“I m very excited about the potential DeFi offers in principle.Vitalik Buterin,Co founder of Ethereum, Ethereal Summit 2020
The idea that just anyone,
anywhere in the world, can have access to a system that lets them pay each other, and choose their own financial exposure, is a really powerful thing.
It s something that a lot of
people don t have access to.”
The Origins of DeFi
o There is not a particular date on which Decentralized Finance was born, but there are some important events that played an important role on its evolution and the form that it has today.
o DeFi is part of the broader ecosystem of cryptocurrencies:
• Bitcoin redefined payments and the concept of store of value.
• However, Bitcoin did not directly impact the main functions of the traditional financial services industry, like
exchange, borrowing and lending, insurance, prediction markets, etc.
• The birth of smart contracts by Ethereum set the foundations for such areas to be disrupted by blockchain.
o The precursors to DeFi were projects like TheDAO and Etherdelta (2016-2018).
• While both projects were hacked and finally failed, they paved the way for many subsequent DeFi applications.
• Etherdelta, was one of the first decentralized exchanges (DEX). It was based on order books, like centralized exchanges, which is an inefficient model for a DEX, in terms of costs for market making.
Further to that important design limitation, the exchange was hacked for around $800K and soon after its founder was charged by the SEC for “operating an unregistered national securities exchange”.
o You can find a brief timeline of the DeFi history until early 2021 here
Early DeFi projects
o Maker is considered by many as the “father” of DeFi. The idea was conceived in 2014, but it was not implemented until 2017.
• Maker is deployed on Ethereum as a smart contract that allows anyone to put a crypto asset as collateral and borrow a percentage of its value through a stablecoin called DAI.
o A bit later (2018-2019), many projects that played an important role in the early DeFi ecosystem were born. Among them Aave (previously ETHLend), 0x and Synthetix.
• Despite these early pioneers, DeFi was not identified/named as a separate crypto sector back then.
o Important breakthroughs in 2019-2020 created the sector as we know it today and popularized the DeFi term.
• The most important innovation was probably the shift from a user-to-user to a user-to-contract interaction model, initially by Compound & Aave.
• Other important developments in that era, were the introduction of liquidity pools and Automated Market Makers(AMM) by Bancor & Uniswap and the liquidity incentive program launched by Compound & Synthetix.
The state of DeFi today
o The main catalysts for the explosive growth of DeFi in the summer of 2020 was the creation of the notion of yield farming.
o As a result, Total Value Locked (TVL) and the total market capitalization of the DeFi ecosystem have skyrocketed.
• TVL is the total amount of assets that are supplied to (locked in) DeFi protocols.
There is a common misunderstanding
that TVL represents the amount of outstanding loans in the DeFi ecosystem, when it actually represents the total amount of underlying supply being secured by a specific decentralized application and/or by DeFi as a whole.
Creating “Money Legos”
o DeFi implements in the world of crypto, services typically provided by the traditional financial system (TradFi), ina way that is (aimed to be) more efficient in terms of capital allocation, execution time, participation, transparency, security, decision making, and decentralization.
o We use the term DeFi ecosystem to refer to the entirety of such services.
• That is because DeFi can be thought of as a living organism, whose different organic systems are connected and dependent on each other to function normally.
• Similarly, you may conceptualize DeFi as an interconnected ecosystem, with several intertwined pillars, connected in what is sometimes referred to as money legos, in which the same building blocks can be reconfigured to create wholly new types of services.
That is because in contrast to TradFi, DeFi protocols are open-ended, and permissionless.
• Of course, there is competition inside the same pillars of the ecosystem to attract users and assets, but among the different pillars there is a (mostly) symbiotic relationship.
o As a matter of fact, it was exactly when DeFi projects realized that the success of one is dependent on the success of others and started to cooperate to unlock further possibilities and increase their efficiency, that the DeFi space exploded in innovation and popularity.
o There is no universally accepted categorization of the different pillars of the DeFi ecosystem.
• Moreover, innovation in the space is moving fast, so any such strict categorization would be short DeFi projects are basically is called Layer 1 (L1) dApps , as it is the first underlying layer of the DeFi stack.
• Typical L1 blockchains include sessions we referred to such L1’s as platform coins) DeFi– lived. (decentralized applications) Ethereum, Binance Smart Chain, , based on an underlying blockchain, which Polkadot , Solana and others (in previous enabling L1’s need to support smart contracts, of course. So, Bitcoin wouldn’t be a natural choice for L1.
• L1’s provide the first and more important line of security of the DeFi ecosystem, responsible for providing the necessary tools that allow DeFi projects to discover and implement application-layer innovations.
•Ethereum Ethereum is, to date, by far the L1 solution with the largest DeFi ecosystem.
• Ethereum was the first platform to focus on smart contracts, which later became the building block of DeFi. That gave Ethereum the first mover’s advantage, creating network effects and scales of economy.
However, the idea of smart contracts was not new, as they were proposed in 1994 by computer scientist Nick Szabo.
Layer 1 – Binance Smart Chain (BSC)
• BinanceBinance Smart Chain Smart Chain (BSC) has recently emerged as a popular L1 alternative, especially as transaction fees skyrocketed in Ethereum due to the popularity and increased used of DeFi applications there.
Layer 1 – Interoperability
Until today, L1 blockchains are, by and large, not interoperable.
• Hence, different L1’s provide the basis for different DeFi ecosystems, which do not communicate with each other. A lot of research is being focused currently on the field of different protocols. Polkadot and Cosmos L1 interoperability and creating are two frameworks focused on blockchain interoperability.
• An example of crosschain interoperability implementation between Ethereum and Polkadot is Clover.
Beyond L1: outline of the presentation
• For many, the most important and disruptive part of DeFi ecosystem, is decentralized lending and borrowing. We will examine how the sector evolved and what kind of services are offered.
• Then, we will look at decentralized exchanges (DEXs), which have recently become very popular, attracting volumes similar to the biggest centralized exchanges (CEXs).
• Following the discussion on DEXs, we will look into how derivative financial products can be implemented in decentralized applications to create synthetic assets .
• We will then move to discuss another revolutionary component of DeFi ecosystem, namely decentralized autonomous organizations (DAOs), focusing particularly on their role as autonomous asset management protocols in DeFi.
• Another important pillar DeFi ecosystem are stable-coins. We will focus on their usage in the DeFi ecosystem, especially for the crypto-backed & alghorithmic stable-coins.
Next we will see how Oracles are used for connecting real-time data with blockchains to allow DeFi applications to algorithmically communicate with the outside (to the blockchain) world.
Then we will briefly rediscuss wallets and their importance for connecting the whole ecosystem together.
Finally, we will briefly explore the most recent pillars added to the DeFi stack, namely decentralized prediction markets.
Disintermediating Commercial Banking
○ Lending & Borrowing were the first DeFi applications that gained popularity.
• Decentralized lending and borrowing platforms are simply smart contracts that let you lend or borrow crypto assets at a fixed or variable interest rate. • In other words, they offer exactly what commercial banks offer through deposits and loans. • What differs here is that there is no central authority to decide who participates and mediate the whole lifecycle of lending and borrowing.• There is no need for credit history or other financial records.
• Anyone can lend their assets and earn interest or deposit some collateral and borrow a percentage of its value.
○ Removing the intermediaries is aimed at enhancing the efficiency of capital allocation, cutting costs, eliminating exclusion and increasing economic privacy and freedom.
DeFi loans are typically over-collateralized meaning that practically a user can borrow less money than the value of the collateral they deposit.
This decreases the likelihood of insolvency that would result in forced liquidation of a user’s position by the smart contract managing the loan.
o One might naturally ask: why would someone want to borrow money (and pay interest), when the value of the loan is less than the collateral they already possess and lock?
- The answer is that borrowers post as collateral assets whose value varies. If someone possesses an asset, the value of which they believe would appreciate in the future, but, at the same time, need liquidity, there is a rational incentive to deposit the asset as collateral and borrow part of its value.
In this way, if the prediction is correct, the user receives liquidity, while continuing to capture the increase of the locked asset’s value. They can even use that liquidity to buy more of the provided asset for multiplicative returns.
However, if the prediction is incorrect and the value of the collateral decreases, the DeFi lending protocol will start to liquidating part of the collateral, as it approaches the value of the loan, in order to repay it or maintain an acceptable loan collateral ratio.
Using DeFi for leverage
o To demonstrate why someone may be willing to borrow even if their collateral is worth more than the loan,consider the following scenario (assuming no interest, transaction costs, or slippage):
- Suppose that I deposit my 1 ETH ($1,500) as loan collateral to platform X, with a collateral to loan ratio of 150%. I will be able to borrow up to $1,000 worth of DAI (stablecoin).
- I then proceed to swap my $1,000 DAI for 0.666 ETH at current prices ($1,500).
- I now own 1,666 ETH ($2,500), of which 1 ETH is loan collateral and 0.666 in my wallet.
- If the price of ETH were to increase by 10% the total value of my holdings would be 1.666 ETH = $2,750.
- My profit is $250, meaning $100 more than if I simply held my 1 ETH
- If the price of ETH decreased by 10%, I would lose $250, instead if $100 (In reality, my losses would be higher
- since my collateral would be liquidated due to the price change)
o I have effectively used leverage to multiply my potential profits (and losses)
- Leverage is the use of debt to amplify returns (and losses) from an investment.
- I can even redeposit my ETH, to borrow more DAI and swap it for ETH to increase my leverage and profit (losses).
- The money Lego nature of DeFi even allows other dApps that do this automatically for me.
Other reasons for DeFi Lending/Borrowing
o You can calculate the potential profit or loss with the following equation
o Besides leverage there are other reasons for lending/borrowing in DeFi
- Lenders and borrowers maintain exposure to the funds they lend or use as collateral
- Lenders receive interest on the funds they lend according to the supply APY
- Lenders and borrowers receive additional rewards in the form of governance tokens that can be sold in the market
- Depending on the jurisdiction, through lending/borrowing users might avoid or delay paying capital gains taxes
Will Update Soon !
There is quite a lot of material to go trough !!!
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