DeFi Overview
Author: @Pathfinder0x18D
⚠️Disclaimer: Not Financial Advice || Do Your Own Research!⚠️
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Throughout history, money is often molded to benefit autocratic regimes. But in light of recurrent issues like debasement and rising inflation – alternatives such as decentralized finance, or DeFi, have emerged as an effort to re-establish sovereignty and power to the everyday person. Decentralized Finance (DeFi)
is a revolutionary frontier of the blockchain industry. The financial products offered by the DeFi ecosystem, such as exchanges, loans, and insurance, have existed for thousands of years.
One of the core components of DeFi is known as ALGOCRATIC or ALGORITHMIC Governance. ALGO Governance is when rules and regulations are written into the software (code). In essence, its structure ensures that smart contracts function as intermediaries so that buyers, sellers, lenders, and borrowers may interact peer to peer without the need for centralized entities or institutions to mediate these very transactions.
Although decentralized finance is still in its nascent stages, the total value locked (TVL) in DeFi contracts is more than $200 billion as of November 2021. Ethereum commands more than 60% of the TVL , according to data from DeFi Llama. Although this data may appear significant, it is still notional as many DeFi tokens lack sufficient adoption, liquidity, and volume to trade in the web3 marketplace.
The History of DeFi
The concept and very term “DeFi” was birthed in 2018 between Ethereum developers and entrepreneurs.
Bitcoin was (and still is) considered to be the first DeFi application. With the genesis block created on January 3, 2009, Bitcoin established itself as the first peer-to-peer digital money that solved prevalent issues like double-spending and centralization that prevented prior efforts from being successful.
What is DeFi: Ethereum and DeFi
Although Bitcoin helped pave the foundations for an open and meritocratic financial system, the limitations of its programming language, Script, prevented a range of solutions that most central financial services and products are capable of offering to their clients such as lending, borrowing, and derivatives.
These limitations, however, helped provide an incentive for Ethereum, which launched in 2015. With a Turing-complete programming language known as Solidity and a flexible ERC-20 contract standard that allows for compatible tokens and applications, Ethereum provides developers with the freedom and flexibility to build on its protocol. In doing so, it functions as one of the first truly programmable versions of money.
Ethereum is often considered a foundation for DeFi for several reasons:
Non-custodial:
no singular entity or person owns Ethereum or its tapestry of smart contracts. This aspect helps give everyone an equal opportunity to use DeFi services on its protocol. It also means no singular person or entity can change the rules
A singular language:
As many DeFi products are built on the Ethereum network, all sharing a range of interoperability with the ERC20 token or similar token contracts, a seamless environment has been created to enable these products to work together.
Autonomous and open:
As Ethereum is open-source and based on a decentralized, autonomous system, it allows users to have complete financial freedom – most products will never take custody of your funds, leaving you (the end-user) in control.
Why is DeFi Important?
Outlined below are several key points to further demonstrate the necessity of DeFi relative to the problems in traditional systems:
Traditional Finance:
Not everyone is granted access to bank accounts or deemed eligible to use financial products and services in their respective nations.
Lacking access to these services can prevent people from job opportunities.
A bank or intermediary like PayPal can prevent its users from receiving or sending funds.
Most financial services often require a premium due to the intermediary institutions needing their commission and fees.
Decentralized Finance:
Allows for complete autonomy and independence — users control where and how to spend their money.
Fund transfers happen almost instantaneously — at the most within several minutes, pending on the nature of the network.
Transactions can be pseudonymous or anonymous.
The network and infrastructure are open to anyone.
Markets don’t close.
Created on a system of transparency where anyone with enough technical knowledge can audit or inspect a product’s data and how the system works.
Although the landscape of decentralized finance is growing on an exponential basis, we’ve elaborated on several of the more well known, credible platforms below
What Are the Components of DeFi?
Coupled with the more definitive aspects of DeFi such as it being non-custodial, open, transparent, and decentralized, here’s a list of the technical layers that make up the standard DeFi stack:
Settlement Layer (LAYER-1): Layer-1 (ETH, SOL, etc.) is considered the most essential DeFi component, the settlement layer serves as a foundation for the following three components by integrating a public blockchain with a native currency (coin).
Ether (ETH) with Ethereum, the currency or token is often a complementary feature of most decentralized apps (dApps) to help users earn passive income or interest through activities like staking (elaborated on below).
Asset Layer: The decentralized apps (dApps) often rely on assets issued on the blockchain which sit on the asset layer (layer 2). Fungible tokens (ERC-20 tokens) are popular assets issued on Ethereum’s asset layer, as these can be traded interchangeably with each other.
Protocol Layer: Above the Asset Layer sits the Protocol Layer, which is where the various smart contracts that enable DeFi to reside. Network protocols are rules designed to regulate actions like sending, receiving, and formatting data.
An array of DeFi protocols help contain the rules or guidelines that users have to follow (as per industry standards) and provide a level of cohesion that allows different entities or developers to collaborate
In a DeFi ecosystem, the protocol layer is essential for achieving sufficient and scalable liquidity.
These DeFi protocols have a myriad of use cases such as exchanges, lending, derivatives, stablecoins, asset management, and many more.
Application Layer: The application layer is viewed as the bridge between the end-users and the protocols, usually through a consumer-friendly application
The Application layer is often home to the most well-known web3 apps, including loan services (Aave) and decentralized exchanges (DEXes such as Uniswap and PancakeSwap).
Aggregation Layer: As the final layer, aggregators integrate a diverse combination of apps and resources from the prior layers to help further strengthen utility for end-users and streamline transactions between different financial instruments.
What is DeFi: Top DeFi Projects:
UNISWAP:
Founded on November 2, 2018, Uniswap is a decentralized finance protocol and exchange (DEX) created by Hayden Adams, a mechanical engineer from New York. The protocol facilitates automated transactions between cryptocurrency tokens on the Ethereum blockchain through the use of smart contracts. At this writing, Uniswap enables approximately $2 billion or more in daily crypto trading. Its governance tokens, UNI, have a market value of about $13 billion, according to CoinMarketCap.
⚠️Disclaimer: The Pathfinder P1 Crypto Invesment Fund does hold Curve ($CRV)⚠️
Curve is a decentralized exchange with a key difference being the type of assets traded. On Uniswap, users can trade any ERC-20 token that has enough liquidity. Curve, however, is specifically focused on trading Ethereum compatible Stablecoins. Some of the core advantages of Curve that have helped it gain critical acclaim as a popular automated market maker platform (AMM) include low slippage and fees.
Curve allows users to provide liquidity via stablecoins to the Curve pool, from which they can earn income from transaction fees.
Curve also helps to give a stronger sense of cohesion in the broader DeFi ecosystem by supplying pool tokens to the Compound protocol and Yearn.
*** If you are interested in more about CRV, we would encourage you to review the write-up @pathfinder0x18d did on CRV back in October 2021 ***
AAVE:
Founded by law student Stani Kulechov in 2017 (originally called ETHLend), Aave is a platform that lets users lend and borrow crypto tokens; users have injected roughly $14 billion worth of collateral for loans on the network, according to Defi Pulse.
MakerDAO:
Conceptualized in 2014 and later launched in 2017, MakerDAO is a lending and borrowing platform that uses Dai, a stablecoin linked to the US dollar. MakerDao has since become one of the largest decentralized applications on the Ethereum blockchain and the first DeFi application to gain widespread adoption. Over 400 apps and services have integrated the Stablecoins Dai, including wallets, DeFi platforms, games, and more. It is currently one of the most extensive DeFi protocols with $9.5 billion of system collateral, according to DeFi Pulse.
HOW TO USE DEFI
As mentioned above, in the world of DeFi, smart contracts replace the role of brokerages or financial institutions that mediate between two or more parties. A smart contract is a type of Ethereum account or program, that is designed to automatically execute, control, or document actions like holding, sending, or refunding funds based on the conditions of the code and context in which it is written.
In the context of DeFi, a contract can be designed to send a stipulated amount of money from Account A
to Account B
at periodic intervals. It will also only ever do this so long as Account A
has enough funds. As an example of its stronger security, the contract cannot be changed or altered to have alternative accounts, (i.e. Account C)
added as a recipient to steal the funds.
TL;DR for DEFI (but we encourage you to read the whole article)
Yield Farming
is a proven approach for investing your crypto assets in liquidity pools of protocols.
Staking
involves locking your crypto assets in the protocol in return for privileges to validate transactions on the protocol.
Liquidity Mining
involves locking in crypto assets in protocols in return for governance privileges in the protocol (LP tokens).
In terms of objectives…
Yield Farming
aims to offer you the highest possible returns on the crypto assets of users.
Liquidity Mining
focuses on improving the liquidity of a DeFi protocol.
Staking
emphasizes maintaining the security of a blockchain network.
What is DeFi Staking?
Commonly used as a way to generate passive income, DeFi staking refers to locking tokens or digital assets (like NFTs) through a smart contract for a set period of time. In doing so, the end-user can become a validator (someone who is responsible for verifying transactions) in their chosen DeFi protocol. The more validators a network has, the more it helps improve the security and functionality of the platform. As with traditional banking, each DeFi platform and network varies in the amount of interest it can provide relative to the duration and total amount of assets locked-up.
(EXAMPLE using Fantom (FTM))
To provide an example, a popular DeFi platform called Fantom has created a calculator that estimates the returns for potential stakers here: https://fantom.foundation/ftm-staking/
Staking: Proof of Stake 101
Aligned with the process of staking crypto assets is a consensus mechanism called Proof-of-Stake. Proof-of-Stake (PoS) was created as an alternative to Bitcoin’s energy and resource-intensive Proof-of-Work that requires large amounts of computational power, the Proof-of-Stake (PoS) concept operates based on selecting validators in proportion to their quantity of holdings in the associated cryptocurrency. As a core feature in the overarching Ethereum upgrade, the PoS system has been designed to increase speed and efficiency while also reducing the cost of fees on the network.
To briefly summarize some of the underlying components of Proof-of-Stake:
Staking is similar to mining, whereby a network participant is selected to add the most recent batch of transactions to the blockchain and earn rewards (commonly more of the same tokens or cryptocurrency) for doing so.
Stakers lock up their assets for a chance to add a new block of data to the blockchain and receive a reward.
Staked tokens help to guarantee the legitimacy of any new transaction added to the network.
The network chooses validators based on the size of their staked assets and the lock-up period. As an example, Ethereum users will need to stake 32 ETH to become a validator. This system (in theory) helps create a deeper level of commitment to the network as the most invested participants are rewarded. If transactions in a new block are found to be invalid, users can be penalized by having a certain amount of staked assets burned (destroyed).
What are the advantages of staking?
While viewed as a way to help contribute to a blockchain’s security and efficiency, many long-term investors view staking as a way to make their assets generate additional income rather than passively storing it in their wallets. Alongside providing additional tokens as a reward, some projects also distribute “governance tokens” to participants that have staked their assets. This gives stakers in the community a say in deciding the upgrades or future changes to the network.
What are some staking risks?
As staking often requires a specific lock-up or “vesting” period, users can’t withdraw or transfer their assets even if market conditions (which are inherently volatile) change.
What is DeFi: Yield Farming
Yield Farming, also known as yield or liquidity harvesting, involves lending or staking cryptocurrency in exchange for interest, fees, and other rewards. Yield farmers measure their returns in terms of annual percentage yields (APY).
Yield Farming is when a user can lend or stake their assets in exchange for interest or other rewards. Yield farmers typically measure their returns through annual percentage yields (APY).
What are the risks of yield farming?
Some risks of yield farming include:
Impermanent Loss: if a user provides liquidity to a liquidity pool and the price of their deposited assets changes compared to when it was first deposited. The larger the change, the bigger the loss.
Smart Contract Exploits/Vulns: Vulnerabilities or bugs in the Smart Contracts can be a target for hackers or scammers to exploit.
Liquidation risk: if the collateral drops below the price of the loan then it is liquidated which means the user bears a loss.
For example, on a platform like Aave, a user can deposit Ethereum (ETH) as collateral to take out a loan for another asset, like Bitcoin (BTC).
If, however, there is a significant increase in the price of Bitcoin during this time, it will create a liquidation risk as the value of the ETH token provided as collateral will now be less than the value of the borrowed Bitcoin.
The same could happen if the price of Ethereum drops while the price of Bitcoin stays the same.
To help mitigate against market volatility, it’s generally recommended to use Stablecoins like USDC as both the collateral and for the loan.
What is DeFi: Liquidity Mining
Liquidity mining is the final entry in the staking vs. yield farming vs. liquidity mining overview of DeFi. Liquidity mining serves as the core highlight in any DeFi project. Furthermore, it also focuses on offering improved liquidity in the DeFi protocols.
Liquidity miners offer their crypto assets to liquidity pools in DeFi protocols for the purpose of crypto trading.
However, it is important to note that participants do not offer crypto assets into liquidity pools for crypto lending and borrowing in the case of liquidity mining.
Investors place their crypto assets in trading pairs such as ETH/USDC, and the protocol offers a Liquidity Provider (LP) token to them.
A deeper understanding of how liquidity mining works can help in anticipating its differences with the other strategies for crypto investment. The investors would receive rewards from the protocol for the tokens they place in the liquidity pool. The rewards in liquidity mining are in the form of native governance tokens (LP tokens), which are mined at every block.
It is important to note that the reward in liquidity mining depends profoundly on the share in total pool liquidity. Furthermore, the newly minted tokens could also offer access to governance of a project alongside prospects for exchanging to obtain other cryptocurrencies or better rewards.
What are the risks of liquidity mining?
Some risks of liquidity mining include:
Just like the other two approaches, liquidity mining also presents some notable risks such as impermanent loss, smart contract risks, and project risks.
In addition, liquidity miners are also vulnerable to the rug pull effect in their projects.
IN CONCLUSION…
Yield Farming aims to offer you the highest possible returns on the crypto assets of users.
Liquidity Mining focuses on improving the liquidity of a DeFi protocol.
Staking emphasizes maintaining the security of a blockchain network.
DeFi 2022 and Beyond
As the technology and ecosystem continue to mature, so too is there an increasing amount of decentralized solutions for most financial services. The biggest concern (read: RISKS) around DeFi is what kind of regulation the USGOV potentially imposes on this sector of the Digital Asset Ecosystem.
Following on from this introduction we will continue to explore a range of applications, explainers, and how-to guides inclusive but not limited to:
Core Pathfinder_P1 Fund holdings
Lending and staking assets to earn interest and rewards
Borrowing funds with collateral
DeFi Wallets
Borrowing without collateral
Fundraising and loans
Buying insurance
Portfolio Management
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