Big V Linda Xie from Twitter explains DeFi

Beginner's guide to popular science | DeFi
Source: Linda Xie, Unitimes

Decentralized finance, also known as "DeFi" or open finance, aims to rebuild traditional financial systems (such as loans, loans, derivatives and transactions) by automating the middleman. Once fully automated, the financial components of DeFi can be combined to produce more complex functionality. Today, the main place for DeFi is ethereum, but in principle these ideas can be implemented on any smart contract platform.

This article serves as a beginner's guide to decentralized finance (DeFi) and Outlines the following:

· stable currency. It is the cornerstone of decentralized finance. Unlike cryptocurrencies known for price volatility, such as BTC and ETH, stable COINS are designed to keep prices "stable" at exactly 1.00 units. Most stable currencies are pegged to the dollar, but some are linked to other fiat currencies, such as the renminbi.
· decentralized lending. Borrowing on blockchain is done programmatically, without the need for a bank account.
· decentralized exchanges. Cryptocurrencies are bought and sold via blockchain rather than centralised exchanges, such as Coinbase. In principle, machines can trade cryptocurrency!
The mortgage. The provision of digital assets to be used as collateral for decentralised lending to provide lenders with some recourse in the event of default.
· decentralized identity. Use identity in a smart contract scenario to accomplish something, such as evaluating your creditworthiness in a decentralized loan.
· composability. Combine the functions of DeFi that do different things, just like a software library. For example, if one contract absorbs cryptocurrency and generates interest income, the other contract can automatically reinvest that interest income.
· risk management. High returns in DeFi are often accompanied by the same high risks. Fortunately, some new tools are emerging to hedge these risks.

Let's go through these concepts one by one.

Stable currency

If we try to recreate traditional financial products on the blockchain, we face a pressing problem: price volatility. Specifically, ETH, the native cryptocurrency of the ethereum blockchain, experiences large intraday fluctuations in the USD/ETH exchange rate, sometimes up to or more than 10% in a single day.

For many traditional financial products, a tool with this level of price volatility is not ideal. For example, if you take out a loan, you don't want the price to fluctuate 10% before you pay it back. This level of volatility will make it difficult to plan for the future.

Stability COINS are one solution to this problem. The cryptocurrency is specially designed to maintain a "stable" exchange rate, meaning each stable coin costs about 1.00 legal tender units. Stablecoin Index and Stablecoin Stats provide a list of highly ranked stable COINS.

Generally speaking, there are three types of stable currency: centralized stable currency backed by legal tender; Decentralized stable currency backed by cryptocurrency; And decentralized algorithm stabilization COINS.

1. Centralized stable currency secured by fiat currency. This stable currency is backed by legal tender in bank accounts on a 1:1 basis. For example, the stable currency USD Coin (USDC) is issued by Coinbase on a 1:1 basis based on the us dollars in its bank account. As long as you trust the issuer of the currency and the underlying legal reserves, there is little risk of holding or using the currency. Another benefit of the stable currency is that if something goes wrong, its centralized issuing entity is responsible, making it popular with many individuals and businesses.

In the United States, the FDIC has a deposit insurance line of at least $250,000, while other countries have their own deposit insurance policies. While it may sound like a near-perfect currency, not everyone has access to a centralized currency. USDC's user agreement, for example, states that USDC is available only in supported jurisdictions and prohibits its users from trading USDC for certain activities.

2. Decentralized stable currency backed by cryptocurrency. The currency has no central operator or user agreement. This means that anyone can use the currency without a company or government license. But the stability currency is not directly backed by fiat money (it is backed by cryptocurrencies), and the trade-off is that the mechanics of maintaining price stability are more complex. Unlike the simple model of a centralised stable currency (for example, a 1000 USDC is backed by $1000 in bank deposits), a stable currency backed by a cryptocurrency worth $1000 requires at least $1000 in cryptocurrency collateral (i.e., excess collateral because cryptocurrencies are highly volatile).

For example, the Maker system based on the ethereum blockchain governs DAI, a decentralized stable currency. DAI aims to anchor $1.00. This anchoring is successful because anyone can "generate" and obtain DAI loans by locking up cryptocurrency (mainly ETH) as collateral in the Maker system. The value of the cryptocurrency that users are mortgaging needs to be higher than the value of the loan, meaning the loan is over-collateralized.

For example, you can lock up $200 worth of ETH as collateral and lend $100 worth of DAI, which you can then trade on an exchange. The main reason for doing this is to get leverage -- if you think the price of ETH will not fall significantly, you get a "free" $100 DAI to trade on a cryptocurrency exchange; And if the value of the ETH falls, causing the value of the ETH you're mortgaging to fall below the demand for the mortgage, then Maker's algorithm will seize your collateral and liquidate it, getting a value of about $100 (because your DAI is worth $100). In this way, the Maker algorithm tries to ensure that it does not lose money when providing the loan.

Although the Maker system is much more complex than a centralized stability currency such as USDC, in theory the end user of DAI does not need to understand the complexity, just as the user of the dollar does not need to understand the intricacies of its monetary policy. Having said that, DAI has its own risks, including smart contract risk and the possibility that DAI will break this anchor and trade at a price well above or well below 1.00 USD/DAI.

3. Decentralized algorithm to stabilize currency. There is no collateral in the stable currency system, and it is entirely algorithmic to keep its price stable. One example is Basis, but the stability coin project was shut down before it was officially launched. The concern that some people have about this type of stable currency is that a well-funded and motivated entity might attack the stable currency system, making people lose confidence in the anchoring stability of the stable currency. This could lead to a death spiral and a collapse of the currency.

Overall, the first two types of stability COINS have proved to be very popular. Whether secured by fiat or cryptocurrency, people seem to want certainty of price stability. But that said, the experiment with algorithmic stability COINS continues, with some trying to combine cryptocurrency guarantees with algorithmic elements.

Related reading:Top ten trends in the field of stable currency in 2020

Decentralized lending

Given the capabilities of stability COINS like USDC and DAI, we can begin to reconstitute components of the traditional financial system into automated smart contracts. One of the most basic is the concept of borrowing and lending.

Currently, many DeFi platforms offer ethereum-based token lending through smart contracts such as Compound, dYdX, and Dharma. One of the nice things about these smart contracts is that the borrower doesn't have to look for the lender, and the lender doesn't have to look for the borrower. Instead, smart contracts replace the middleman, and interest rates are calculated algorithmically based on supply and demand.

1. A centralized order book for cryptocurrency lending

Before we explain this, it's worth outlining some of the central cryptocurrency exchanges that enable cryptocurrency lending. Below is a visualization of Bitfinex's funding book:



To understand what is shown in the screenshot above, we start on the left (the left side is the information about the borrower). The first line indicates that a borrower in the market is willing to take out a 30-day loan worth $4,421.58 at a daily interest rate of 0.0265%. The second line shows another borrower willing to take out a 30-day loan worth $34,292.38 at a lower daily interest rate of 0.0263%.

On the right is information about the lender. The first line represents a lender willing to lend $8,199.32 for two days at a daily interest rate of 0.027418%. In the second line, a lender is willing to lend $255.68 for two days at a higher daily interest rate of 0.027436%.

And so on. This is how a centralized loan order book works. In the example above, the maximum daily interest rate the borrower is willing to accept is 0.0265%, while the minimum daily interest rate the lender is willing to offer is 0.027418%. Either the borrower or the lender will compromise, either by raising the interest rate on the loan or by lowering it, and then a deal can be struck. Bitfinex provides a service to set up orders and match users, allowing Bitfinex to extract a service fee from each loan.

2. Decentralized order book for cryptocurrency lending

Some decentralized encryption currency borrowing and lending is available from the service provider to the service to another level, allowing the user to directly from smart contracts out or to the intelligent borrowing encryption currency, rather than creating an order book and push orders match, this way can raise or lower the matching dynamically interest rates. For example, if a large amount of cryptocurrency is lent out in a smart contract, the borrower is charged a higher interest rate. Moreover, in order to borrow money, users need to provide collateral to smart contracts that make borrowers pledge more than they borrow, so the loans are over-collateralised.

But why would decentralised lending be more useful? The answer is that it is a scalable application. A cryptocurrency service that offers higher interest rates and less risk than traditional bank accounts could theoretically attract billions of deposits.

Compound for decentralized lending agreements has attracted $120 million worth of deposits, and other cryptocurrency services are growing rapidly. The main risk is related to smart contract vulnerabilities and cryptocurrency volatility, but the interest rate offered is much higher than the 2 per cent (or less) offered by traditional Banks.

The following screenshot shows the interest rates that can be obtained by lending stable COINS through various platforms. The data source is LoanScan:



Decentralized exchanges

Decentralized exchange attempts to move trading services provided by centralized exchanges such as Coinbase Pro to the block chain. In other words, a decentralized exchange aims to facilitate the exchange of different cryptocurrencies between trading parties.

To make things easier to understand, let's look at centralized exchange. Centralised exchanges, such as Coinbase Pro, act as middlemen and custodians on both sides of a transaction, with traders hosting and trading encrypted assets through them.

While centralised exchanges have delivered massive multibillion-dollar transactions, they do have a single point of failure that can be attacked, vetted or blocked by someone.

Decentralized exchanges aim to address this problem by using smart contracts to reduce or eliminate middlemen. The dream is for all digital assets to be traded entirely peer-to-peer.

There are currently a number of projects that use a variety of approaches to promote the decentralization of ethereum-based tokens, such as Uniswap, 0x, and Kyber. Uniswap, for example, USES a so-called automated market maker (AMM) to provide liquidity in an algorithmic manner. Both cryptocurrency buyers and sellers derive liquidity directly from smart contracts, getting quotes based on the number of tokens they want to buy/sell and the liquidity available. For an introduction to Uniswap, see beginner's guide | what is Uniswap?

Currently, a decentralized exchange can handle only a fraction of the trading volume on a centralized exchange, so it cannot move large amounts of money back and forth. Moreover, many of the decentralized exchange projects are limited to trading ethereum-based tokens on the ethereum blockchain, limiting access to high-value cryptocurrencies with their own blockchain. Nevertheless, some very promising technologies, such as atomic exchange and zk-starks, may address these limitations.

Decentralized identity

As mentioned above, one of the characteristics of decentralized lending services is that they require large amounts of collateral. The need for this excess collateral may have created a very inefficient use of capital, and many people did not initially have additional capital to use as collateral.

But efforts are under way to decentralise identity and credit systems, which will reduce mortgage demand. One of the first USES of such a system is to build blockchain-like legal-based credit bureaus, such as Experian, TransUnion and Equifax, which rely on credit points like Banks.

The current credit agencies clearly put certain groups, such as foreigners and young people, at a disadvantage. But new providers, such as Lending Club, have solved the problem of over-reliance on FICO scores by providing additional data points, such as residential ownership, income and employment hours.

Decentralized identity and credit services can provide similar services, including social media reputation, repayment history of previous loans, guarantees from other creditworthy users, and so on. Making this service useful for actual financial decisions will require a lot of trial and error with the specific data points that will be used and the corresponding mortgage requirements, and we are still in the early stages of that process.

Interestingly, in the long run, DeFi, with its decentralized identity system, could become an alternative for those excluded from the traditional financial system. For example, there are currently about 1 million people worldwide without an official ID, and about 50 percent of women in low-income countries do not have an ID. But many of these people do have smartphones. So once decentralized ids work in the developed world, it has the potential to be a leapfrog technology that can be quickly imported to the developing world, like smartphones.

composability

We've talked about decentralized stability COINS, lending, exchanges, and identity, and perhaps the most important aspect of building decentralized financial components on smart contract platforms like ethereum is composability. Like a software library, smart contracts for different financial applications can be linked together like lego bricks.

For example, if you want to add the ability to trade token assets on your platform, you can easily trade these assets by incorporating a decentralized exchange protocol on the platform.

These smart contract legos can even create entirely new concepts that have not yet been explored in the traditional world. One example is a project called 2100, which combines DeFi with social media by allowing participants to "mint" new tokens for themselves using their Twitter accounts, essentially generating digital dollars from their social capital. Popular accounts can publish premium content accessible only to a specific set of token holders, allowing account owners to benefit from their fans. Then you can do something fun, like bet on which Twitter accounts will become more popular.

Another example is a project called PoolTogether, which combines DeFi with lottery draws to create a "lossless" lottery. Users buy lottery tickets on the chain, and all of the money will be deposited into the Compound platform to earn interest income. At the end of each round, each buyer will be able to get their money back, but only one of them will receive the interest earned from the Compound. This is essentially a way of using lottery mechanisms to incentivize the storage and creation of wealth.

As DeFi matures, we should expect these codebase to be used outside the cryptocurrency community. Eventually, you'll be able to add a decentralized market to a video game by adding a line of code, or a line of code to allow merchants in your e-store to earn interest on their savings.

risk

While DeFi is attractive, it is important to understand the risks involved. We will list some types of risks:

· smart contract risk: many DeFi systems are new and need more time to be tested. As the protocols interact with each other, the risks of smart contracts accumulate. If there is a critical contractual hole in a protocol, that protocol could leave the entire system vulnerable. Therefore, at an early stage, excessive funding of these systems should be avoided.
· mortgage and volatility risk. There are also risks associated with the particular type of collateral that underpins the loans. Excess mortgages reduce the risk of volatility, but margin calls are not guaranteed to cover all lending if the price of the mortgage falls too fast. But with a reasonable guarantee ratio and a vetted type of guarantee, the risk is reduced. Another potential problem is that interest rate fluctuations on many DeFi platforms may keep some people from participating. There may be interest-rate swaps or other ways to lock in premium rates, but that adds its own complexity.
· regulatory risk: DeFi platforms are decentralized to varying degrees, and we have not yet seen all of the alleged court cases for testing these platforms. We will need to keep an eye on what happens in this area in the future.
· decentralized insurance in DeFi areas (such as Nexus Mutual and Convexity) provides the ability to hedge risk. Predictive markets (such as Augur) also provide hedging use cases by allowing users to bet on the probability of a smart contract problem with a protocol they are using.

That said, these risk hedging methods themselves are still in their infancy, and their own smart contracts are risky. But we do think these approaches will mature. If the DeFi domain grows large enough, traditional insurers will likely offer such products as well.

The related resources

The DeFi domain is huge and growing. With hundreds of millions of dollars worth of cryptocurrencies already deployed, the potential for the future is huge. This article covers only a few of the DeFi use cases, but the readings below provide a better understanding of DeFi and follow developments in this area:

Understand the DeFi

The DeFi Series
Decentralized Lending
DeFiprime
Keep abreast of developments in the DeFi domain

The Defiant newsletter
Compound Digest newsletter
DeFi Pulse

Thanks to Balaji Srinivasan, Will Warren, and Jordan Clifford for reviewing this article!

Disclaimer: Linda Xie is the managing director of Scalar Capital Management, LLC, an investment manager specializing in cryptographic assets. This article does not constitute investment advice.

Source:https://www.unitimes.pro/p/e66a677488684061bdd78f911296c7c5

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