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The Evolution of DeFi Across Four Financial Primitives

Photo by Hello I’m Nik on Unsplash

Financial Primitive 1: Liquidity

The opportunity cost of captive capital scaled along with DeFi and now v2s and v3s are fighting to achieve greater capital efficiency.

Collateral as Liquidity

DeFi v1 figured out how to use liquidity as collateral (LP tokens). v2 and v3 protocols are figuring out how to convert collateral into liquidity.

While the newest generation of stablecoins are focused on lowering collateralization requirements, we need to solve for confidence in the peg (effective mechanism design) before capital efficiency.

Liquidity as a Liability

The next generation of AMMs require less capital but result in more liquidity.

Liquidity Trade-offs

Financial Primitive 2: Leverage

Leverage is easy in DeFi , controlling it is still hard.

Creating Leverage

New lending protocols utilize the time value of money and the separation of principal and yield to allow users to benefit from (over)collateralization.

Cross-Collateral Complexity

Controlling Leverage

Financial Primitive 3: Risk

Binary Risk

Risk on a Sliding Scale

Risk tranches have become toxic in the past, namely when they’ve tried to circumvent the risk/reward ratio. The CDO² will forever be my favorite example of clever financial engineering, packaged to look like a riskless instrument when it was actually full of risk.

Financial Primitive 4: Arbitrage

v1s focused on cross-protocol arbitrage, v2s/v3s are focusing on chain-cross arbitrage

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Zero Knowledge Blog is a blog that looks into the tech that will power the emerging Web3 and the community that is building it. Here we are able to take the ideas explored on the Zero Knowledge Podcast and go deeper with them, showcasing new insights and perspectives.

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Justine Humenansky, CFA

if it’s not a dao, why do it? former ballerina. currently @ rabbithole