Exploring DeFi Innovations
Reconstructing the DeFi stack with a focus on security and non-collateralization.
DeFi has been having quite a year but that doesn’t mean it’s not experiencing some challenges. When the Ethereum DeFi ecosystem was in its infancy a few years ago, users started to build on what was available to them at the time. Looking back, we are now at the stage where we can reflect on the missing pieces with the early fundamentals laid out by developers and the new protocols built on top of them. Decentralized services like insurance, seigniorage stablecoins, and non-collateralized loans could be the solutions that propel DeFi beyond the $1 billion in total locked value.
Existing DeFi applications like lending, borrowing, and trading protocols benefit from composability, to create future DApps that can work seamlessly with each other and allow developers to spend more time innovating and less time integrating. At Conflux Network, we are taking innovative approaches to make sure our DeFi ecosystem strives to enhance and emancipate development for the essential building blocks to provide sustainable platforms for users looking to utilize DeFi.
Our DeFi solution will build from the bottom up, and not reinvent the wheel.
One area of opportunity is non-collateralized or seigniorage stablecoins. Seigniorage-style stablecoins are an alternative to the two models of stablecoins offered in the Ethereum DeFi space currently. The prices of non-collateralized stablecoins are pegged by algorithmically adjusting supply, and depend on only the smart contracts to act as its reserve — automatically inflating and deflating the prices by using bonds. For those who are unfamiliar, this stablecoin works on a new economic mechanism, different from USDT (fiat-collateralized) or DAI (crypto-collateralized).
We believe that an ecosystem fully utilizing all three types of stablecoins will prosper, because of the different applications each type of stablecoin facilitates and the liquidity that comes with them — two factors that are integral for DeFi community growth. Even though the on-chain activity for stablecoins has increased over 800% in the past 12 months, some may wonder why the need for an even more decentralized option is necessary and whether it would be accepted when the current two options are performing fine.
Referencing the graph below, we can see that in the centralized aspect of the market, like centralized exchanges, people tend to lean towards the centralized stablecoins like USDC or USDT. Whereas in the DeFi space, DAI trumps the others as the decentralized market attracts decentralized stablecoins. In today’s market there is a growing concern that DAI is becoming more centralized with the introduction of WBTC and USDT as collateral. If the market was offered a stablecoin that kept its peg and had no reliance on central entities at all, it is fair to assume the community would accept and favor seigniorage over other stablecoins which rely on third-parties to maintain its reserve.
By establishing non-collateralized stablecoins in the infancy of a DeFi ecosystem, DEXes and other protocols get access to a new source of liquidity that is not offered on other chains. There are several other advantages to using seigniorage stablecoins which collateralized options do not offer, they include:
- With no reliance on collateral or central entities, you are provided with an even more decentralized alternative to DAI
- There is fundamentally no need for collateral, which avoids several peg related issues, something stablecoins have had an issue maintaining
- Smart contracts put in place allow for more trust since the peg is tied to an algorithm and not volatile collateral
Non-Collateralized Loans With KYC
Another innovation that should be a priority is a strong KYC application that the developer community can utilize to create the holy grail of DeFi: non-collateralized loans. Many DeFi enthusiasts believe that there is no space for KYC or other identity protocols in the space, but we believe that by offering a regulatory compliant service such as a KYC model to protocols they will have the ability to mold their application to be exactly what they want.
To give an example, imagine you want to create a decentralized exchange where users can make simple market trades, there would be no need to implement a KYC protocol into the interface, but if you would like to provide users with the ability to margin trade on the same exchange, with other users staked funds, it might make sense to implement an identity protocol to that function should there be misconduct. The same ideology can be applied to the market of lending and borrowing in DeFi, with non-collateralized loans. Flash loans are an autonomous solution offered to consumers.
Flash loans occur when a user takes out a loan for a certain amount of crypto, performs an arbitrage opportunity, and then pays back the loan in the same transaction. This process is technically a non-collateralized loan but is only practical for technical users who can program an arbitrage opportunity into code and properly work the flash loan protocol. For the everyday user, who would like to take a loan out they currently have to over-collateralize a loan so that they can access the funds without KYC, the system works, but at Conflux Network we believe we can benefit the growth of open finance by offering simpler loans using KYC to facilitate the process, without the over-collateralization so that new users are not tasked with the burden of the current lending system in DeFi.
Part of the problem as to why simple non-collateralized loans are not a thing is that the only real approach is using KYC models that are used by the community — a sector the DeFi space is yet to fully capitalize on. Unfortunately, most current KYC protocols were not designed to be easily integrated with other DeFi applications; thus hindering the development of applications where the only solution in today’s market is identity protocols. Providing a proper KYC portal for people to use is important to bring the lending and borrowing market to the next level. For example, if someone wants to create a DEX aggregator they can build it using different DEXes in our ecosystem, and if a developer wants to build a non-collateralized lending platform, they can do so by building on top of a KYC portal, lending platform, and oracle. Opening up the world of non-collateralization in open finance leads us to unchartered waters and exciting new opportunities in DeFi, as shown in the diagram below.
Another market we want to integrate into our ecosystem is insurance. Insurance is fundamental to the traditional finance market and is a sector that has not been fully capitalized on in the open finance community, especially considering the security risks that come along with operating a decentralized financial ecosystem. Insurance is significant for the stability of financial systems mainly due to them being the safeguard for risk in firms. Companies and consumers can interact with insured financial products with confidence that should something go wrong, their funds are safe. As we mentioned in a previous article, DeFi is somewhat failing when trying to gain the trust of users, this can partly be to blame for fears of losing assets.
As a new platform for DeFi apps, we want to minimize the risk as much as possible and ensure all developers and users are fully protected from attacks or scams. As an extra precaution we want to give new protocols the ability to add a trusted third party smart contract attack insurance protocol and give their users the ability to insure their assets when interacting with the DApps.
We consider this to be highly important since millions of dollars have been lost because of re-entrancy, flash-loan attacks, and other security flaws. The current standard of security is not sufficient to support close to billion USD locked in DeFi and there have been several attacks this year alone to prove that, such as the dForce and the imBTC Uniswap pool drain. The need for this goes without saying; the level of security and the extended composability we hope to achieve requires DApps to depend on one another to function securely and reliably.
This current state of dependency mentioned is shown in the graph above. In today’s DeFi ecosystem protocols do not exist in isolation. If someone were to drain the millions locked in Compound and their protocol was not insured, nearly every big player in DeFi would fall along with them creating a chain reaction.
We believe that by offering developers a trusted insurance DApp under these large middleware applications, users can interact with protocols on the network with confidence.
These are just some of the innovations we are planning to support when building the foundation of our DeFi ecosystem, with a revamped middleware and more focus on security and non-collateralization, we aim to add tremendous value to the world of open finance and look forward to working with developers to bring these ideas to fruition.
At Conflux Network, we believe that many chains can serve very synergistic purposes. Our cross-chain asset swapping protocol, ShuttleFlow, is a perfect example of how we plan to work with other chains to provide the best DeFi experience for users and work together with other networks to help get past the current roadblocks. While mapping out the fundamentals for our DeFi ecosystem, we believe that by utilizing different stablecoin mechanisms, non-collateralized loans, and insurance protocols we can provide a new financial landscape to the community for users to get the most out of their crypto assets and look forward to the future of open finance and the innovations ahead.
Written by Conflux Network’s DeFi analyst, Sami Tannir