DeFi: An Overview of the Decentralized Financial Ecosystem

Just as the Internet changed the global information infrastructure forever, today we are witnessing how blockchain technology is creating a new global financial infrastructure that combines both existing markets and completely new ones directions.

The main advantage of such a decentralized financial system (DeFi) is that the only condition for access to its services is an Internet connection, which greatly simplifies the process of participation, reduces costs, reduces the possibilities for censorship and manipulation by centralized organizations that own and control infrastructure underlying existing financial markets.

What is DeFi?

DeFi (decentralized finance) is a collection of specialized services based on smart contracts and decentralized applications (Dapps) that make up a decentralized financial ecosystem and provide users with access to a variety of financial services such as investing, lending, trading on stock exchanges, etc., without the need to trust centralized financial institutions and companies. These financial services are provided without restrictions to everyone 24 hours a day due to the active development of blockchain technology in general, and in particular the Ethereum platform.

Why DeFi?

With the advent of cryptocurrencies, the concept of “money” has acquired a completely new meaning and the ability to make payments appeared for everyone, without exception, regardless of location and access to the banking system.

A completely logical continuation of the development and distribution of cryptocurrencies was the emergence of an independent financial system, which is an open and transparent alternative to the outdated centralized financial services that people around the world use today.

Blockchain and smart contracts have created a completely new paradigm of financial relationships between parties that do not trust each other, but at the same time have the ability to interact without intermediaries in the form of financial institutions. Thus, the concept of “transaction” when it comes to smart contracts and decentralized applications based on them, includes more complex interactions than just sending and receiving cryptocurrency.

Key advantages of a decentralized financial system

• Accessibility for any user, regardless of his geographic location, credit history and other restrictions that exist in a centralized financial system.
• Transparency of all transactions in the blockchain. Also, all smart contracts are open source, which can be easily audited and identified for possible vulnerabilities.
• Flexibility of the software interface — the user can use any convenient interface offered by third-party developers or created independently.
• Openness (Permissionless) allows users to directly interact with applications through browser extensions (or software wallets), and also provides the ability to create their own applications
• Interoperability provides amazing opportunities to combine new DeFi applications with existing services (like Lego) that interact with each other through universal protocols and can be combined to create completely new products.

Main Directions of DeFi Development

• Decentralized Lending is a service that allows users to lend and borrow crypto assets. Lending offers a new way to earn interest on free assets.
• Decentralized exchangers — provide users with the ability to exchange cryptocurrencies without the participation of centralized exchanges.
• Stablecoins — the issue of cryptocurrencies with a fixed price pegged to a unit of fiat currency (usually USD), backed by fiat currencies, decentralized cryptocurrencies (BTC, ETH) and other valuable assets, in order to minimize volatilit
• Synthetic cryptoassets — creation of derivative financial instruments (derivatives ) on the blockchain
• Tokenized Assets — management of user funds by distributing them to various pools of liquidity (balancing deposits) in order to maximize profit.
• Smart wallets — wallets and DeFi portfolio managers with advanced management features
• Payments — decentralized payment protocols
• Decentralized insurance — minimizing risks when holding assets in the event of an error in a smart contract or other unforeseen circumstances

Review of projects of the decentralized financial ecosystem

1. Compound

Along with MakerDAO, Compound to date day is the fastest growing and most promising project in the field of decentralized lending, capitalization of which, according to DeFiMarketCap has already exceeded $ 2 billion.

In fact, Compound is a protocol built on top of the Ethereum blockchain that forms money markets in the form of pools of cryptoassets with algorithmically determined interest rates based on supply and demand for a given asset. At the same time, lenders and borrowers interact directly with the protocol (and not with each other, as in the case of p2p lending), earning (and paying) a floating interest rate, without the need to first agree on conditions such as maturity, interest rate or the amount of collateral.

The pooled liquidity approach allows Compound to provide good volume for every asset it supports, and users can easily withdraw any amount without having to worry about the details of the loan and withdraw their funds at any time.

Unlike traditional (centralized) financial markets, there are no restrictions on withdrawals. Along with all the advantages described above, it should be noted that the annual interest rates in Compound on some assets significantly exceed those offered by banks and other financial institutions today.

Compound is also governed in a decentralized way through community voting. This control system completely eliminates the protocol administrator and eliminates the biggest point of failure — the Compound command. Voting is carried out through the ERC-20 COMP token, which grants its owners the right to delegate the right to any participant and transfers control to those who, in their opinion, have the desire and competence to propose, discuss and implement changes to the protocol. Thus, anyone with at least 1% of delegated COMP tokens has the right to participate in the management of Compound (regardless of whether they own these tokens or not).

2. Uniswap

Decentralized application is designed to exchange one token for another directly, bypassing trading platforms and other intermediaries. To carry out exchange operations, the user does not need to create an account on the exchange, go through the KYC procedure and trust their funds to third parties. All you need to do is connect your browser wallet (eg. MetaMask), select the exchange direction and make a transaction. Next, the smart contract will automatically send the corresponding amount of ETH or tokens to your account.

However, for all its simplicity, a natural question arises: how to provide sufficient liquidity for conducting exchange operations in Uniswap?

The answer lies in the fact that Uniswap is based on a simple but very effective idea: liquidity for exchange transactions is provided by the users themselves, who provide their assets (for example, a pair of ETH and ERC-20 token) for the exchange, creating the so-called … liquidity pools. In return, such users (liquidity providers) receive tokens from the exchange contract (liquidity tokens), which can be used to withdraw their share from the liquidity pool at any time. For each transaction on the exchange, the user pays 0.3% commission on the ETH / token exchange and 0.6% on the token / token exchange, which is added to the liquidity pool. Since the number of liquidity tokens is strictly limited, this results in a proportional distribution of transaction fees among all liquidity providers. In addition, liquidity providers profit from arbitrage transactions if the price of an asset in foreign markets differs from its price on Uniswap. Thus, all participants in liquidity pools have the opportunity to receive constant income even if the number of user transactions is relatively small, but the value of the asset is constantly changing.

3. Synthetix

Synthetix is a decentralized platform on the Ethereum blockchain for creating synthetic crypto assets, the value of which is tied to the value of real assets.

As of June 2020, there are over 40 Synth assets on the platform, most of which are tied to top cryptocurrencies (sBTC, sETH, sXTZ, etc.), as well as to some fiat currencies (sEUR, sGBP, etc.). etc.), commodity indices (sXAU, sXAG) and stock market shares (sNIKKEI, sFTSE).

In total, the Synthetix DeFi service includes three decentralized applications (Dapps):

• Synthetix.Exchange — a trading platform for exchanging synthetic assets without intermediaries.
• Mintr — an application for issuing Synth assets by blocking SNX tokens by their owners.
• Dashboard -statistics dashboard Synthetix Network.

Key among these applications is Mintr, because with its help, synthetic assets are issued through SNX tokens, which have their own value and are traded on foreign markets.

The basic principle of issuing new units of synthetic cryptoassets is that they are backed by SNX tokens and to create them, the user needs to block their SNX with a security ratio of 750% (currently)

The collateral ratio (Collateral Ratio or С-Ratio) is one of the basic concepts of DeFi and determines the amount of collateral with which the user covers issued (or borrowed) assets. Due to the fact that all financial transactions are carried out by pseudo-anonymous users and in order to compensate for possible high volatility and provide comfort for participants and stability of the protocols, all DeFi companies use an increased collateral ratio (from 150% or more).

Accordingly, when SNX is unlocked, the opposite process occurs — the corresponding amount of Synth assets is burned. The entire collection of blocked SNX is combined into a single pool (debt pool), from which token holders receive weekly rewards in proportion to their share: from trading operations (0.1% — 1%), as well as additional tokens created based on the underlying inflationary model of the protocol.

In addition, users Synthetixcan use ETH as an alternative collateral method with a collateral ratio of 150%. However, in this case, users are not included in the general debt pool and, as a result, do not receive any additional rewards.

4. Curve

The goal of the decentralized service Curve is to provide an exchange pool of liquidity for exchanging one stablecoin for another with minimal commissions without price slippage. For this, a special mechanism is used, called StableSwap, which ensures efficient interaction with liquidity pools of third-party DeFi services (1inch, Paraswap, Totle, Dex.ag , etc.).

It is known that in the cryptocurrency environment, the so-called. stablecoins — cryptocurrencies with a fixed value pegged to fiat currencies (eg. US dollar) or valuable assets (eg gold). Stablecoins are designed to protect market participants from excessive volatility and are the main source of liquidity on cryptocurrency exchanges, because the bulk of trading falls on cryptocurrency / stablecoin pairs.

Source: CoinCodex

Since the inception of the first and most popular fixed price cryptocurrency, Tether (USDT), many alternative stablecoins have emerged, offering different models and designs of universal characteristics and competing in terms of risk aspects, collateral types and trade-offs in various functional components.

From the point of view of the methods of emission, the entire range of stablecoins can be divided into two large types: custodian (issued in a centralized manner) and non-custodial (issued in a decentralized manner).

In the DeFi sphere, non-custodian stablecoins are mainly used, as the most appropriate to the concept of decentralized finance, while in external markets, cryptocurrencies are traded in relation to custodian stablecoins (USDT, USDC, TUSD), therefore, market participants have a constant need to exchange some stablecoins to others. However, it is unprofitable to make an exchange on cryptocurrency exchanges due to high fees, so Curve.fi is the best place for such operations.

In addition, Curve.fi offers the most favorable terms for its liquidity providers thanks to the yield aggregator iEarn.

It is known that liquidity providers are key players in the DeFi market, providing their assets for transactions within the ecosystem of decentralized financial applications. But, unlike Uniswap, where such participants earn only a percentage of user and arbitrage transactions within the exchange site, Curve.fi allows you to significantly increase the annual interest rate by creating liquidity pools combined with other DeFi services (eg Compound). In other words, Curve.fi liquidity providers have the opportunity to increase their income by participating in several liquidity pools simultaneously.

The image above shows all Curve Pools liquidity pools with parameters of annual yield (APY:%) at a given point in time.

Pools PAX, Y and BUSD use the so-called. Yield Tokens (yTokens), which are credited to members of these pools. At the same time, the initial deposit is automatically divided into parts and distributed in certain proportions between all the tokens contained in the pool (e.g. DAI, USDC, USDT and TUSD in the figure below)

yTokens are supported by the iEarn protocol and are used to balance profits between different credit protocols with the best interest rates (Compound, Aave and dYdX) — a more profitable option, but with increased risks.

The sUSD, ren, and sbtc pools do not use credit protocols. Accordingly, this is a less profitable option with minimal risks.

In the list you can see the so-called. incentivized pools (highlighted in yellow), which help to maintain the value of stablecoins at a fixed level. All members of these pools, in addition to commissions from trading and lending operations, also receive additional rewards from third-party companies (currently Synthetix and Ren).

It should also be noted that thewebsite curve.fi always has access to the results of smart contracts audits periodically conducted by Trail of Bits, as well as full service statistics.

5. PoolTogether

The service offers, perhaps, the most original way of non-custodial storage of funds (in DAI or USDC tokens) with the opportunity to take part in a prize drawing (analogous to a lottery). Each member of the pool receives the so-called. “savings tickets” in proportion to their deposit (one ticket for 1 DAI or 1 USDC). Only unlike the regular lottery, PoolTogether tickets are not redeemed after each round, but are eligible to take part in the next draw. The draws are held daily (among the USDC pool members) and weekly (among the DAI pool members), so each participant has the opportunity to win a prize up to 365 times a year, but all his assets are preserved and he does not need to deposit additional funds! Accordingly, the larger the participant’s deposit, the more chances he has to win, and if the participant withdraws his funds from the system, all his tickets are canceled.

Obviously, in such a win-win lottery, there must be a source of additional income to form the prize pool. To this end, the PoolTogether smart contract directs the participants’ funds to the Compound credit pool and transfers all earned interest to the prize pool. In addition, sponsored DAIs are added to the pool — funds from people (and companies) who do not participate in the drawing, but want to support the development of the ecosystem.How is the prize draw?

How is the prize draw?

In PoolTogether there is a privileged administrator account, which is responsible for the daily work of the pool determines the winning ticket by selecting a random number.

The determination of the winning ticket is as follows:

1) The administrator generates a secret random number before the prize is revealed

2) The administrator opens the prize, while new deposits will also be eligible to win. When opening a prize, the administrator also records a fingerprint that uniquely identifies the random number, but does not disclose it.

3) The administrator fixes the prize and blocks deposits that will be eligible for winning.

4) to award a prize, the administrator must “reveal” a secret random number. A smart contract guarantees that a given random number corresponds to a fixed unique fingerprint.

5) the Smart contract uses a random number to select the winner.

As a result, despite the participation of the administrator, it can be argued that the lottery organization is completely transparent and honest, given the fact that all PoolTogether smart contracts are audited, the results of which are available on the Audits & Security page.

Probable risks and liability aspect

Since all DeFi services are actually decentralized applications on the blockchain, interaction with which is carried out through smart contracts based on strict mathematical algorithms, users need to be aware that for all the undeniable advantages of such a decentralized financial system, no financial organization in any jurisdiction of the world is responsible for the actions of its participants.

It is also necessary to understand that all operations with financial assets occur automatically in a distributed environment and no one (including application developers) has access to user funds and is not responsible for their safety and use.

Due to the fact that all decentralized applications are based on experimental blockchain technologies, all risks can be divided into several categories:

• Risks associated with smart contracts. Due to the fact that in such systems, different protocols constantly interact with each other, it becomes obvious that in the event of a critical error in one of the protocols, the smart contract, as a fully Autonomous executable program code, significantly increases the risk of vulnerability of the entire system.
• The risk of a temporary loss. This type of risk is inherent in the AMM (automated market maker) technology itself and applies only to liquidity providers on decentralized exchange platforms. The risk arises if there is a significant difference between the value of assets at the time of placement in the pool and their value at the time of withdrawal from the pool. Thus, it not only loses profit, but also gains a loss compared to the strategy in which it would just keep its assets in its wallet. To avoid such losses, you can carefully study the section concerning impermanent loss (present in the documentation and described in the blog of any decentralized exchange).
• The risk of collateral and volatility. Even if the SOFTWARE itself is sufficiently reliable, has been tested for a long time and has passed a full audit, there are certain risks associated with the types of assets used to repay loans. Naturally, if the main collateral asset (e.g. DAI) is sufficiently (or excessively) secured, then volatility is extremely low and the credit system is in a stable state. However, if the price of the underlying asset (e.g. ETH) experiences a significant decline in a short period of time, in this case, the total volume of liquidated positions does not cover the borrowed funds. This can be avoided by varying the collateral ratio and reducing interest rate volatility, which is currently quite high. But this will further complicate the mechanics of the system and may lead to additional risks.
• Regulatory risks. While according to the concept of DeFi, it is assumed that the system should be completely decentralized, in reality, not all DeFi services have fully decentralized management and theoretically, the possibility of lawsuits against the creators of applications is not excluded. However, there are still no such precedents.

You will learn more about how to manage using a (decentralized oracle) in the next part of this article.

At the moment, we already know about several cases of” hacking “ the DeFi protocols due to errors in smart contracts (bZx, Fulcrum, Dforce, BlockFi, Balancer), mainly related to the flash loan function, which allows you to take short-term unsecured loans. However, due to the fact that the system is open and all transactions are easily tracked in the block browser (for example, Etherscan), the vulnerability was quickly detected and fixed.

There is also a known case of collapse on the MakerDAO platform, associated with the sudden collapse of the price of the underlying asset ETH on cryptocurrency exchanges in March 2020.

Current state of the market and prospects for the development of decentralized financial infrastructure

While in 2018–2019 the first implementations of financial protocols on the blockchain were just beginning to appear and the first decentralized stablecoins were being created, 2020 can be confidently called the year of DeFi. According to research, one of the catalysts of the process was the coronavirus crisis, which had a significant impact on the entire world economy and initiated the active phase of the next global financial crisis. In such circumstances, the world needs decentralization more than ever and people are aware of the importance of creating a reliable infrastructure for a decentralized economy that can provide much greater efficiency, flexibility and self-governance than the traditional financial and economic model.

Today, we can see that in just three months, the total amount of funds concentrated in DeFi services has already exceeded the $2 billion mark. and it continues to grow.

Source: DeBank

At the same time, the weekly turnover of decentralized exchange platforms has fully recovered after the March collapse and is about $500M

Due to the active growth of the largest decentralized credit platform, Compound, the total capitalization of DeFi’s assets has grown 6 times in one month and has now reached $6.5 billion. according to DeFiMarketCap. This is an indicator of active interest on the part of large investors who are not satisfied with the control of the banking system and are looking for new ways to place their capital.

Summarizing all the above, we can state the fact that today we have witnessed another explosive wave of interest in decentralized technologies in the light of new opportunities offered by DeFi.

We really like what is happening with financial services and we are actively working on integrating our wallet with the most popular and proven DeFi services, this will make it easy and convenient to work with different services from one place.

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