An Intro to De-Fi — Part I
An Intro to De-Fi — Part I
If you’re involved with the Crypto space in any capacity (or not) you’ve probably heard the term “De-Fi” or Decentralized Finance. It’s all the rage these days. We felt it’s a good time to do a series of posts on the subject. We assume some knowledge of what a blockchain is, but beyond that this is an attempt to introduce the concept to someone unfamiliar with De-Fi.
Background information
Bitcoin script, Ethereum, Solidity
First some background information. Most of you are familiar with the Bitcoin blockchain, which is used to store various users’ balances in a distributed ledger. Miners construct blocks of transactions by executing bitcoin script code, which are typically, but not always, authorized transfers of money from one user’s balance to another.
The functionality possible to bitcoin scripts is intentionally constrained so as to limit the ‘attack surface’ a hacker would have to try to exploit vulnerabilities in the network. It’s sole purpose at the base layer is to serve as a secure, decentralized store of value: Global trust-less money.
Ethereum was created without the constraints of being global money and hence had more room to experiment with new features on it’s blockchain. The first one was to build a Turing-complete language, Solidity, to replace Bitcoin Script. Now the blockchain could be used to store state for a worldwide distributed compute platform.
The job of miners in this scenario is similar to Bitcoin: Construct blocks by processing transactions (application logic) that involve executing solidity code and updating the state of data on the blockchain in a consistent, predictable manner. The possibilities opened up to innovate, were tremendous.
dApps
Traditional applications (think Facebook, Youtube) work by having a user interact with a centralized system. All of the user’s data is controlled on that system. This gives these platforms great power to de-platform users or censor content that they find disagreeable. Unfortunately, as these platforms are controlled by private entities, freedom of speech considerations do not apply. They really have all the power other than the power of the free market and consumer choice to move away from them.
dApps or distributed apps on the other hand are applications that have either an API or UI that interacts with a decentralized system like a blockchain. One can write smart contracts on Ethereum and build sophisticated user interfaces that interact with these smart contracts to provide some functionality to users in a decentralized way.
Although it really depends on the smart contract logic, dApps typically enjoy a combination of ownership of data by their users, decentralization of power and censorship resistance. Some of the first dApps built were in the financial space and have already started disrupting traditional finance in a number of ways.
Fundraising
Raising money in a decentralized way was one of the first types of smart contract built on Ethereum. One could write a smart contract (later to be standardized in the form of ERC20, ERC223 interfaces) that would issue tokens and keep track of user balances. The smart contract would have options such as burning tokens (reducing supply) or minting new tokens (increasing supply).
One could audit the code and see exactly what it was doing or capable of. Armed with just this piece of code, many high profile projects embarked on Initial Coin offerings (ICOs) which involved raising money, typically in Ethereum or Bitcoin, in exchange for a set quantity of these tokens. Users that felt that the prospects of a particular project were great could invest in these tokens by exchanging some BTC or ETH for them.
The beauty of this system is because it was on top of Ethereum it was instantly a permission-less, censorship resistant and worldwide phenomenon. Anyone with an Ethereum address and some ETH could now participate in any projects they chose to, without boundaries. On a technical basis, it could not be stopped. The good however comes with the bad and there were a large number of high profile scams in the space.
ICOs have since died down and been replaced by more ‘sane’ models such as STOs (Security token offerings) and IEOs that have a few more regulatory hurdles to jump through, in order to raise money, unlike the wild west ICO days. However the genie is out of the bottle and we firmly believe that this form of fundraising has come to stay, in one form or the other.
Major forms of De-Fi
Decentralized Exchanges (DEX)
Another innovation in the De-Fi space is the decentralized exchange. Unlike their centralized counterparts, these DEXes allow a user to exchange a token they own for a token they want in a completely trust-less, non-custodial manner. The user’s wallet is hooked up to the DEX smart contract and retains control over their funds at every point.
These DEXes are pretty good for swapping of tokens in specific ecosystems e.g. Ethereum, EOS, Tron and so on. Although less popular owing to the current state of development, a more promising development is the Atomic swap, a technology that allows a similar trust-less swapping of tokens or coins across different blockchains e.g. Bitcoin for Litecoin, Decred for Litecoin and so on.
Anyone using Metamask, Scatter or similar wallets has instant access to DEXes.
Stablecoins
One of the most important things that will drive adoption in the crypto space is having moorings to the traditional finance world. One of the key innovations that helps with that is the Stablecoin. A Stablecoin is a token on a blockchain (available on ETH, EOS and other Blockchains) that is backed 1:1 by a traditional fiat currency, the largest being the US dollar.
There are 2 major ways a token is backed by fiat, the simpler one being that there exists 1 unit of the Fiat currency in a bank account somewhere for every 1 unit of the token that’s been issued. While verification of backing is possible through periodic audits in the real world, it’s definitely quite cumbersome. Tether (USDT) is the larger player in this space.
The other way a token can be backed by fiat is to have the value of 1 unit of the token pegged to 1 unit of fiat, algorithmically through the use of collateral or reserves. While blockchains such as Bitshares were the first in the space, the most prominent example of this is MKR DAO (Decentralized autonomous organization), which issues a token called DAI, backed by multiple forms of Crypto collateral such as Ethereum and other ETH based tokens (and SAI which is a single collateral stablecoin backed by Ethereum). The collateral value is typically a multiple of the stablecoin issuance, with mechanisms in place to automatically handle under-collateralized and over-collateralized scenarios in a decentralized manner, with oracles providing updated price information. While MKR has suffered from some high profile attacks and crises recently, most of this should serve to harden the protocol and make it viable for the long term.
Borrowing / Lending Marketplaces
The introduction of leveraged trading in the crypto space has created a demand for borrowing by traders or by exchanges on behalf of their traders. A robust market for borrowing and lending crypto assets, including stablecoins, has sprung up and is being served in both a decentralized manner by protocols such as Compound, Aave and others as well as in a centralized manner by Exchanges like Binance and Coinbase.
The interest rates being offered on crypto lending platforms are typically much higher than in the traditional world. This premium can be explained by the different forms of risk a lender is taking on, on these platforms.
Risks
The types of risk that a participant in crypto lending or borrowing markets takes on are
Financial Risk — In addition to exposure to the value of the borrowed / lent asset itself, one is exposed to the exchange risk on the cryptocurrencies they are borrowing vs the ones they are putting up as collateral.
Smart contract bugs / Hacking — As seen in a number of recent high profile cases such as the bZx / Fulcrum hacks (read more here and here), it’s entirely possible that funds can be lost or stolen due to human error, smart contract bugs and malicious hacking. This is one of those risks that will probably never entirely go away, and the larger the prize the more sophisticated the hacking attempts.
Governance attack — A lot of the decentralized protocols depend on DAOs (decentralized autonomous organizations) for their governance and to make decisions on the structure and direction of the protocol. It’s possible for a protocol’s governance to be co-opted or taken over by entities with interests other than the health of the protocol.
Conclusion
That’s a pretty high level and quick overview of the De-Fi space. We hope you enjoyed the content.
In Part II, we talk about market making / liquidity mining, data oracles, options and insurance.
In Part III, we will do a deeper dive into DEXes.
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