DeFi All Beings: Looking at the industry trend from the 2008 US subprime mortgage crisis, technology and design structure

Editor's Note: This article comes fromPlatON（ID：PlatON_network）Editor's Note: This article comes from

, Author: PlatON CTO Qu Junjie, reprinted by Odaily with authorization.

DeFi has ushered in a "small explosion" in the industry in the short term. The scale from hundreds of millions of dollars to billions of dollars has achieved exponential growth.

There is no obvious difference between the structure of DeFi and traditional finance. If the Ethereum public chain is compared to the central bank that issues currency, and the commercial bank that issues various currencies in the form of ERC-20, DeFi is the central bank currency and various other currencies. type of financial services. Such as banks, asset management, securities companies, exchanges, insurance, etc.

Based on the characteristics of public chain transactions, permissionless, non-custodial, low threshold, and encouraging innovation, DeFi has achieved a certain degree of "inclusive" finance. In other words, all asset holders can participate, and the products are rich and varied with strong choices.

Some innovative products even allow participation without asset pledges, such as Flashloan, which is atomized based on smart contracts. At the same time, the bubble will also trigger the vampire attacks encountered by Uniswap. For example, Sushiswap uses the LP Token pledged by Uniswap to mine liquidity. But the bubble that nurtures innovation is ultimately a healthy bubble, and we should embrace it with all our strength and discern the pearls under the light and shadow of colorful bubbles.

This article will focus on the current DeFi projects and industry trends from several perspectives, and strive to provide you with diverse thinking.

The "culprit" of subprime mortgages - the design logic of MBS/CDO/Synthetic CDO

MBS is the earliest asset securitization product. It was first produced in the United States in the 1960s. It is an asset securitization product mainly issued by American housing professional banks and savings institutions using their mortgage loans. Its basic structure is to collect loans that meet certain conditions in the housing mortgage loans lent to form a pool of mortgage loans, and use the cash inflow of principal and interest that occurs regularly in the pool of loans to issue securities, and The security is guaranteed by a government agency or a government-affiliated financial institution.

In traditional fixed-income structured products, risk and return can be achieved through transaction structure design. The higher the Tranche (supporting mortgage bonds), the later it will suffer from the default loss of the underlying asset pool, the lower the risk, the lower the return, and the lower the Tranche The sooner Tranche suffers the default loss of the underlying asset pool, the higher the risk and the higher the return, as shown in the figure below:

The picture comes from the Internet

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The picture comes from the Internet

The figure above shows how this type of structured debt product develops from MBS (the asset pool is housing mortgage loans), and then some tranches of MBS (Senior or Equity can be used) enter the asset pool of CDO to form a transaction structure again, and then develop From Synthetic CDO (CDO's Tranche is packaged again), the entire ecology has formed a very strong leverage effect.

The first layer of MBS has the practical significance of this structured product, and it still exists in the market, while CDO and Synthetic CDO are created leveraged gambling tools, which have disappeared from the market.

The essence of DeFi - debt contract and equity contract: the same risk as the subprime mortgage crisis

As a decentralized protocol, DeFi is essentially a combination of debt contracts and equity contracts.

The blockchain is a trustless environment. The address is anonymous in nature, and there is no necessary connection with the identity and reputation mechanism outside the blockchain. The credit risk assessment methods of mainstream finance are invalid. Credit risk management in DeFi , is highly dependent on over-collateralization (Over-collateralization), whether it is MakerDAO or Compound.

If we regard each DeFi project as a structured product, then designing the protocol is designing the transaction structure of a structured product, and the main function of the platform currency is to adjust the core of this structured product through community-based methods parameter, or become an equity certificate to obtain future cash flow.

The basis for realizing the value of the debt contract is over-collateralization, and the loan interest rate reflects the market risk (opportunity cost) and default risk of the collateral project. Currency rate:

image description

The picture comes from the Internet

We have seen that the asset pool of Compound is still assets with relatively low credit risk and market risk DAI, ETH, USDC, USDT, ZRX, and BAT. Even so, due to the leverage characteristics of structured products, COMP tokens are in the market The characteristics of performance will also be leveraged, that is, if the underlying asset ETH rises by 5%, COMP may rise by 12%, while ETH falls by 5%, COMP may fall by 14%. The market performance on September 2 is shown in the figure below

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The picture comes from the Internet

What will happen if we re-mortgage the bottom-level equity tranche platform tokens in similar structured products of DeFi projects as assets? Is it very similar to Synthetic CDO?

But just like the situation encountered in the subprime mortgage crisis, leveraged products such as the basic asset BTC and ETH prices will be very popular during the rising cycle, but once it comes to the falling cycle, there will be great risks.

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Looking at DeFi from the perspective of basic technical capabilities

Different from traditional financial infrastructure and financial products, DeFi utilizes blockchain technology and is based on tokenized assets to achieve equal, efficient, highly transparent, and highly credible financial services. Thanks to the application of smart contracts, DeFi contracts are automatically executed, so they are highly equal and credible.

It is precisely because of the use of blockchain technology that DeFi risk events occur frequently, which are greatly restricted by the underlying platform technology. Blockchain technology currently seems to be immature, and it is still under exploration in the field of financial applications. Many security incidents It also reflects "dependence" on blockchain technology, DeFi is also restricted by the performance and security of the underlying infrastructure, and the basic technical capabilities still need to be consolidated.

Therefore, among the many DeFi projects in the market, how to build a basic technology matrix is ​​the primary consideration of the DeFi team. In addition to core functions such as consensus and governance of the public chain, ecological support for DeFi also requires the following capabilities.

First, asset (Token) issuance technical capabilities (such as: ERC-20 method) asset cross-chain import technical capabilities (such as: notary mechanism, side chain/relay mechanism, hash lock, support for WalletConnect protocol, etc., and actively import MPC application scenario);

The third is the ecological entrance (wallet, website front-end and back-end, etc.); the fourth is the construction of ORACLE oracles and the access of external ORACLE oracles.

The "full body" of DeFi - the "three-stage" evolution under the blessing of technology

With the improvement of basic technical capabilities, the evolution process of DeFi can be divided into three stages:

The first stage provides basic Lego modules, Token issuance categories, including asset creation, asset cross-chain import, stable currency issuance, liquidity mining, etc. (for example: PlatON LAT, USDT, USDC, ETH, BTC, KeyShard threshold signature import asset management) ; Borrowing pledge payment (basic commercial banking services) (Note: Simple CDP engine enters Token lending, pledge, re-pledge, etc.); supports basic DeFi protocol standards, and ecological categories (such as: Uniswap, etc.).

The third stage is ecological improvement, including: the entry of DeFi insurance as a risk hedge, the wide application of reliable and credible information data aggregation services (the foundation of ORACLE), credit management services based on distributed digital identities, etc.

Let’s look at the design considerations of the project from the classic products of transaction and loan respectively.

In 2020, with the explosion of the DeFi concept, the overall transaction volume of DEX and the number of daily active users on each platform will increase significantly. And the market competition is becoming more and more fierce, IDEX's user popularity (number of daily active users) will drop again in 2020. The emerging projects Uniswap and Kyber in 2019 will catch up with the old projects in user popularity in 2020.

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Number of active users from 2018 to 2020 | TokenInsight

Constant function market makers can be divided into four types from the mechanism (formula) behind them: constant product market makers, constant total market makers, constant average return market makers, and hybrid constant function market makers. Curve, Uniswap V2, and Balancer are typical representatives of constant function market makers, and their basic information is shown in the table below.

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Uniswap (launched V1 in November 2018) performed even better and has become the leader among DEXs. The Uniswap V2 launched by the project team in May this year has attracted attention as soon as it was launched, and its trading volume ranked first in the DEX industry in June. The market performance comparison of the two in the first half of 2020 is shown in the table on the left. The overall performance of V1 in the first half of the year was high and low, and V2’s performance in June was strong.

Uniswap V1&V2 | TokenInsight

The biggest difference between Uniswap V1 and V2 is that all the liquidity pool Tokens of V1 rely on ETH links, and the exchange between different Tokens needs to be exchanged for ETH in advance; while V2 is upgraded to directly realize the exchange between different ERC20 Tokens. exchange. But both have the same limitation, that is, there is a fixed ratio between Tokens in the liquidity pool, 50%:50%.

Uniswap V2

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Liquidity: Core AMM formula: X*Y=K Assume that the liquidity of ERC-20 trading pair tokenA/tokenB is X and Y respectively. The trading pair of Uniswap V2 can be composed of any two ERC-20 tokens.

One advantage of this is that it can reduce the slippage of the exchange rate, because each transaction pair will charge a certain fee as the exchange fee, and the exchange through two transaction pairs will cost twice as much. V2's support for ERC-20/ER-C20 trading pairs makes it no longer necessary to exchange DAI to USDC with two trading pairs, reducing the cost by half, and the exchange rate slippage will be lower.

In order to realize the exchange from A to D, it can be completed by exchanging A to B, B to C, and C to D. The current routing protocol in the code is version 01, and the path needs to be calculated off-chain and submitted to the routing protocol for processing.

ORACLE

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The improvement of Uniswap V2 is that the history saves the price on the chain and adds time weight. Its storage method is to save a cumulative price on the chain, and by using the difference and time difference between the two cumulative prices, an average price with time weight can be calculated.

With the cumulative price, the time-weighted average price TWAP (Tx, Ty) in a certain period of time can be obtained by dividing the cumulative price by the time.

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Why is Uniswap popular in the DeFi ecosystem?

Uniswap has the following characteristics: 1. Uniswap V2 directly realizes the exchange between different ERC20 Tokens; 2. Free token issuance realizes the work completed by ICO; Very important)

DeFi lending fluctuated drastically in the first half of 2020. After experiencing the extreme market of 3.12, the total lock-up value of DeFi has shrunk from 880 million US dollars to 550 million US dollars in one day, a drop of more than 37%. In June, the total lock-up value of DeFi continued to rise and exceeded US$1.6 billion, of which the lending platform Compound locked in a value of US$486 million, surpassing Maker's US$419 million, and took the top spot in the DeFi protocol.

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DeFi lending ecology | TokenInsight

In the first half of 2020, the DeFi lending market currently accounts for 70%-80% of the total locked positions, and lending projects are still the main force in the DeFi market.

Proportion of DeFi loans | TokenInsight

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Compound and Liquidity Mining

The figure below shows the supply and loan amount of the top 30 active addresses on Compound from February to July 10, 2020. It can be seen from the figure that the scale of loan funds on the Compound platform has been relatively flat from February to May; after the launch of liquidity mining in June, the scale of its funds has grown exponentially.

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Supply and loan amount of Compound Top30 active addresses from February to July | TokenInsight&Dappradar

Dappradar data shows that in June, the top 30 active addresses accounted for 71.11% of deposits and 54.19% of loans; as of July 10, the top 30 addresses on the Compound platform accounted for 54.01% of deposits and 67.27% of loans %. In other words, more than half of the COMP mining rewards are exclusive to "big users".

High-yield arbitrage opportunities have even attracted the participation of centralized lending platforms. According to DeBank data, after the start of the incentive activity on the 15th, the centralized platform NEXO deposited a total of about 60 million USDT funds into Compound for mining arbitrage. However, based on the rate of return at the time of deposit, its annualized rate of return can reach 55.36%, while the interest rate of investors depositing USDT on NEXO is only 10%.

The core of Compound’s liquidity mining is that as long as users provide liquidity to the Compound fund pool, they can get COMP as a reward. However, for investors, the liquidity mining of DeFi projects still faces risks such as smart contract security risks, platform risks (team management keys), exchange rate risks, increased asset liquidation risks due to leveraged transactions, and unstable returns due to liquidity crunch in the later stage and other risks.

Role division: asset holder, receiver, user, liquidator, platform side (loan spread interest, Comp currency price, liquidation income), ORACEL price service, definition of excess mortgage rate, definition of liquidation boundary. Comp token holders participate in governance. Such as managing lending rates.

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Thinking about the DeFi position of the public chain

The new generation of public chains may build a data transaction market with a scale of more than one trillion US dollars in the future. Token will undertake the important task of data transaction circulation market clearing and settlement tool. This is an important scenario as the future financial infrastructure.