecoins) on decentralized exchanges, Transfer these assets to an equally decentralized lending platform to earn interest, and then add interest-bearing instruments to decentralized liquidity pools or on-chain investment funds.
The backbone of all DeFi protocols and applications is the smart contract, which usually refers to a small application stored on the blockchain and executed in parallel by a group of large validators . In the context of a public blockchain, the network is designed such that every participant can participate and verify the correct execution of any operation. Therefore, smart contracts are somewhat inefficient compared to traditional centralized computing. Their advantage, however, is a high degree of security: smart contracts will always execute as specified, and allow anyone to independently verify the resulting state changes. When implemented securely, smart contracts provide a high degree of transparency and minimize the risk of manipulation and arbitrary intervention.
To understand the novelty of smart contracts, we must first understand conventional server-based web applications. When users interact with such an application, they cannot observe the internal logic of the application. Additionally, the user has no control over the execution environment. Either (or both) could be manipulated. Therefore, users must trust the application service provider. Smart contracts can alleviate both of these problems and ensure that applications function as expected. The contract code is stored on the underlying blockchain, so it can be publicly reviewed. The behavior of the contract is deterministic, and function calls (in the form of transactions) are processed in parallel by thousands of network participants, which ensures the legality of execution. When execution results in state changes (such as changes in account balances), these changes are subject to the blockchain network consensus rules and will be reflected in and protected by the blockchain's state tree.
Smart contracts have access to a rich set of instructions and are therefore very flexible. Furthermore, they can store encrypted assets and thus assume the role of custodians, with full customization of how, when, and to whom those assets are released. This has enabled a wide variety of new applications and a thriving ecosystem.
The original concept of smart contracts was proposed by Nick Szabo in 1994, and Szabo further described it in 1997 with the example of a vending machine In 2013, Vitalik Buterin proposed a decentralized blockchain-based smart contract platform to solve any trust issues related to the execution environment , and achieve a secure global state. In addition, the platform allows contracts to interact with each other and build on top of each other (composability). In 2015, Gavin Wood further standardized this concept and named it Ethereum (Ethereum) .Although there are many alternatives, Ethereum is the largest smart contract platform in terms of market capitalization, available applications and development activity.
DeFi is still an advantage Based on the market, the relevant figures are still low, but these numbers are growing rapidly. Assets locked in smart contracts related to DeFi recently exceeded $10 billion. It is necessary to understand that these are not transaction volume or market capitalization, value refers to Reserve funds locked in smart contracts used in various ways, which will be explained in the course of this article. Figure 1 shows the value of ETH and USD locked in DeFi applications.
Figure 1: The total value locked in DeFi contracts (USD and ETH)
The incredible growth of these assets and some truly innovative protocols show that DeFi may be more widely used context and has sparked the interest of policy makers, researchers and financial institutions. This paper targets individuals in these organizations with backgrounds in economics or law to investigate and present the topic. In particular, its identified Opportunities and risks should be regarded as the basis for further research.
Second, DeFi building blocks
This section presents a conceptual framework for analyzing these layers and examining the token and protocol layers in more detail. It distinguishes five layers, as shown in Figure 2, including: settlement layer, asset layer, protocol layer, application layer and aggregation layer.
- The settlement layer (layer 1) consists of the blockchain and its native protocol assets (e.g., the Bitcoin blockchain BTC on the Ethereum blockchain and ETH on the Ethereum blockchain). It allows the network to securely store ownership information and ensure that any state changes comply with its ruleset. Blockchain can be seen as the basis for trustless execution, which acts as a settlement and dispute resolution layer.
- The asset layer (layer 2) consists of all assets issued on top of the settlement layer. This includes native protocol assets as well as any other assets (often referred to as tokens) issued on this blockchain.
- The protocol layer (Layer 3) provides standards for specific use cases such as decentralized exchanges, debt markets, derivatives, and on-chain asset management. These standards are usually implemented as a set of smart contracts that can be accessed by any user (or DeFi application). Therefore, these protocols are highly interoperable.
- Application Layer (Layer 4) Creates user-facing applications that interface to various protocols. Smart contract interactions are usually abstracted by a web browser-based front end, which makes the protocol easier to use.
- The aggregation layer (layer 5) is an extension of the application layer. Aggregators create user-centric platforms that connect to multiple applications and protocols. They typically provide tools to compare and rate services, allow users to perform otherwise complex tasks by connecting to multiple protocols simultaneously, and combine related information in a clear and concise manner. Now that we understand the conceptual model, let's take a closer look at the tokenization and protocol layers. After a brief introduction to asset tokenization, we will examine decentralized exchange protocols, decentralized lending platforms, decentralized derivatives, and on-chain asset management protocols. This allows us to provide the necessary basis for our analysis of the potential risks of DEFI.
2.1 Asset Tokenization
The public blockchain is A database that allows participants to establish a shared, immutable record of ownership - the ledger. Typically, ledgers are used to track the native protocol assets of each blockchain. However, as public blockchain technology becomes more popular, so does the idea of providing additional assets on these ledgers. The process of adding new assets to the blockchain is what we call tokenization, a blockchain representation of an asset, also known as a token.
The general idea of tokenization is to make assets more accessible and transactions more efficient. In particular, tokenized assets can be easily transferred from anyone in the world to anyone in the world in seconds. They can be used in many decentralized applications and stored in smart contracts. Therefore, these tokens are an important part of the DeFi ecosystem.
From a technical point of view, there are various ways of creating public blockchain tokens (cf. Roth, Schär, and Schöpfer, 2019). However, most of these options can be ignored because the vast majority of tokens are issued on the Ethereum blockchain through a smart contract template known as the ERC-20 token standard. These tokens are interoperable and can be used in almost all DeFi applications. As of January 2021, there are more than 350,000 ERC-20 token contracts deployed on Ethereum. Table 1 shows the number of tokens listed on exchanges and the cumulative token market capitalization (USD) per blockchain. We can see that nearly 90% of the listed tokens are issued on the Ethereum blockchain.
From an economic point of view, my comparison of the properties of assets is used to achieve asset numbers The underlying technology standard represented is more interesting. The main motivation for adding additional assets on-chain is to add stablecoins. While the aforementioned protocol assets (BTC or ETH) can be used, many financial contracts require low-volatility assets. Tokenization can support the creation of these assets.
However, one of the main problems with tokenized assets is issuer risk. Native digital tokens (BTC and ETH) do not have this problem, in contrast, when someone launches a token with a promise (such as interest payments, dividends, or delivery of goods or services), the value of the corresponding token Will depend on the credibility of the claim. If the issuer is unwilling or unable to deliver, the token may become worthless or be traded at a steep discount, and the same logic applies to stablecoins.
Generally speaking, there are three endorsement models for commitment-based tokens: "off-chain collateral", "on-chain collateral" and "no collateral" . Off-chain collateral is where the assets of the indicator are stored via a third-party escrow service, such as a commercial bank. On-chain collateral means assets are locked on the blockchain, usually within a smart contract. Counterparty risk is highest when there is no collateral, in which case commitments are based entirely on trust. Berentsen and Schär (2019) analyze these three categories in relation to stablecoins.
On-chain collateral has several advantages, first, it is highly transparent and claims can be secured through smart contracts, allowing execution in a semi-automated fashion process. One downside of on-chain collateral is that it is usually held in native protocol assets (or derivatives thereof) and therefore experiences price volatility. Take the Dai stablecoin, which primarily uses ETH as its on-chain collateral to create a decentralized, trustless $1 Dai token. Since there is no native dollar-pegged coin on Ethereum, the Dai token must be backed by another asset. Whenever someone wants to issue a new Dai token, they first need to lock up enough ETH as underlying collateral in a smart contract provided by the Maker protocol. Since the USD/ETH exchange rate is not fixed, over-collateralization is required. If at any point the value of the underlying ETH collateral falls below a minimum threshold of 150% of the outstanding Dai value, the smart contract will auction off the collateral to cancel the debt in Dai.
Figure 3 shows some key metrics of the Dai stablecoin, including price, the total amount of Dai in circulation, and the stability fee, which anyone creating new Dai must the interest rate paid (see Section 2.3).
Figure 3
There are several examples of off-chain collateralized stablecoins, the most popular one is USDT and USDC, both stablecoins backed by the U.S. dollar, are also ERC-20 tokens on the Ethereum blockchain. DGX is an ERC-20 stablecoin backed by gold, and WBTC is a tokenized version of Bitcoin that allows Bitcoin to be used on the Ethereum blockchain. Collateralizing tokens off-chain can reduce exchange rate risk as the collateral may be equivalent to tokenized claims (e.g. USD claims backed by actual USD). However, off-chain collateralized tokens introduce counterparty risk and external dependencies, and tokens using off-chain collateral require regular audits and precautions to ensure that the underlying collateral is readily available. This process is costly and, in many cases, not fully transparent to token holders.
While I disagree with any functional design of an unsecured stablecoin, that is, a stablecoin that does not use any form of collateral to maintain a pegged exchange rate, some organizations This idea is being researched. Note that elastic tokens such as Ampleforth or YAM do not qualify as stablecoins, they only provide a stable unit of account but still expose holders to volatility in the form of dynamic token volumes.
While stablecoins play a vital role in the DeFi ecosystem, limiting the tokenization discussion to these assets does not address tokenization problem of transformation. A wide variety of tokens serve multiple purposes, including governance tokens for decentralized autonomous organizations (DAOs), tokens that allow holders to perform specific actions within smart contracts, tokens similar to stocks or bonds , or even synthetic tokens that track the price of any real-world asset.
Another distinct category are so-called non-fungible tokens (NFTs), NFTs are tokens that represent unique assets (i.e. collectibles). They can be either digital representations of physical objects, such as works of art, subjecting them to usual counterparty risk, or digitally native units of value with unique characteristics. In any case, the non-fungibility properties of tokens ensure that ownership of each asset can be tracked individually and assets can be accurately identified. NFTs are typically built on the ERC-721 token standard (Entriken et al., 2018).
The following sections discuss the protocol layer and examine how tokens can be traded using decentralized exchanges (Section 2.2), how tokens can be used as Lending collateral (section 2.3) and creating decentralized derivatives (section 2.4), and how to incorporate tokens into on-chain investment funds (section 2.5).
2, 2 Decentralized Exchange Protocol
As of September 2020, there are Over 7,092 cryptoassets are listed on exchanges, and while most of them are economically irrelevant (i.e. negligible market capitalization and trading volume), there is a need for a market where people can trade some of the more popular assets . This will allow owners of these assets to rebalance exposures and adjust portfolio allocations according to their preferences and risk profile.
In most cases, crypto asset transactions are conducted through centralized exchanges. Centralized exchanges are relatively efficient, but they have a serious problem. In order to be able to trade on a centralized exchange, traders must first deposit assets on the exchange. As a result, they lose direct access to their assets and need to trust the exchange operator. Dishonest or unprofessional exchange operators may confiscate or lose users' assets. In addition, centralized exchanges also have the risk of a single point of attack and face the threat of becoming the target of malicious third-party attacks. Both problems are exacerbated by relatively low levels of regulatory scrutiny, and many exchanges have had to scale massively in a short period of time. Therefore, it is not surprising that some centralized crypto asset exchanges lost customer funds.
Decentralized exchange protocols attempt to alleviate these problems by removing the need for trust. Users no longer have to park their funds on a centralized exchange, but instead, they retain control over their assets until the transaction is completed. Transaction execution is atomicized through smart contracts, which means that both parties to a transaction are executed in one inseparable transaction, reducing counterparty credit risk. Depending on the specific implementation, smart contracts may take on additional roles, effectively rendering many intermediaries such as custodial services and central counterparty clearing houses (CCPs) obsolete.
Early decentralized exchanges (like EtherDelta) were set up as walled gardens with no interaction between different implementations. Exchanges have no shared liquidity, resulting in relatively low trading volumes and wide bid-ask spreads. High network fees, and the cumbersome and slow process of moving funds between these decentralized exchanges renders so-called arbitrage opportunities useless.
Recently, DEX has begun to develop towards an open trading protocol. These projects attempt to simplify the architecture of decentralized exchanges by providing standards on how assets are exchanged and allowing any exchange built on top of the protocol to use shared liquidity pools and other protocol features. Most importantly, however, other DeFi protocols can use these markets and exchange or liquidate tokens when needed.
In the subsections below, I compare various types of decentralized exchange protocols, some of which are not exchanges in the narrow sense, but include in analysis because they serve the same purpose. The results are summarized in Table 2.
Decentralized order book exchanges: Decentralized order book exchanges can be implemented in a number of ways, they all use smart contracts for trade There is a significant difference in the way that we have to distinguish between on-chain order books and off-chain order books.
On-chain order books have the advantage of being fully decentralized, with each order stored in a smart contract. Therefore, no additional infrastructure or third parties are required, but the downside of this approach is that every action requires a blockchain transaction, so this is a costly and slow process, even for announcing the intent to trade. result in network charges. This disadvantage becomes all the more expensive when you consider that volatile markets will require frequent order cancellations.
As a result, many decentralized exchange protocols rely on off-chain order books, using the blockchain only as a settlement layer. Off-chain order books are hosted and updated by centralized third parties, often referred to as relays, that provide takers with the information they need to select the orders they want to match. While this approach does introduce some centralized components and dependencies to the system, the role of relayers is limited, they have no control over funds and neither match nor execute orders. They simply provide an ordered list with quotes and may charge a fee for this service. The openness of the protocol ensures competition between relay layers and reduces potential dependencies.
The main protocol that uses this approach is called 0x, and the protocol uses a three-step process for transactions: first, the maker sends a pre-signed order to the relayer, in order to include it in the order book. Second, a potential taker queries the relay layer and selects one of the orders. Third, the taker signs and submits the order to the smart contract, triggering an atomic swap of encrypted assets.
Constant Function Market Maker (CFMM) is a smart contract liquidity pool that holds (at least) two cryptoassets in reserve, allowing anyone to deposit a One type of token to withdraw another type of token. To determine the exchange rate, the smart contract-based liquidity pool uses a constant function model where the relative price is a function of the smart contract’s token reserve ratio. The earliest implementations I know of were proposed by Hertzog and Benartzi in 2017, Adams simplified the model in 2018, Zhang, Chen and Park provided a formal proof of concept in 2018, Martinelli and Mushegian in 2019 Extending the concept to situations with more than two tokens and dynamic token weights, Egorov optimized the idea of stablecoin swaps in 2019.
Figure 4
The simplest form of constant function model can be expressed as x*y = k, where x and y correspond to the token reserve of the smart contract, while k is a constant. Considering that this equation must hold, when someone makes a transaction, we get (x + Δx) * (y + Δy) = k, then it can be easily seen that Δy = (k / x + Δx) – y. Therefore, for any Δx > 0, Δy will take a negative value. In fact, any transaction corresponds to a movement on the convex token-reserve curve, as shown in Figure 4A. Liquidity pools using this model cannot be depleted because the lower the reserve of tokens, the higher the cost. When the token supply of either token approaches zero, its relative price rises infinitely.
It must be pointed out that the liquidity pool based on smart contracts does not rely on external price feeds (so-called oracles). Whenever the market price of an asset changes, anyone can take advantage of arbitrage opportunities and smart contracts to trade tokens until the liquidity pool price converges to the current market price. The implied bid/ask spread of the constant function model (plus a small transaction fee) can lead to accumulating more money. Anyone who contributes liquidity to the pool receives pool share tokens that allow them to participate in that accumulation and can exchange those tokens for their share in a potentially growing liquidity pool. The liquidity provision causes k to grow, as shown in Figure 4B.
Prominent examples of smart contract-based liquidity pool protocols are UniSwap, Balancer, Curve, and Bancor.
Smart contract-based reserve aggregation: Another approach is to aggregate liquidity reserves through smart contracts, which allow large liquidity providers (LPs) to connect and Publish the price of a specific trading pair. A user who wants to exchange token x for token y can send a transaction request to the smart contract, and the smart contract will compare the prices of all liquidity providers, accept the best offer on behalf of the user, and execute the transaction. It acts as a gateway between users and liquidity providers, ensuring best execution and atomic settlement.
Different from the smart contract-based liquidity pool, the price of the smart contract-based reserve aggregation is not determined in the smart contract, but by the liquidity provider Decide. This approach can work well if there is a relatively broad base of liquidity providers. However, if there is limited or no competition for a particular trading pair, this approach may introduce risks of collusion and even monopoly pricing. As a countermeasure, reserve aggregation protocols usually have some (centralized) control mechanism, such as a maximum price or a minimum number of liquidity providers. In some cases, liquidity providers can only participate after completing background checks, including KYC.
The most famous implementation of this concept is Kyber Network, which is the backbone protocol for various DeFi applications.
P2P agreement: An alternative to the traditional exchange or liquidity pool model is the P2P agreement, also known as the over-the-counter (OTC) agreement, most of them Using a two-step approach, participants query the network for counterparties who want to trade a given pair of cryptoassets, and then negotiate bilateral exchange rates. Once the two parties agree on a price, the transaction is executed on-chain via a smart contract. Unlike other agreements, an offer can only be accepted by the parties involved in the negotiation. In particular, it is impossible for a third party to prearrange someone to accept an offer by observing the pool of unconfirmed transactions (mempool).
For efficiency, this process is usually automated. Additionally, peer discovery can also be done using an off-chain indexer. These indexers take on the role of a directory where people can announce their intent to make a particular transaction. Note that these indexers are only used to establish a connection, and the price is still negotiated P2P.
AirSwap is the most popular decentralized P2P protocol implementation, which was first proposed by Oved and Mosites in 2017.
2, 3 Decentralized Lending Platform
Lending is an important part of the DeFi ecosystem part. There are various protocols that allow people to lend and borrow crypto assets, and decentralized lending platforms are unique in that they require neither borrowers nor lenders to identify themselves. Anyone can use these platforms and may borrow money or provide liquidity to earn interest. Therefore, DeFi lending is completely permissionless and does not rely on trust relationships.
In order to protect the lender and prevent the borrower from absconding with the money, there are two different approaches: first, credit is provided on the condition that the loan must be repaid atomically , which means that the borrower receives, spends, and repays funds in the same blockchain transaction. Assuming the borrower does not return the funds (plus interest) by the end of the transaction execution cycle, in which case the transaction would be void and any results of it (including the loan itself) would be reinstated. These so-called flash loans are an exciting but still highly experimental application. While flash loans can only be used for applications that settle atomically and fully on-chain, they are an effective new tool for arbitrage and portfolio restructuring. As such, they are poised to become an important part of DeFi lending.
Second, the loan can be fully secured by collateral. Collateral is locked in a smart contract and is only released when the debt is repaid. There are three variants of mortgage lending platforms: mortgage debt positions, pooled mortgage debt markets, and P2P mortgage debt markets. Collateralized debt positions are loans using newly created tokens, while debt markets use existing tokens and require borrowers and lenders to match. These three variations are discussed below.
Collateralized debt positions: Some DeFi applications allow users to create collateralized debt positions, thereby issuing new tokens backed by collateral. To be able to create these tokens, users must lock crypto assets in smart contracts. The number of tokens that can be created depends on the target price of the generated tokens, the value of the crypto assets used as collateral, and the target collateral ratio. Newly created tokens are essentially fully collateralized loans that require no counterparty, allowing users to acquire liquid assets while maintaining market exposure through collateral. The loan can be used for consumption, enabling individuals to overcome a temporary liquidity crunch, or obtain additional crypto assets for leveraged exposure.
To illustrate this concept, let’s take MakerDAO as an example, a decentralized protocol for issuing the USD-pegged stablecoin Dai. First, a user deposits ETH into a smart contract classified as a Collateralized Debt Position (CDP) (or vault). They then call contract functions to create and withdraw a certain amount of Dai, thereby locking up collateral. The process currently requires a minimum collateralization ratio of 150%, which means that for any $100 of ETH locked in the contract, users can create up to 66.66 Dai.
Any outstanding Dai is subject to a stability fee, which should theoretically correspond to the highest interest rate in the Dai debt market, a rate determined by the community (i.e. MKR token holders). As shown in Figure 3, MakerDAO’s stability fee fluctuates between 0% and 20%.
To close a CDP, the holder must send the unpaid Dai plus accumulated interest to the contract. The smart contract will allow the owner to get back the collateral after the debt is repaid. If the borrower fails to repay the debt, or if the value of the collateral falls below the 150% threshold, the entire collateral of the loan is at risk and the smart contract will begin liquidating the collateral at a potential discount.
Interest payments and liquidation fees are used in part to "burn" MKR, thereby reducing the total MKR supply. In exchange, MKR holders bear the residual risk of an extreme negative ETH price shock, which could lead to insufficient collateral to maintain the stablecoin peg. In this case, new MKR will be created and sold at a discount, so it should be in the game's best interest for MKR holders to maintain a healthy system.
It is worth mentioning that the MakerDAO system is much more complex than what is described here. Although the system is mostly decentralized, it relies on price oracles, which introduces some dependencies, as described in Section 3.2.
MakerDAO recently moved to a multi-collateral system with the goal of making the protocol more scalable by allowing multiple cryptoassets to be used as collateral.
Collateralized Debt Market: Instead of creating new tokens, existing crypto assets can be borrowed from others. For obvious reasons, this approach requires a counterparty with opposite preferences. In other words: if someone wants to borrow ETH, someone else must be willing to lend ETH. To reduce counterparty risk and protect the lender, the loan must be fully collateralized, and the collateral is locked in a smart contract, just like our previous example.
The matching of lenders and borrowers can be achieved in many ways. At present, the main classifications are P2P and pool matching. P2P matching refers to the lending of crypto assets to specific borrowers by those who provide liquidity. Therefore, the lender only starts earning interest if there is a match. The advantage of this method is that the parties agree on a time period and it operates at a fixed rate.
The asset pool lending rate is affected by the relationship between supply and demand. All borrowers’ funds are concentrated in a single loan pool based on smart contracts. Lenders will Funds start earning interest when they are deposited into the pool. However, interest rates are a function of pool utilization. Lending is cheap when liquidity is readily available. And when demand is high, loans get more expensive. Lending pools have the added advantage that they can execute maturity and scale transformations while maintaining relatively high liquidity for individual lenders.
Figure 5
There are many types of lending agreements, the most popular of which are Aave, Compound and dYdX, Figure 5 5 shows the asset-weighted lending rate for Dai and ETH. For Dai, this figure also includes the MakerDAO stability fee, which should be the highest rate in the system. Surprisingly, this has not always been the case, meaning some pay a price premium in the secondary market, with Dai accounting for nearly 75% of all loans in the DeFi ecosystem as of September 2020.
2, 4 Decentralized Derivatives
Decentralized derivatives are derived from the underlying A token that derives its value from the performance of an asset, the outcome of an event, or the development of any other observable variable. They usually require an oracle to keep track of these variables, thus introducing some dependencies and centralized components. Dependencies can be reduced when derivatives contracts use multiple independent sources of data.
We distinguish between asset-based and event-based derivative tokens, which we call derivative token assets when their price is a function of the performance of the underlying asset. When the price of a derivative is a function of any observable variable other than the performance of an asset, we call it an event-based derivative. These two categories are discussed in the following sections.
Asset-based Derivative Tokens: Asset-based Derivative Tokens are an extension of the CDP model described in Section 2.3. Locking up issuance collateral can not only limit the issuance of USD-pegged stablecoins, but can also be used to issue synthetic tokens that follow price movements of various assets. Examples include tokenized versions of stocks, precious metals and other crypto assets. The higher the volatility of the underlying asset, the greater the risk of falling below a given mortgage rate.
A popular derivative token platform called Synthetix implements the scheme so that the total debt pool of all The total price increases or decreases. This ensures that tokens with the same underlying asset remain fungible, meaning that redemption does not depend on the issuer. The flip side of this design is that users take on additional risk when minting assets, as their debt status is also affected by the asset allocation of everyone else.
A special type of asset-based derivative token is an inverse token, in which case the price is determined by the performance of the underlying asset within a given price range Determined by the inverse function of , these inverse tokens allow users to short the corresponding cryptoasset.
Event-based derivative tokens: Event-based derivative tokens can be based on any objectively observable variable. Anyone can purchase a full set of sub-tokens for a given event by locking 1 ETH in a smart contract. A complete sub-token set consists of 1 sub-token for each potential output.
These sub-tokens can be traded individually, and when the market settles, the smart contract's cryptographic assets are distributed among the sub-token owners of the winning outputs. Therefore, in the absence of market distortions, the ETH price of each sub-token should correspond to the probability of the potential outcome.
In some cases, these prediction markets may become decentralized oracles of the likelihood of future outcomes. However, market resolution (and therefore price) is largely dependent on the credibility of the resolution source. In this way, event-based derivative tokens introduce external dependencies and can be unilaterally influenced by malicious reporters. Potential attack vectors include flawed or misleading problem statements, incomplete result sets (potentially rendering an incident unresolvable), and choosing unreliable or fraudulent resolution sources.
Currently the most popular implementation is called Augur, which uses a multi-stage resolution and dispute handling procedure that should minimize the need for a single reporting source dependency. If token holders disagree with the designated reporter, they may initiate a dispute which should eventually lead to the correct outcome.
2.5 Asset management agreement on the chain
Like traditional investment funds, on-chain Funds are primarily used for portfolio diversification, and they allow users to invest in a basket of crypto assets and employ various strategies without having to deal with tokens individually. Unlike traditional funds, on-chain funds do not require a custodian. Instead, encrypted assets are locked in a smart contract. Investors will never lose control of their funds. They can withdraw or liquidate funds, and can observe smart contracts at any time token balance.
Smart contracts are set up in such a way that they follow a variety of simple strategies, including semi-automatic rebalancing of portfolio weights and trend trades using moving averages. Alternatively, one or more fund managers may be selected to actively manage the fund. In this case, smart contracts can ensure that asset managers adhere to predefined strategies and act in the best interest of investors. In particular, asset managers are limited to acting according to the risk profile specified in the fund’s rule set and smart contracts. Smart contracts can alleviate many forms of principal-agent problems and incorporate regulatory requirements by being implemented on-chain. Therefore, the asset management protocol on the chain can reduce the cost of fund establishment and audit costs.
Whenever someone invests in a fund on the chain, the corresponding smart contract will issue fund tokens and transfer them to the investor's account. These tokens represent fractional ownership of the fund, allowing token holders to redeem or liquidate their share of assets. For example, if an investor owns 1% of the fund tokens, they will be entitled to 1% of the locked crypto assets. When the investor decides to close the investment, the fund token will be destroyed, and the underlying assets will be sold on the decentralized exchange, and then the investor will obtain the corresponding assets.
There are several ways to realize the fund agreement on the chain, including Set Protocol, Enzyme Finance (formerly Melon agreement), Yearn Smart Pool and Betoken. All these implementations are limited to ERC-20 tokens and ETH, moreover, they rely heavily on price oracles and third-party protocols, therefore, they have heavy dependencies, which will be discussed in detail in Section 3.2.
Both Enzyme Finance and Set Protocol allow anyone to create new investment funds, Enzyme Finance focuses on building the infrastructure of decentralized funds, using smart contract-based A set of rules to ensure that fund managers adhere to the fund's policies. These smart contracts enforce trading restriction parameters such as maximum concentration, price tolerance, and maximum open interest, as well as user and asset whitelists and blacklists, which are enforced by the smart contracts. The same goes for a fund’s fee set, the Set Protocol is primarily designed for semi-automated strategies that trigger deterministic portfolio rebalancing via pre-determined thresholds and timelocks, but the protocol is also used for active management. Betoken operates as a single fund and is managed by a community of asset managers through a meritocratic system. The more successful an individual fund manager is, the greater its future influence on the allocation of collective resources will be. UniSwap's liquidity pool (see Section 2.2) also has some characteristics of on-chain investment funds, the constant function model creates incentives for semi-automatic rebalancing of portfolio weights, and transaction fees create passive income for investors.
Yearn Smart Pool is a type of asset pool investment fund designed to maximize the rate of return on a given asset, with a variety of strategies , but often involves multiple steps and active management. In many cases, these operations would be prohibitively expensive (in terms of transaction fees) for smaller amounts, plus they require investors to be vigilant and informed. The Yearn Smart Pool alleviates these problems by sharing network fees proportionally among all participants by leveraging the knowledge and collective action of the crowd. However, the deep integration of protocols also introduces serious dependencies.
3. Opportunities and risks
In this section, we will analyze the DeFi ecosystem opportunities and risks, which also lays the foundation for the discussion in Section 4.
3, 1 opportunity
DeFi can improve the efficiency, transparency and reliability of financial infrastructure accessibility. Furthermore, the composability of the system allows anyone to combine multiple applications and protocols, thereby creating new and exciting services. We discuss these aspects in the following subsections.
Efficiency: Traditional financial systems are based on trust and rely on centralized institutions, while DeFi replaces some of these trust requirements with smart contracts. Contracts can assume the roles of custodian, escrow agent, and central counterparty clearing house (CCP). For example, if two parties wish to exchange digital assets in the form of tokens, they do not need to be secured by a CCP. Instead, the two transactions can be settled atomically, which means that either both transfers are executed, or neither transfer is executed. This greatly reduces counterparty credit risk and makes financial transactions more efficient. There may be an added benefit of lower trust requirements, which could reduce regulatory pressure and reduce the need for third-party audits. Almost every area of financial infrastructure could gain similar efficiency gains.
Furthermore, token transfers are much faster than any transfer in the traditional financial system. Transfer speed and transaction throughput can be further improved using Layer 2 solutions such as sidechains or state and payment channel networks.
Transparency: DeFi applications are transparent, all transactions are publicly visible, and smart contract codes can be analyzed on the chain. Observability and deterministic execution allow unprecedented transparency, at least in theory.
Financial data are public and may be used by both researchers and users. In the event of a crisis, the availability of historical (and current) data is a vast improvement over the traditional financial system, where much information is scattered across numerous proprietary databases, or simply not available. In this way, the transparency of DeFi applications can reduce the occurrence of bad events and help them understand their origin and potential consequences when they arise.
Accessibility: By default, anyone can use the DeFi protocol, so DeFi may create a truly open and accessible financial system. In particular, infrastructure requirements are relatively low and there is little risk of discrimination due to lack of identity. ,
If regulations require access restrictions (for example, for security tokens), such restrictions can be implemented in the token contract without compromising the settlement layer Integrity and decentralization properties.
Composability: DeFi protocols are often compared to Lego bricks, and a shared settlement layer allows these protocols and applications to connect with each other. For example, an on-chain fund protocol could utilize a decentralized exchange protocol or leverage a leveraged position via a lending protocol.
Any two or more parts of the DeFi protocol can be integrated, forked, or re-create something completely new, any content created before can be created by Personal or other smart contract use. This flexibility has led to an ever-expanding and unprecedented interest in the possibilities of open financial engineering.
3, 2 Risks
DeFi also has certain risks, namely smart contract execution risks, Risk of operational security and dependencies on other protocols and external data. We discuss these aspects in the following subsections.
Smart Contract Execution Risk: While the deterministic and decentralized execution of smart contracts does have its advantages, there is also the risk of things going wrong. If there are coding errors, these errors can create vulnerabilities that allow attackers to drain smart contracts of funds, cause confusion, or render the protocol unusable. Users must be aware that a protocol is only as secure as the smart contracts behind it. Unfortunately, ordinary users do not have the ability to read the contract code, let alone assess its security. While audits, insurance services, and formal verification are part of the solution to this problem, a degree of uncertainty remains.
A similar risk exists in contract execution. Most users are unaware of the data payload they are being asked to sign as part of a transaction and could be misled by a leaked front end. Unfortunately, there seems to be an inherent tradeoff between usability and security. For example, some decentralized blockchain applications often request permission to transfer an unlimited amount of tokens on behalf of users to make future transactions more convenient and efficient. However, such permission puts users' funds at risk.
Operational Security: Many def protocols and applications use administrative keys that allow a predefined group of individuals (usually the project's core team) to upgrade contracts And implement the emergency shutdown mechanism. While it is understandable that some projects wish to implement these precautions and maintain some flexibility, the existence of these critical points can be a potential problem. If key holders do not create or store keys securely, malicious third parties could obtain these keys and compromise smart contracts. Alternatively, core team members may themselves be malicious or receive significant monetary incentives.
Most projects try to mitigate this risk with multi-signature or timelock (timelock), multi-signature requires M-of-N keys to perform Any administrative function of a smart contract, a timelock specifies the earliest time at which a transaction can be (successfully) confirmed.
Alternatively, some projects rely on voting mechanisms, where the corresponding governance tokens grant their owners the right to vote on the future of the protocol. However, in many cases, the majority of governance tokens are held by a small group of people, effectively leading to a similar outcome to managing keys. Some projects attempt to mitigate the issue of voting concentration by rewarding early adopters and users who meet certain criteria, ranging from simple protocol usage, to active participation in the voting process and third-party token lockup (i.e., liquidity mining). Although this distribution method is considered relatively "fair", the actual distribution is often still highly concentrated.
Governance tokens can lead to undesirable consequences: in fact, when these rights are tokenized, a high concentration of power can be even more problematic. With no vesting period, malicious founders can make a profit by dumping all their tokens on CFMM, causing a huge supply shock and damaging the project's reputation. Additionally, liquidity mining could lead to centralization sprawl, which could create large meta-protocols whose token holders essentially control a significant portion of the DeFi infrastructure.
Dependency Risk: As mentioned in Section 3.1, some of the most promising features of the DeFi ecosystem are their openness and composability. These functions allow various smart contracts and decentralized blockchain applications to interact with each other and provide new services based on the combination of existing contracts. On the other hand, these interactions introduce serious dependencies. If there is a problem with one smart contract, it can have a wide-ranging impact on multiple applications throughout the DeFi ecosystem. Additionally, issues with the Dai stablecoin, or a severe Ethereum price shock, could have ripple effects throughout the entire DeFi ecosystem.
It is obvious to use an example to illustrate this problem. Let us assume that one locks ETH as collateral in a MakerDAO contract to issue a Dai stablecoin, and let us further assume that the Dai stablecoin is locked in a compound lending smart contract to issue an interest-bearing derivative token called cDai, cDai The tokens are then transferred to the UniSwap ETH/cDai liquidity pool along with some ETH, allowing individuals to withdraw UNI-cDai tokens representing a share of the liquidity pool. With each smart contract added, the potential risk of bugs increases, and if any contract in the sequence fails, UNI-cDai tokens could become worthless. These layer upon layer of tokens can entangle projects so that theoretical transparency does not correspond to actual transparency.
External Data Risk: Another point worth mentioning is that many smart contracts rely on external data. Whenever a smart contract cannot rely on data being available on-chain, then the data must be provided by an external data source. These so-called oracles introduce dependencies that, in some cases, can lead to highly centralized contract execution. To mitigate this risk, many projects rely on decentralized oracle networks and various data provisioning schemes.
Illegal activity risk: A common concern among regulators is the potential use of crypto assets by individuals who want to avoid recording and monitoring. While the inherent transparency of DeFi is a deterrent to this use case, the pseudonymous nature of the network may provide some privacy. However, this is not necessarily a bad thing, and the situation is more complicated than it might appear at first glance. On the one hand, the pseudonymous feature can be abused by actors with false intentions. On the other hand, privacy may be a desirable attribute for some legitimate financial applications. Regulators, accordingly, should tread carefully and try to find sensible solutions that allow them to step in when necessary without stifling innovation. Additionally, one must be aware that it may not be feasible to regulate a decentralized network.
While there are questions about whether regulators can (or should) regulate decentralized infrastructure, two areas deserve special attention, namely fiat Import/export and decentralized fields.
The import and export of legal currency is the interface with the traditional financial system. Whenever people want to transfer assets from a bank account to a blockchain-based system or otherwise, they have to go through a financial service provider. These financial service providers are regulated and may require background checks on the source of funds.
Similarly, it is important to distinguish between legitimate decentralized protocols and projects that only claim to be decentralized, but are actually controlled by one organization or few individuals. The former may offer exciting new possibilities and remove some dependencies, while the latter may introduce the worst of both worlds, de facto reliance on centralized operators with limited oversight. Keeping this in mind, regulators should pay close attention and carefully analyze whether a given DeFi protocol is indeed decentralized, or whether the DeFi label is just to evade regulation.
Scalability: Blockchains face an ultimate trade-off between decentralization, security, and scalability. Although the Ethereum blockchain is generally considered relatively decentralized and secure, it has struggled to keep up with the huge demand for block space. Rising gas prices (transaction fees) and long confirmation times have adversely affected the DeFi ecosystem and favored wealthy individuals able to conduct large transactions.
Potential solutions to this problem include base layer sharding, as well as various Layer 2 solutions such as state channels, ZK (zero-knowledge) rollup, and optimistic rollup . In many cases, however, scalability efforts have undercut two of DeFi's most prominent properties: composability and general transactional atomicity. On the other hand, moving DeFi to a more centralized base layer does not seem like a reasonable approach, as this would inherently weaken its main value proposition. Therefore, it remains to be seen whether there will be a truly decentralized blockchain network that can keep up with demand and provide the foundation for an open, transparent and immutable financial infrastructure.
4. Conclusion
DeFi offers exciting opportunities and has the potential to create A truly open, transparent and immutable financial infrastructure. Since DeFi is composed of many highly interoperable protocols and applications, everyone can verify all transactions and data, so that users and researchers can analyze it at any time.
DeFi has set off a wave of innovation. On the one hand, developers are using smart contracts and decentralized settlement layers to create trustless versions of traditional financial instruments. On the one hand, they are creating entirely new financial instruments that would not be possible without the underlying public blockchain. Atomic swaps, autonomous liquidity pools, decentralized stablecoins, and flash loans are just a few examples of the vast potential of this ecosystem.
Although this technology has great potential, it also has certain risks. Smart contracts may have security issues that allow accidental use, and scalability issues limit the number of users. . Additionally, the term "decentralized" is deceptive in some cases, with many protocols and applications using external data sources and special administrative keys to manage the system, perform smart contract upgrades, and even perform emergency shutdowns. While this doesn't necessarily pose a problem, users should be aware that in many cases, DeFi still involves a lot of trust. However, if these issues can be resolved, DeFi may lead to a paradigm shift in the financial industry and may contribute to a more robust, open and transparent financial infrastructure.
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