Briefly describe the importance, subdivision types and challenges of DeFi
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Main points of this article
Chain News ChainNews (ID: chainnewscom)
, Written by Liu Nanxun, Senior Research Analyst at Crypto.com, published with permission.
Main points of this article
Decentralized finance (ie DeFi) refers to financial services built on public blockchains and smart contracts (the most common is Ethereum), including lending, exchanges, investments, stable coins, etc.;
The main advantage of DeFi is that financial services become trustless, censorship resistant, permissionless and open source. In theory, DeFi can make platforms safer, more resistant to manipulation, accessible to anyone, and transparent;
Although most DeFi protocols have achieved a high degree of architectural decentralization, it is difficult to achieve complete political decentralization. As a result, most protocols are still partly managed centrally by the main developer team or foundation;
The most popular use of DeFi is lending, which allows users to spend their cryptocurrencies to earn interest;The main disadvantage of DeFi is smart contract risk, through which attackers can exploit vulnerabilities in smart contracts to steal user funds. However, we believe that any attack presents an opportunity for DeFi to refine and improve security;first level title
Introduction
What is DeFi
Introduction
What is DeFi
Decentralized finance (DeFi) refers to financial services built on public blockchains and smart contracts, where the right to use and control the system is distributed among many different parties. This area has taken off quickly and is one of the main use cases for Ethereum. Similar to how Bitcoin established the first decentralized currency, DeFi participants are trying to establish a decentralized and trustless financial system, providing services such as lending, exchanges, investments, stable coins, etc. This system can not only For cryptocurrencies, and potentially for all financial assets.
DeFi has spread widely since last year and has developed rapidly. As of today, more than $700 million worth of Ethereum has been locked in DeFi applications.
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In the cryptocurrency industry, centralized exchanges have become the primary way people access products and services. Users must first complete the account opening process and provide their personal information. In addition, they must also hold assets in custody with the exchange. If the exchange has a security breach and loses assets, users have little recourse.
What is DeFi
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What is DeFi
In the above, we have briefly introduced DeFi and the significance of its existence. We will now explain the core principles that make DeFi attractive and the types of services DeFi offers.
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Types of Decentralization
Before exploring why decentralization is so important, we must first introduce two main types of decentralization: 1) architectural decentralization; 2) political decentralization.
Architecture decentralization
Architecture decentralization refers to the number of physical nodes participating in the system operation. In short, the Bitcoin network is decentralized due to the many different nodes working independently to verify transactions. Nodes also monitor each other to ensure no collusion is taking place. This is important because DeFi runs on public decentralized blockchains like Ethereum. We believe architectural decentralization is the defining hallmark of a DeFi protocol.
While political decentralization is a desirable feature, in practice it is difficult to fully achieve because it requires developers to first implement the system and then hand over its governance and maintenance to developers who may not fully understand how the system works, or lack ownership of building it and stakeholder groups with technical expertise such as maintaining the code. Therefore, there are very few DeFi protocols that have achieved full political decentralization today.article。
degree of decentralization
To learn more about the concept of decentralization, feel free to read this article by Vitalik Buterin
article
degree of decentralization
Decentralization is related to the above general types in many other ways. These aspects involve:
price oracles;
to develop
governance;
to develop
It is worth noting that decentralization is not black and white. Instead, it exists on a spectrum, from fully centralized to fully decentralized, with most protocols and products falling somewhere in between.
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The Importance of Decentralization
Why is it so important for DeFi to create financial services where their usage and control are decentralized? We will cover all the advantages related to DeFi.
Since financial services essentially deal with users' money, trust and security are important to the sustainability of these systems. Once trust is lost, it is difficult to regain, whether guaranteed or not, and could lead to the collapse of the entire financial system.
anti-censorship
History is replete with examples of this – hyperinflation and recessions caused by failed monetary regimes in Venezuela, Argentina and Zimbabwe, or bank runs in Greece due to economic mismanagement. Trust in centralized cryptocurrency systems is just as important: users must trust centralized exchanges that keep their funds safe, and Tether (USDT) users must trust that each USDT is actually backed by U.S. dollars. Given the poor track record of centralized systems, it's natural to wonder if there are better systems out there.
DeFi came into being. In DeFi, assets are hosted in smart contracts on the blockchain and cannot be withdrawn unless certain conditions are met. Additionally, DeFi protocols are able to incentivize stakeholders to behave in a way that benefits the system, completely removing trust from the equation.
anti-censorship
Censorship resistance refers to how easy it is to tamper with a system for any reason, be it financial or political. Since the operation and control of ideal DeFi systems are decentralized, they are more resistant to censorship than their centralized counterparts.
Centralized systems are vulnerable to interference, manipulation, or shutdown by external interested parties. For example, governments can shut down exchanges’ centralized servers, preventing them from serving users or functioning at all. Likewise, owners of exchanges can manipulate internal mechanisms to their own benefit, leaving users unaware.
An ideal DeFi system would reduce the likelihood of these censorships by distributing architecture and distributing governance. Since DeFi protocols run on public blockchains like Ethereum, the only way to stop them is to shut down the Ethereum network. This task is much more difficult than shutting down individual exchanges. Similarly, decentralized governance capabilities make it difficult for any party to gain control over a DeFi protocol and tamper with its operations.
Due to this characteristic, DeFi systems are inherently more secure and tamper-resistant than their centralized counterparts.
Permissionless and Borderless
DeFi protocols are almost without exception permissionless – anyone can participate in their governance or usage. Since no personal information is required, it is difficult for regulators to forcibly prevent them from operating.
This makes DeFi services more accessible than centralized financial services, which require potential users to go through various vetting before gaining access.
Of course, this begs a natural question about the exploitation of DeFi by criminals and money launderers, and what regulators will do to deal with it. We will explore the topic of regulatory risk in the Analysis section.
One of the core philosophies of DeFi is that everything should be open source. This includes several reasons:
First, open source code can be audited to test for security flaws that could put user funds at risk. Second, it allows anyone to explain how the system works, letting the user base know what to expect on a consistent basis without arbitrary and hidden changes. Finally, it can prompt the community to recreate (“fork”) the protocol when the original protocol is compromised (or simply someone comes up with a better version of the protocol).
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stable currency
DeFi Subcategories
Almost every financial service you can possibly think of has a DeFi counterpart. We'll cover the most prominent categories below. Note that some of the examples we give below are not fully decentralized, and we strongly recommend that you investigate further on your own or read our DeFi report before trying it out!
A common medium of exchange and unit of account is critical to any well-functioning financial ecosystem. DeFi is no exception, but the often volatile nature of the most widely used cryptocurrencies makes them unsuitable as trading vehicles. Hence, stablecoins were invented as cryptocurrencies that maintain a constant value.
borrow money
The most famous stablecoin is the fiat-backed Tether (USDT), which promises a 1:1 exchange rate between USDT and USD, since each USDT is theoretically backed by $1. Obviously, this requires users to trust that Tether is hosted in USD. But in the past, people have doubted whether Tether is actually fully backed by the U.S. dollar, leading to unexpected fluctuations in the value of USDT.
The Dai stablecoin (DAI) was created by MakerDAO to eliminate the need for escrow. Each DAI is backed by at least 150% of its cryptocurrency value and is the only widely used trustless non-custodial stablecoin in the market today. This makes it a mainstay of the DeFi landscape, often used as a fundamental building block in other DeFi protocols.
borrow money
Lending platforms are perhaps the most fundamental of all financial services and the most common use case for DeFi today. These protocols aim to replace financial intermediaries such as centralized exchanges and banks by using smart contracts to build peer-to-peer lending platforms.
Since this system is created based on the blockchain, anyone with an Ethereum address can obtain credit without going through cumbersome account opening or credit review processes. Borrowed funds can also be transferred anywhere as the funds are credited directly to the user’s wallet, unlike centralized exchanges where margin loans must remain in the exchange’s systems.hereplease at
exchange
here
Read our report on Maker and Compound.
exchange
Unlike centralized exchanges, decentralized exchanges (DEXs) execute trades in a peer-to-peer manner by using smart contracts. In this way, users do not need to rely on third parties to conduct transactions, thus saving part of the fees paid to exchanges. Plus, there are no account opening processes or withdrawal fees. Unlike centralized exchanges, these DEXs face no service interruption as long as the Ethereum network is functioning normally.
Note that decentralized exchanges use two exchange models: an order book and a token swap model.
Order book DEX example:
You can findhereYou can find
asset Management
here
asset Management
Derivatives
Traditionally, if you wanted someone to manage and invest on your behalf, you would need to relinquish custody of the assets. Frauds and Ponzi schemes caused by third-party asset management are emerging one after another, and DeFi solutions naturally emerge as the times require. These protocols allow users to allocate assets to different trading strategies in a non-custodial and trustless manner.
Examples of DeFi asset management:
Derivatives
Derivatives are designed to replicate the actual holding of an asset without actually performing the operation, or to simulate a different way of investing in the underlying asset (i.e. derivatives that provide short or leveraged exposure).
In traditional finance, there are derivatives of stocks and bonds. Similarly, in the crypto industry, centralized exchanges offer Bitcoin futures, options, etc. In the DeFi space, the Synthetix platform allows users to issue and trade synthetic assets in a trustless manner, which simulate the value of cryptocurrencies and real assets such as fiat currencies and gold.
non-custodial wallet
Regardless of the technical level of the product, if an easy-to-use user interface does not exist, the product will be difficult to adopt at scale.
Due to the relative complexity of the DeFi protocol and the complexity of the interface to be matched, DeFi is still only used by a minority. For example, look at the curve.fi main interface below, which is difficult for all but hardcore DeFi veterans to use:
Therefore, the missing link is a user-friendly non-custodial wallet (NCW). NCW can provide users with the following advantages:
Smooth user experience;
other
Facilitate interoperability between DeFi protocols
NCW example:
other
Currently, DeFi solutions are being developed for many other markets, such as prediction markets, insurance, and DeFi infrastructure. For example, Nexus Mutual is a decentralized insurance platform that allows users to buy and sell insurance against DeFi risks. In prediction markets, Augur is gaining popularity as a betting platform. Additionally, there are protocols that contribute to the overall growth of DeFi; for example, 0x is a relayer protocol that supports decentralized exchanges.
All of the aforementioned DeFi protocols are based on Ethereum. However, DeFi is not necessarily built on Ethereum. As long as they are decentralized and related to finance, we can classify them as DeFi.
analyze
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analyze
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Smart Contract Risk
Disadvantages of DeFi
As mentioned above, DeFi has the potential to completely revolutionize existing financial services as we perceive them, and bring many benefits that make cryptocurrencies more attractive. But what are the downsides of DeFi and why is it not being more widely utilized? We will go through the main drawbacks of DeFi one by one.
Smart Contract Risk
Perhaps the biggest disadvantage of DeFi is the introduction of smart contract risk. As an alternative to centralized hosting and servers, users of DeFi must trust that the smart contracts upon which the protocol is based do not have any vulnerabilities that could put user assets at risk.
Recently, the most prominent type of abuse and attack against DeFi has been the manipulation of assets in protocols seeking external pricing (i.e. price oracles).
This happened twice on DeFi lending platform bZx in February 2020, when one or more attackers twice manipulated the price given by the collateral’s oracle. This allowed the attackers to borrow significantly more money than they should have been able to, costing bZx lenders a total of nearly $1 million.
A similar vulnerability was exposed by Synthetix in 2019, when traders on the Synthetix platform were able to exploit a bug in the Korean won price feed to realize a $1 billion profit in less than an hour. Fortunately, the trader agreed to forfeit his profits in exchange for bug reporting rewards, since he couldn't cash out his profits.
Most notorious, though, was the 2016 attack on one of the original DeFi protocols, the DAO (Decentralized Autonomous Organization). The attackers consumed over 3.6 million ether (worth $72 million at the time) from the DAO's smart contracts. The Ethereum community agreed to return funds to DAO investors through a "hard fork" of the network, which is now split between Ethereum (ETH) and Ethereum Classic (ETC).
Critics point out that the reason for the hack is that DeFi is inferior to centralized exchanges. Each attack generates a flood of articles and debates about DeFi’s fatal flaws, and central intervention is always required to counteract the damage caused by the attack.
Limited by blockchain speed
regulatory risk
If you've ever tried to use a DeFi app, you've probably noticed a noticeable delay between transaction requests and confirmations. This is because every transaction and interaction is confirmed by the Ethereum network, which can take anywhere from a few seconds to ten minutes, depending on network congestion. For users who prioritize speed and determinism, these types of delays can be deal-breakers.
However, ETH 2.0, expected to be released in July 2020, is expected to increase throughput and confirmation speed (see our University article for more information), and dApps are expected to greatly increase the speed.
regulatory risk
DeFi operates in an area that has traditionally been under the spotlight of governments and regulators around the world looking to protect unsuspecting users from fraudulent and dangerous products.
Judging by the current trend towards stricter know-your-customer (KYC) regulation and other compliance requirements, we suspect that as DeFi grows in size, it will be brought under the purview of global regulators. As a result, DeFi may end up using decentralized identity and address checking services to discourage some users from using them, thereby gaining at least partial permission.
Statistical data
This is obviously not a good outcome for users who wish to remain anonymous, but, on the other hand, it could mean greater adoption of DeFi by large financial institutions and the general public.
Since 2017, the DeFi space has developed rapidly, and the number of Ether locked in DeFi applications has grown from 5,000 in late 2017 to 2.8 million in April 2020.
in conclusion
We can see two examples of massive asset outflows from DeFi. The first occurred after the Synthetix oracle vulnerability was exploited in mid-2019. The second time occurred in February 2020 after bZx was attacked.
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All in all, DeFi offers a new way of conducting financial transactions and may herald a new era of development for the cryptocurrency industry. Eventually, we could even see DeFi principles applied to traditional financial markets as more central banks create programmable digital currencies. We are excited to see where DeFi takes us as it develops and matures.
References
Biggs, J. (2019). Synthetix Trader Rolls Back Broken Trades That Netted $1 Billion Profit. Coindesk
Buterin, V. (2017). The Meaning of Decentralization. Medium
Facts, C. (2020). "Ethereum 2.0" Explained
Falkon, S. (2017). The Story of the DAO — Its History and Consequences
Foxley, W. (n.d.). Everything You Ever Wanted to Know About the DeFi ‘Flash Loan’ Attack. Coindesk
Trustology, C. (2019). Enabling cost-effective, compliant access to decentralized finance (DeFi)
