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Explore the four main factors for the development of the DEFI market: liquidity, leverage, risk and arbitrage

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Defi has grown by leaps and leaps, with many innovations based on composability, but there are still trails and reasons behind it.

The author & have spent | Justine Humenansky is a venture partner at Playground

Compile & have spent | Echo, gu yu

Defi has grown by leaps and leaps, with many innovations based on composability, but there are still trails and reasons behind it.

Playground venture partners wrote on the Medium blog that liquidity, leverage, risk and arbitrage are the main factors driving the development of the DEFI market, and used them as a perspective to elaborate on how the DEFI agreement evolved. This article has been translated and edited without prejudice by Chaincatcher.

This is Justine Humenansky's original translation:

While still in the experimental stage, DEFI has matured considerably since I first wrote about it in June 2019. As the Defi protocol rolled out V2 and V3, I revisited the industry and how it had evolved. After working in finance for many years, I realize that most of the factors affecting the DEFI market can be boiled down to four basic elements of finance: liquidity, leverage, risk and arbitrage. This article provides an overview of the evolution of DEFI's marketing logic through these lenses.

This article provides an overview of financial primitives, the core building blocks of financial markets, which are different from software or cryptographic primitives. This article assumes that you have some knowledge of finance, encryption, and DEFI, so the protocol is not exhaustive.

01 liquidity

Almost everything comes down to liquidity, but we consistently underestimate its importance. Higher liquidity leads to smaller slippages and greater market efficiency. The low liquidity exaggerated market moves and extended the sell-off. It produces a flywheel effect on the way up and a cliff on the way down.

The V1 DEFI protocol relies on a liquidity vacuum of restricted capital.The term Restricted Capital refers to capital locked in an agreement that is underutilized and allocated inefficiently. This creates an opportunity cost, as the capital could have earned a higher return, either inside or outside the agreement. The V1 DEFI protocol relies on proprietary capital:MakerDAORequiring a minimum mortgage rate of 150%, the loan agreement has not yet accepted over liquid collateral (byCompoundV2 innovation led),UniswapThe distribution of liquidity across all price curves is very inefficient.

The opportunity cost of restricted capital expanded with DEFI, and now V2 and V3 are striving to achieve greater capital efficiency.

As collateral for liquidity

Stable currencyIt plays a huge role in DEFI. Stability supported by fiat moneycurrencyThere are many issues such as centralization, regulation, potential competition from CBDCs, and crypto mortgage stablecoin is the most viable option. However, V1 Defi relies on over-collateral to maintain the exchange rate at which it is anchored to the dollar, so it cannot scale up.

Many of the latest stablecoin iterations (FEI, OHM, Float, Frax) utilize protocol control values (PCV). This is a concept in which the collateral supporting the stablecoin cannot be redeemed by the user, but is owned by the agreement (the agreement decides whether/how to invest it, can use it to restore anchoring, etc.). This is similar to Treasury or insurance funds, but the difference is that PCVs can be immediately converted into liquidity (AMM pools).

Issue issues aside, FEI's PCV makes it the largest liquidity provider (LP) on Uniswap. The AVE V2 similarly blurs the line between collateral and liquidity, allowing borrowers to repay debt against existing collateral. Liquidity certificates create a similar dynamic for collateral derivatives, as described in more detail below.

Defi V1 addresses how liquidity can be used as collateral (LP tokens). The V2 and V3 protocols are studying how to convert collateral into liquidity.

Unfortunately, liquidity alone does not bring stability. The real reason for the collapse of the stablecoin system is the crisis of confidence in the anchored exchange rate system. Solving the constrained capital problem is not enough. Over time, a sound economic mechanism is needed to keep the stablecoin near its anchored level, and the mechanism design is difficult. Pure algorithmic stabilization mechanisms (Basis Cash, PPTY Set)Dollar) has been struggling, and these mechanisms require users to maintain confidence in future anchoring mechanisms.

So-called direct incentives, which penalise transactions that move away from the anchored exchange rate and reward those that do, end up draining liquidity from the system when it is most needed. Tough selling penalties mimic restricted liquidity and keep more capital under control, which is what we are trying to address in the first place.

Other models try to address the confidence problem first and improve capital efficiency over time, starting with fully secured tokens and letting the market adjust the collateral ratio dynamically. As confidence increases, so does capital efficiency.

Frax uses this model, but is currently backed by a basket of fiat backed stablecoins. While this mechanism appears to be working, it is not clear how it will hold up if it is entirely backed by unregulated assets.

While the latest generation of stablecoins has focused on reducing collateral requirements, we need to address the issue of confidence in anchoring mechanisms before we can improve capital efficiency.

Liquidity as a liability

We can't talk about liquidity without talking about the dominant Uniswap. Uniswap played an important role in the rise of fluid mining, which in turn played an important role in the trajectory of Uniswap. After we learned the hard way that liquidity is not a moat, the focus shifted from acquiring it to retaining it.

Competitors are moving forward, adding higher moat/margin services such as Kashi Lending, which takes a page from traditional fintech: acquire users cheaply and upsell credit products.

Instead, Uniswap radically rethought the liquidity mechanism for asset management, resulting in V3, which improves capital efficiency by up to 4,000 times in exceptional circumstances.

While AMM V1s are innovative from zero to one, they are also inefficient because they need to provide liquidity for prices that may never be reached. For example, ifETHIn the $200 range, with $10 million in the ETH/DAI pool, the pool of liquidity for ETH purchases under $10 or over $5,000 could be as high as 25%. In this example, the likelihood that liquidity will be needed at these levels is small. Maintaining this constant price curve results in low volume (~20%) because $5 billion of locked capital is equivalent to only $1 billion of volume.

The even distribution of liquidity across the spectrum also means that little is concentrated where the most trading is taking place.CurveRecognizing this early on, the AMM was created specifically for stablecoins, which trade within a very narrow range.

Uniswap v3 addresses these issues and, in the process, moves closer to a restriction order, as LPs can now specify the price range at which liquidity is provided (i.e. ETH/)USDCFrom $1,800 to $2,200). This change should result in almost all trading taking place in a range around the midpoint, improving liquidity where it is most needed.

More concentrated liquidity would also reduce the risk of assets. For example, if an LP bids $500 for the ETH/DAI pair, but is convinced that the ETH price will go up, then they are taking on exposure to an asset (DAI) that they do not want to hold (the ETH opportunity cost). The concentrated liquidity of Uniswap V3 reduces this risk by allowing LP to significantly increase its exposure to senior assets.BalancerV2 also attempted to reduce inventory risk by introducing an asset manager, which allowed LPs to lend assets on the side of the trade pair without being used as trade liquidity. Yearn's StableCredit uses similar functionality.

Next-generation asset management systems require less capital but provide more liquidity.

Liquidity transaction

Ultra-liquid collateral is a V1 concept that refers to the ability to toketize a locked asset (collateral or liquidity) in order to obtain liquidity or leverage on that asset. Pledged derivatives extend this concept to pledged assets (assets that secure proof-of-stake networks) through stETH, rtokens, essentially allowing users to deploy pledged assets more effectively elsewhere.

Proponents of pledged derivatives argue that without them, the liquidity of pledged tokens would be affected. There is also concern that verifiers will not be incentivized to pledge tokens if they can get a higher return from the DEFI protocol. In theory, pledging derivatives could increase the percentage of ETH pledged from 15-30% to 80-100%, as it eliminates the additional cost of pledging compared to not pledging.

Pledged derivatives also allow the creation of new financial instruments. For example, by proof of equityRewarding "guaranteed" cash flows can make products look similar to interest-bearing bonds (Terra's bAssets, blocks)Swap). These tools can be used to produce sustainable, stable, and relatively high yields (such as Anchor Protocol), which may enable more mainstream users to support DEFI.

Pledged assets are unique compared to collateral in that they are not just a promise to pay, but a promise to paysecurityMechanism. Some designs, especially those that enable collateral derivatives to be able toAcross the chainThe design of the movement, which allows for a transition of risk (from endogenous to exogenous), may affect basic game theory that helps protect public networks.In contrast, liquidity demonstrated that the liquidity of the conversion of pledged tokens to underlying network tokens in a way that balances capital efficiency and network security should be a major priority.

02 leverage

Leverage magnifies gains (the ultimate result of capital efficiency) but it also magnifies losses. Leverage is easy to build and hard to control. We love leverage until we hate it.

Traditional financial markets have collapsed countless times because of excessive or implicit leverage. In the last six months alone, we've seen the market impact of Archegos' high leverage and GameTop's short leverage (140% of GameTop's circulation was sold short).

In the cryptocurrency market, we've seen $10 billion liquidated in the last 24 hours, in part due to a series of liquidations of leveraged long positions. This is a kind of stress test for the crypto market, and some of the DEFI protocols are under considerable pressure.

Create leveraged

During the DEFI summer of 2020, the frenzied activity was largely driven by the active leverage strategy of liquidity mining. While this activity has quieted down since then, we are starting to see new leverage mechanisms emerge. Elpent's revenue token is one example.

When a user deposits collateral through Elpent, two tokens are generated: the principal token and the yield token. Assuming a user deposits a principal of 10 ETH at 20% APR, the user can sell his principal token at a discount, and at a fixed rate of 10%, the user will receive 9 ETH, while maintaining interest exposure to all 10 ETH over time through the yield token. After that, the remaining 9 ETH take a new position and repeat the operation, which can achieve leverage of up to 6.5 times. The ability to earn interest on the full principal amount and be able to obtain the net present value of the loan is unique compared to earlier loan agreements.

Although there are a number of agreements aimed at implementing undercollateralized loans in DEFI, it is largely conceptual. Although Cream V2 strives for agreement to agreement unsecured lending through Iron Bank, it is only available to whitelist partners and the parameters are determined directly by the Cream team, highlighting the current limitations.

Instead, Alchpix approached the problem from a completely different Angle, allowing borrowers to benefit from overtaking their mortgages. For example, a user who saves 1000 DAI can access 500 ALUSD. Place 1000 DAI into Yearn's vault to earn earnings that can be used to repay the loan over time.

The alternative is to buy the $500 and invest the unspent $500, which would obviously be less than the $1,000 return ($280, assuming a 25% annual interest rate for two years). Similarly, the borrower can earn the full amount of interest on the principal and still get a discounted portion of the principal.

The new lending agreement takes advantage of the time value of money and the separation of principal and return, allowing users to benefit from an (excess) mortgage.

Complexity across collateral

While the earlier DEFI ecosystem relied primarily on cycles denominated in one asset (ETH), V2 extended the complexity of lending agreements by allowing the use of a multi-collateral system. In this system, N assets can be borrowed with M kinds of collateral, single collateral DAI evolves into multi-collateral DAI, and Compound supports cross-collateral money market.AaveAnd Cream expanded by supporting more and more assets. Yearn's Stablecredit protocol allows users to create synthetic debt positions, which are essentially collateral swaps (a feature that AVE V2 supports through flash lending).

Some agreements go further, pooling exposure across all assets and spreading counterparty risk across users. inSynthetixWhen the value of any synthetic asset cast in the agreement increases, it increases the value of the total debt in the system, while the user's ownership of the total debt pool remains unchanged. This may increase the user's debt balance as the price of assets to which the user has no direct exposure increases. This cross-collateral complexity and cross-asset exposure improves functionality, but also increases the possibility of market pass-through, where a sell-off of one asset can lead to a sell-off of others.

The control lever

Composability allows for rapid innovation, but it also means that Defi Lego blocks can quickly become dominoes. Despite transparency on the chain, the difficulty of creating a unified view of cross-protocol integrated leverage means that there is currently no easy way to understand the ratio of commodity credit to circulation credit, which has implications for the solvency of the system.

Solvency is particularly important in a system without a lender of last resort. In addition, while centralised venues clear underwater mortgages themselves to avoid counterparty risk, decentralised agreements rely on third-party liquidators to remove underwater liabilities from the balance sheet. These liquidators can choose to buy underwater collateral from the agreement at a discount, or they can opt out due to volatility, network congestion or other market factors.

Liquidity attempts to solve this problem by creating pools of capital that can be used for clearing. Under this model, the LP agrees in advance that its liquidity will be used to buy collateral at a discount during liquidation. While this allows the agreement to lower the mortgage rate on the loan to 110 per cent and offer a fixed interest rate of 0 per cent, LPs may end up paying more for the collateral as prices fall.

03 risk

In finance, one ratio is inescapable: risk/return. The idea is simple: higher returns are associated with greater risk, a ratio that is hard to break.

When the market is new, risk is usually expressed in binary form: risk on or risk off. As markets have developed and people have a better understanding of what constitutes risk, risk transfer mechanisms have also developed, as well as a sliding risk that allows market participants to express their individual risk tolerance.

Dual risk

Volatility products give market participants a binary view of market risk and are an important part of the market infrastructure. The VIX represents the market's estimate of future volatility and is the cornerstone of traditional financial markets. The CEFI market already offers some VOL products (FTX Move), but the DEFI market has almost none. While protocols like Volmex are trying to create VIX, and Benchmark's stables use VIX as an input to their stability mechanism, Index Coop would seem to be a natural candidate for DEFI's inherent volatility Index.OpynAlso expressed interest in creating "DeFi VIX".

The floating risk

The emerging DEFI protocol is under development"Risk matching engine "to match market participants with low risk appetite with market participants with high risk appetite. Most projects achieve this through a multi-token system, which separates speculative and non-speculative aspects of the protocol and reallocates cash flow accordingly (Saffron,BarnBridge, Elpent).

For example, Elpent separates principal from yield, allowing users to buy the net present value of principal (essentially a zero-coupon bond) or take on a leverage yield of up to 10 times. Barnbridge divides cash flow into fixed and variable yields. Variable yield holders receive higher returns than fixed rate holders, but subsidize fixed yield token holders in the event of a gap.

Again, Saffron divides risk into priority and riskThe lower-grade, senior bonds have lower yields. Higher return = higher risk.

These programmable risk protocols support peer-to-peer risk transfer and allow users to bet on different parts of the capital structure. Risk-averse capital (such as corporate finance departments) may prefer to buy the senior tranches, while yield-seeking gamblers and traders may prefer the inferior tranches. Increased risk tolerance is a positive development for the DEFI market and there is nothing inherently dangerous about graded trading.

04 arbitrage

Arbitrage is necessary for many DEFI protocols to function properly, and any protocol needs to be designed with arbitrage in mind.Uniswap relies heavily on arbitrageurs to maintain price discovery. It is believed that the size of MakerDAO is limited due to the imfeasibility of arbitrage CDP. Yearn's Stablecredit relies on arbitrage rather than governance to keep the system stable.1inch, Yearn, Paraswap, and ARI can all be used as arbitrage tools. ThorChain andSerumWill be the key to enabling cross-chain arbitrage, as the DEFI protocol will be initiated across the layer 1 blockchain.

As DEFI scales, reducing gas costs will provide a temporary arbitrage opportunity that is increasingly shaping the V2/V3 design of the DEFI protocol (AVE V2 collateral transactions, DYDX's no-gas orders, Balancer V2 poolassets,SushiswapBentoBox).

V1 focuses on cross-protocol arbitrage, while V2/V3 focuses on cross-chain arbitrage.

Arbitrage improves market efficiency (the extent to which market prices reflect all available relevant information), but it also leads to narrowing spreads and normalisation of yields, eliminating the temporary advantage between agreements. As markets become more efficient, competition increases. Maintaining dominance in this environment requires genuine agreement innovation, not just incrementalism.

The V2 and V3 DEFI protocols will require innovation in all four financial primitives, as their interrelated nature is what drives the market. Without arbitrage, stablecoins cannot expand. Without liquidity, there is no capacity for arbitrage. Leverage allows you to take on more risk, and risk transfer allows you to take on more leverage.

Importantly, DEFI supports entirely new financial primitives, such as flash lending, that have no traditional counterparts. Protocols that resolve all of these primitives and/or create new ones will lead to the next generation of DEFI.

I can't wait to see V4 and V5.