The field of DeFi innovation is very broad, but there are still these risks that need attention

, Author: Lucas Outumuro, Compiler: Uncle Red Army, reprinted by Odaily with authorization.

secondary title

01 Introduction

Blockchain has been touted by many as a technology with the potential to provide banking services to the unbanked. While the ICO bubble of 2017 failed to deliver on this promise, the growing decentralized finance (DeFi) sector has reignited hopes for this vision. Using blockchain technology, DeFi provides access to financial services without the need for trusted third parties.

These services are built on smart contract platforms such as Ethereum, and can be provided with the help of P2P software and governance. By eliminating reliance on corporations, DeFi protocols have the potential to eliminate the risks and drawbacks of being controlled by centralized organizations.

Risks of DeFi

final thoughts

"I start by introducing some key terms inside DeFi, and then dive into specifics about its development and risks. Feel free to skip or enjoy the entire article."secondary title

02 Growth and innovation of DeFi

Tell me your motivation, I'll tell you the result of your motivation

--Charlie Munger.

Buffett's longtime business partner, Charlie Munger, commented eloquently on the relationship between current incentives and future outcomes. The message behind this statement resonates across fields including behavioral economics, game theory, and -- perhaps unexpectedly -- decentralized finance.

DeFi protocols have seen significant growth in adoption, token prices, and total value locked. While websites and social media platforms that rely on third-party advertising require a large number of daily/monthly active users to capture value, decentralized protocols generally do not rely on frequent usage to create value.

Instead, the dollar amounts held by smart contracts that power decentralized financial services are more reflective of the value created by these projects.

As a result, the total value locked has become a widely watched barometer in the DeFi space, as most of these protocols require collateral to be locked in order to use their services.

As the chart below shows, it took about two and a half years for the total value locked to reach the $1 billion mark. Although the total value locked in DeFi fell sharply during the market-wide crash in March, the total value locked in DeFi continued to grow throughout the second quarter of 2020, breaking through the 20-digit mark only six months after reaching the ten-digit mark for the first time. One hundred million U.S. dollars.

In the graph above, readers may have noticed a recent inflection point in total value locked. By zooming in, we can determine that this happened in mid-June, coinciding with the release of COMP, the governance token of the lending protocol Compound.

In less than a month, the total value locked in DeFi protocols has more than doubled. This is mainly because users are incentivized through so-called yield farms.

secondary title

03 Rocket fuel for DeFi

In a nutshell, yield farming (also known as liquidity mining) is the process of earning rewards in the form of tokens in return for providing liquidity to DeFi protocols.

The concept has been around since last summer, when Synthetix — a decentralized derivatives exchange — first attempted to reward users for providing liquidity to its derivatives synthetic ether (sETH) pairs on Uniswap, using their They are paid in native SNX tokens.

However, it wasn’t until the launch of Compound’s native token, COMP, that this became a common practice and buzzword within the crypto space."In the case of Compound, users can borrow or lend tokens to the protocol for income farming, and receive COMP tokens in return. Given that COMP is currently priced at around $180, the rewards in tokens are large enough that users can profitably borrow money, even though users are required to pay interest on loans."As a result, users have flocked to Compound, and since the launch, the total value locked in the protocol has increased more than 6x to over $650 million.

Recognized figures in the space laud the practice as DeFi’s

growth hacking

For example, let’s observe how the number of holders has changed since the token’s inception on June 15th.

As can be seen from the figure above, in less than a month, the number of COMP addresses with balances has risen rapidly from almost zero to over 14,000, effectively capturing a sizable community from the very beginning and putting the tokens Ownership is decentralized.

Taking this as an example, since MakerDAO, the pioneer of DeFi, launched in November 2017, the number of holders of its MKR governance token has reached 22,000.

secondary title

04 Improve Staking

In addition to yield farming, DeFi protocols have been utilizing other tactics to foster growth and community adoption. A common method that many projects have implemented or are looking to implement is piling.

For example, popular decentralized exchange Kyber rolled out its Katalyst upgrade on July 7, enabling holders of its native KNC token to stake their holdings, allowing them to vote on improvement proposals .

Along with this, it has adjusted its governance structure into a decentralized autonomous organization, KyberDAO, empowering its community members to make decisions. In order to motivate holders to participate, they get fixed-point rewards of ETH through voting or delegated voting.

Through this process, 65% of the decentralized exchange's network fees will be redistributed to holders who staked votes, incentivizing positive decentralized governance.

Additionally, as an exchange, Kyber realizes that incentivizing liquidity is also critical in order to build a robust trading infrastructure.

Therefore, as part of the Katalyst upgrade, 30% of Kyber network fees will now be used to provide rebates to liquidity providers, a reserve within the Kyber ecosystem.

Through these, Kyber effectively reduces the cost of market-making activities on the exchange, encourages the creation of more and higher-quality reserves, and strengthens the liquidity of the platform.

In anticipation of Katalyst's upgrade, the crypto market is optimistic about KNC tokens. Year-to-date, the price of KNC has risen by more than 700%, leading the rally of DeFi tokens.

However, analyzing the activities on the chain, we can prove that the transaction volume of KNC tokens has actually increased. Throughout 2020, the transaction volume of KNC tokens has increased by about 9 times.

All of these innovations benefit from the permissionless nature of DeFi. Given Ethereum's transparent and open-source dynamics, DeFi projects built on it are able to take advantage of quick and free access to information.

In a line from Compound founder Robert Leshner, he highlighted how COMP’s governance is based on what MakerDAO was built on before, and how COMP’s yield farm was inspired by Synthetix’s previous incentive design scheme.

Because it is open source, the DeFi protocol can freely copy, integrate and improve existing solutions, thereby accelerating the construction and deployment of open financial services.

05 Risks of decentralized finance

While DeFi’s ability to incentivize the rapid adoption and decentralization of its tokens has grown into overdrive, it’s not without risks and unintended consequences.

Some of the risks to consider with yield farms and DeFi in general include potential hacks, liquidation of loans, unpegging of stablecoins (often used as collateral) and devaluation of tokens received as rewards.

secondary title

06 General Risks

Readers may have heard of recent hacking incidents in the DeFi field, such as the dForce attack, where hackers used smart contract vulnerabilities to steal $25 million and then returned most of the stolen assets.

Recently, a hacker attacked the automated market maker platform Balancer, using flash loans to drain the liquidity of the deflationary token STA, manipulating its price and exchanging it for $500,000 worth of other tokens.

A silver lining emerging from this threat is the rise of decentralized insurance protocols, such as Nexus Mutual, that protect users from the risk of smart contract failure."Currency Lego"Further magnifying the risk of hacking is the composability of DeFi.

The permissionless nature of DeFi facilitates the process of integrating with other protocols, enabling what is known as

Currency Lego

interoperability.

While this composability facilitates the construction of spaces, it can also lead to instability of the entire system if one of the components is damaged.

MakerDAO’s decentralized dollar-pegged stablecoin DAI serves as the key infrastructure for these money building blocks.

For example, lending protocols allow users to earn and borrow DAI. If a hacker discovers a vulnerability in the DAI smart contract, users of these lending protocols risk losing their funds, potentially causing a systemic failure.

Associated with this risk is the uncoupling and liquidation of stablecoins.

As readers may know, most stablecoins are pegged 1:1 to a fiat currency, usually the U.S. dollar. While DAI within DeFi apps has grown, the most traded stablecoin remains Tether, which is centrally managed by the team behind BitFinex.

For example, if you take out a loan using a stablecoin as collateral and its peg falls below $1, the loan could become undercollateralized, leading to liquidation.

Conversely, if you are borrowing a stablecoin that is pegged to more than $1 in value, that debt could cause you to pay more interest than expected, and could end up being held if it exceeds the amount held as collateral. liquidation.

This risk has been brought to the attention of many recently, as the amount of DAI (cDAI) in compound coins appears to have surpassed the total amount of DAI in circulation.

secondary title"07 The Dark Side of Yield Farms"The market capitalization of cDAI is currently more than 8 times that of its related DAI. This is an unintended consequence of yield farming in Compound. Since yield farms are currently rewarded in high-value COMP tokens based on the amount of liquidity provided, users have an incentive to provide as much liquidity as possible.

In general, liquidity strengthens the financial system and is seen as a prerequisite for adoption. However, yield farms create a perverse incentive to provide liquidity at all costs, which leads users to

Recycle

their DAI to take advantage of this scheme.

Essentially, users deposit DAI into Compound to earn interest plus COMP tokens, and then they use this DAI to over-collateralize loans to borrow more DAI, which is re-deposited as collateral, thereby analogy.

While this process cannot be performed directly within Compound, several users have been exploiting this vulnerability to transfer DAI to other DeFi protocols such as InstaDapp. A simplified diagram of this process is shown below.

This process is extremely risky as it artificially inflates the amount of DAI in Compound. While loans were initially issued over-collateralized, by re-depositing the loan amount as collateral to borrow more money, the actual collateralization rate dropped dramatically; leading the community to worry that the equivalent of some Reserve Banking.

In this case, Compound users appear to be overleveraged, putting the protocol at risk with many users attempting to withdraw DAI at once.

To examine how far this has come, one need only consider the fact that in the less than a month since COMP launched, the DAI locked in InstaDapp has increased more than 285-fold — from $350,000 to over $100 million.

Since multiple DeFi protocols use DAI, they would be vulnerable to a severe decoupling of DAI from the U.S. dollar. At the time of writing, DAI is valued at $1.02, and while the gap may not be that great at the moment, the artificial recycling of DAI in Compound is probably the most relevant near-term risk facing the DeFi space."the farmer"Overcoming this challenge, realigning incentives, and mitigating the risk of overleveraging may be the biggest test of decentralized governance since TheDAO hack.

Finally, just like in farming, there is the risk of a bad harvest. As yield farms kickstart this new era of crypto farming,

Rely on high-quality products to profit from their efforts.

In other words, if the value of tokens earned through these incentive systems drops significantly, users may start to opt out of providing liquidity to the protocol.

Additionally, if the prices of these tokens suddenly and sharply drop, it could cause a liquidity shock, which would further exacerbate the protocol’s problems.

secondary title

08 Final Thoughts

In general, there is no lack of innovation in the DeFi field, nor is there a lack of risk.

Leading DeFi protocols have successfully managed to create multi-stakeholder incentive systems that perhaps we have never seen before. Leveraging the transparency of the blockchain, these projects can improve each other permissionlessly, accelerating the pace of innovation.

While the recent frenzy over DeFi tokens may remind some of the ICO boom of 2017, it’s important to note that these protocols have actually provided their users with products that have already created value through permissionless access to financial services.

Another difference is that ICO teams generally control most of the token supply, while DeFi protocols actively seek decentralized governance; reducing the risk of relying on the founders, such as using the project as an exit scam.