Decentralised Finance (DeFi) – Crypto as a New Financial Ecosystem

We introduce the basics of this new financial system and three notable projects you can trade on and invest in.

Jan 09, 2022

Cryptocurrency has evolved into much more than just a new version of digital cash or payments. Cryptocurrency (crypto) is a new financial ecosystem built using blockchain’s globally accessible, censorship-resistant, non-haltable and autonomous platform. Here we introduce the basics of this new financial system and three notable projects you can trade on and invest in.

Introduction to Decentralised Finance (DeFi)

DeFi is an abbreviation of ‘decentralised finance.’ Defi is decentralised financial software often built on top of a blockchain (predominantly on Ethereum).

DeFi enables decentralised autonomous financial services to be provided to its users without going through centralised third parties. For example, imagine some people who wish to lend their excess capital out and people who wish to borrow money to fund their business. Traditionally, banks will be the centralised intermediaries who decide both the borrowing and lending rates and hold the final decision on whether to offer the contract or not. Whereas in DeFi, the lender and borrower will only need to interact with a smart contract where the lending/borrowing rules are preset based on some algorithm. Therefore, the system is completely decentralised and autonomous, working 24×7 continuously and without any central party that can intervene or halt the transactions.

Bitcoin can be considered the first ‘DeFi application,’ but its functionality is limited to payment because it lacks smart contracts that can enforce rules to be executed across time. As Ethereum became popular, smart contracts enabled the birth of Decentralised Applications (DApps) and eventually Decentralised Finance (DeFi). In this regard, DeFi can be considered as DApps that are specified for financial applications.

However, DeFi is more complicated than normal DApps. The economics underneath must be carefully designed to ensure that the system is safe and participants are properly incentivised to use the platform.

Notably, the concept of liquidity pool is emerging quickly in DeFi, which is something that doesn’t exist in traditional finance. Since DeFi is an autonomous system that allows users to join freely, the system can pair up customers automatically based on pooled demand and supply. For example, the system can automatically determine the lending and borrowing rate based on the total supplied capital and total demanded loans, while such a design is not possible in the traditional financial system.

Although the majority of high profile DeFi projects are on Ethereum nowadays, readers should note that projects like Trust Wallet, Lightning network, or even Tether can also be classified as DeFi as long as they are decentralised and finance related.

Most traditional finance areas can have their DeFi counterparts, for example:

  • Asset exchanges
  • Money market
  • Asset management
  • Insurance

And there are even more projects possible. In the remaining section of our article, we will introduce three popular DeFi projects:

  • Uniswap
  • MakerDAO
  • Compound

These projects are among the most popular and therefore are good examples for illustration purposes. We hope that through the introduction of these projects, you’ll get a better idea of what DeFi is about.

Uniswap

Overview

Platform: Ethereum

Written in: Vyper

Token: No

Founder: Hayden Adams

Category: decentralised Token Swapper

Website: https://uniswap.io/

What is Uniswap?

Uniswap is an Ethereum-based token swapping protocol. It allows decentralised token swapping (i.e. exchange) without a centralized service provider and order book matching mechanism.

Uniswap facilitates automated transactions between cryptocurrency tokens on the Ethereum blockchain through the use of smart contracts. It pools liquidity from liquidity providers who supply the system with tokens for a proportional share of transaction fees. The mechanism is called ‘automated market maker.’

The initial idea was published on Reddit in October 2016. In 2017, Hayden Adams started to implement the idea, and the Ethereum Foundation granted the project 100K USD in August 2018, later Uniswap was officially launched in November 2018

The key idea behind Uniswap is Automated Market Maker (AMM). AMM quotes prices to the end-user according to some predetermined set of rules.

There can be many variants of AMM. The one that Uniswap uses is called the ‘Constant Product Market Maker Model.’

A way to look at the equation is via the relationship k = xy

If we increase the token spent for the swapping (i.e. ↑ Δy) , we need to Δx asymptotically to keep the product constant = k.

In Uniswap, users can freely exchange Ether to other ERC20 tokens (or vice versa), or even from ERC20 to ERC20.

Since Uniswap removed the order book, it is relying on pooled liquidity. Uniswap allows users to provide liquidity to earn fees, the fees are generated from charging swap users 0.3% per transaction.

MakerDAO

Overview

Platform: Ethereum

Written in: JavaScript, Python, Solidity

Token: Yes (DAI & MKR)

Founder: Rune Christensen

Category: decentralised Stablecoin

Website: https://makerdao.com/en/

What is MakerDAO?

MakerDAO creates DAI, which is the first non-fiat-backed stable coin.

Maker is a smart contract platform on Ethereum that backs and stabilizes the value of Dai through a dynamic system of Collateralized Debt Positions (CDPs), autonomous feedback mechanisms, and appropriately incentivized external actors.

MakerDAO was founded in 2014 by Rune Christensen, but the project was not publicly announced until 2015. An updated whitepaper and Mainnet were launched in December of 2017, followed by a private sale of USD 12M worth of MKR tokens lead by Polychain Capital and Andreessen Horowitz with participation from Distributed Capital Partners, Scanate, FBG Capital, Wyre Capital, Walden Bridge Capital, and 1confirmation.

In short, MKR is the governance token, and DAI is the stablecoin. DAI is generated via a leveraged loan, where users can deposit ETH as collateral and generate DAI as a loan.

MKR holders have voting rights to decide certain parameters in the protocol, such as the stability fees (which are similar to loan interest rate). MKR is also used as the buffer capital in extreme scenarios where the collateral’s price dropped significantly.

DAI’s price stability is achieved automatically by arbitrageurs’ activity when the price has deviated from USD $1. Due to the existence of collateral that is often excessively capitalized, the markets are generally confident about the stability of DAI’s price.

MakerDAO allows users to deposit ETH as collateral to generate stable coin DAI.

Users with MKR tokens have voting rights on deciding specific parameters in the protocol.

Compound

Overview

Platform: Compound

Written in: Solidity

Token: No

Founder: Robert Leshner, Geoffery Hayes

Category: decentralised Money Market

Website: https://compound.finance/

What is Compound?

Compound is a decentralised money market with an algorithmically determined interest rate.

Compound is a protocol on the Ethereum blockchain that establishes money markets, which are pools of assets with algorithmically derived interest rates based on the supply and demand for the asset. Suppliers (and borrowers) of an asset interact directly with the protocol, earning (and paying) a floating interest rate without having to negotiate terms such as maturity, interest rate, or collateral with a peer or counterparty.

Compound was announced with the blogpost ’Introducing Compound, the Money Market Protocol’ from Robert Leshner in January 2018. It has obtained its seed round funding of USD 8.2M led by a16z, Coinbase Venture, Bain Capital, Polychain, and more in May 2018. The whitepaper was released in June 2018.

At the heart of Compound, the protocol is its Automated Money Market consisting of lender and borrower. The interest rate is dynamically determined based on the supply and demand of lending and borrowing utilisation.

Rather than individual suppliers or borrowers having to negotiate over terms and rates, the Compound protocol utilizes an interest rate model that achieves an interest rate equilibrium, in each money market, based on supply and demand. Following economic theory, interest rates (the ‘price’ of money) should increase as a function of demand; when demand is low, interest rates should be low, and vice versa when demand is high. The utilisation ratio U for each market unifies supply and demand into a single variable:

Users can supply tokens (e.g. ETH) to earn interest. With supplied tokens as collateral, users can also borrow loans with ‘borrowing power’ granted.

Introduction to Decentralised Applications (DApps)

DApps stands for Decentralised Applications, usually – but not necessarily – run on a blockchain. The interface of a DApp should look no different from any website or mobile app we use nowadays. Still, the core logic of the backend utilises smart contracts or a P2P network instead of a Web API service.

DApps may run on top of existing public blockchains, for instance, EOS, TRON and Ethereum. The modification of data or information involves all the nodes on the blockchain network participating, and it is a distributed blockchain in nature. Not a single entity has the authority to delete or modify the status or the information once it’s posted on the network after running through the consensus mechanism.

Traditional apps that run on top of a centralised server model can be controlled completely by one authority or organisation. It can be manipulated or changed according to the organisation’s needs, putting our privacy or data rights at potential risk.

DApps are transparent and decentralised in nature. They often provide advantages like no single point of failure, censorship-resistant and autonomous.

DApps typically have the following characteristics:

Data and information are kept on a public and decentralised blockchain (or P2P network)

  • Usually involve cryptocurrencies
  • Open-source
  • Not controlled by a single centralised authority, the changes to be introduced in the app should be decided through the consensus of the system users
  • They have no central point of failure and cannot be shut down due to the absence of a centralised server

Here are some common examples of DApps:

How to invest in DeFi

Now that we’ve touched on all the bases of what decentralised finance is and how it’s shaping the future of the financial ecosystem, let’s take a look at how DeFi is reinventing the investment world. From ICO (initial coin offerings) to its security checks and balances, DeFi has the potential to reshape your investment strategy and part two of this DeFi article series explains the works behind it.

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