When people are discussing DeFi, what are they actually discussing?

Editor's Note: This article comes fromFirst class warehouse blockchain research institute (ID: first_vip1)Editor's Note: This article comes from

First class warehouse blockchain research institute (ID: first_vip1)

First class warehouse blockchain research institute (ID: first_vip1)

• , Author: Victor von Wachter Philipp Sandner, translation: First Class Warehouse (First.VIP) Annie, reprinted with authorization by Odaily.

• What You Need to Know About Decentralized Finance (DeFi)

• Overall, the blockchain-powered decentralized finance (DeFi) space is still nascent, but it offers an attractive value proposition in that individuals and institutions can access a wider range of financial resources without the need for trusted intermediaries. financial applications. Especially those who previously did not have access to such financial services could benefit. DeFi promises to create a full-fledged capital market. Do not deny the growth of DeFi, here we do a small analysis.

• DeFi celebrates network effects, and true innovation is achieved through unique combinations of applications.

For Ethereum, whether to adopt DeFi in the future is closely related to the scalability and usability of Ethereum.

DeFi has yet to prove to be truly progressive. Currently, usability is not intuitive, there is no risk-adjusted pricing, and liquidity cannot compete with centralized alternatives. However, we are optimistic that these are problems for the new ecosystem.

First Class Note: All data and examples as of November 30, 2019.

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What are the hot topics related to DeFi?

Definition of DeFi:

Broadly speaking, DeFi is an ambitious attempt to decentralize core traditional financial use cases such as trading, lending, investing, wealth management, payments, and insurance on the blockchain. DeFi is based on decentralized applications (DApps) or protocols, and by running these DApps on the blockchain, it provides a peer-to-peer financial network. Like Lego blocks, each DApp can be combined with each other. Smart contracts act as connectors - comparable to APIs specified in traditional systems.

The total number and activity of DeFi dominated by Ethereum (source: own data)

The use of DeFi on the blockchain is still in its infancy (source: own data)

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Daily transaction volume (USD); EOS is an exception (source: own data)

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The rise of DeFi

In short, DeFi’s other competitors are currently far away because they either lack a healthy developer base (IOST), or lack true decentralization, and thus the core advantages of blockchain (EOS). Some lack both. This raises the general question of whether DeFi can also be replicated on the most popular blockchain protocols. Contrary to popular belief, DApps can indeed be used on Bitcoin, but programming is much more complicated.

Bitcoin emphasizes security, which is very important in financial infrastructure. Therefore, Bitcoin may be suitable for a healthy, but significantly smaller DeFi ecosystem. The most successful DeFi application of Bitcoin to date is the Lightning Network. These applications have been developed over the past few years and are based on a technology called state channels. The Lightning Network supports super-fast and low-fee payments and has seen phenomenal growth in 2019, with more than 6,000 active users and $6.2 million locked in the network. Other well-known Bitcoin DApps are decentralized exchanges (such as Bisq or Sparkswap).

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Monthly Locked Funds vs. Top 6 Protocols in Millions of Dollars (Source: Own Data)

It is very important to note that the fuel that keeps DeFi running is ETH and DAI. Ethereum requires ETH to pay blockchain transaction fees, and ETH is also the easiest to convert into other cryptocurrencies. DAI is a token generated on top of the Ethereum blockchain that offers the benefits of a stablecoin: fully decentralized, pegged to the U.S. dollar, and therefore inherently less volatile. A major factor driving this success is the ability to circulate DAI between different DeFi protocols and use it as the unit of account on these DApps.

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• What are the core advantages of DeFi now?

• DeFi is built on top of the blockchain. The blockchain is called a common infrastructure layer, so DeFi can be seen as a DApp cluster on top of this infrastructure. This allows DeFi to have the core characteristics of decentralization. Note that this is only true if the blockchain itself is decentralized. Under this premise, the core benefits of open financing and the core benefits of blockchain are shared:

• True decentralization allows for censorship resistance, global participation regardless of social status, and distribution to trusted third parties.

• Using blockchain as a technical infrastructure enables relatively high-speed and low-cost transactions/settlements, immutable financial contracts, and contract automation.

DeFi applications often allow users to keep private keys. This is called non-custodial in the blockchain ecosystem. There are no trusted third parties and users are in full control of these funds.

DeFi respects network effects, enabling many innovations through unique combinations of different DeFi applications.

For example, the largest active DeFi contract has locked up $10 million without a bank account, without a third party, and customers can always own these underlying cryptocurrencies.

This is in stark contrast to the traditional financial industry, which allocates a lot of resources to build a trust system, which is based on serious centralization (such as too-big-too-fail banks), transparency (e.g. the 2007 crisis) and censorship/discrimination in many countries. Moreover, the system has failed to keep pace with the digital age: a cross-border transaction takes an average of 3 business days and costs around 6.8%.

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• So why hasn't it skyrocketed yet?

• However, the adoption of DeFi currently lacks useful theoretical support. In order for decentralized applications to be widely adopted, DeFi must overcome some major hurdles.

• The DeFi ecosystem is an area of ​​technological experimentation and innovation. Accessibility is global, but not yet intuitive in terms of user experience. Also, since it is cryptocurrency-based, traditional currency must first be exchanged for cryptocurrency.

• Liquidity is replaced by centralized alternatives. This is important because liquidity is critical to efficient pricing in the financial industry. In fact, most current protocols cannot compete as efficient, low-fee competitors. Given the double-digit stability fees, MakerDAO is not currently being used as a permissionless credit provider, but rather as a decentralized way to create leverage in Ethereum. This follows the centralized strategy of leveraged longs by exchanging ETH for DAI and reinvesting it in ETH.

• Product Overcollateralization: Since there is currently no credit score or shared collateral, many products must be overcollateralized (sometimes as much as 150%), which reduces leverage for professional traders and gives users the opportunity to not control funds. Traditional credit scoring based on identity and complex deleveraging systems, liquidation algorithms, and insurance funds make centralized systems highly capital efficient. This is a research direction.

Due to the novelty of these approaches, technical risks such as bugs in smart contracts or blockchain infrastructure are difficult to detect. By design, false or fraudulent transactions are irreversible on the blockchain.

• Additionally, there is operational risk due to price feeds (so-called "oracles") and failure/manipulation of complex governance protocols.

• The interdependence of DeFi protocols poses potential systemic risks. This can be observed in MakerDAO’s “too-big-too-fail” state, arguably the most critical piece of infrastructure within DeFi given the space’s reliance on oracles and stablecoins. MakerDAO is open source and mostly decentralized, which eliminates the "too-big-too-fail" debate, at least to some extent. However, market participants are currently faced with few viable alternatives to the dominant lending protocol and its oracles.

• Some issues with Ethereum itself (below) could create problems for DeFi:

High transaction costs (such as gas fees on the chain): Since transaction processing priority is determined based on gas fees, transactions with lower gas fees may wait for longer transaction processing times.

Since the state of the blockchain is updated every 15 seconds on average, this is very rare for traditional finance. In DeFi, interest and price are calculated by block, and stable block mining is required to achieve stable operation.

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Different DeFi use cases

DeFi Use Case Summary

looking to the future

Providing financial services to the cryptocurrency ecosystem is currently being discussed from two perspectives: centralization and decentralization. For example, the exchange of two currencies can be carried out centralized (such as Coinbase) or decentralized (such as Uniswap, Kyber). In addition, stable assets linked to the U.S. dollar also exist in the form of centralization (such as USDT, which maps U.S. dollars on the blockchain) and decentralization (such as DAI, which comprehensively maps U.S. dollars on the chain).

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looking to the future