This is a reading note for book “How to DeFi“.
When Tom hand in $20 to Jack in exchange of goods. Both Tom and Jack has to agree that the greenback with $20 sign actually is worth the value of the goods. Since the paper money is signed by some big shot from the central banker, which they both trust, they can therefore reach consensus on the value of that paper. The central bank acts as a centralized body of trust. Now you’d ask what if the central banker cheats on us? As long as we centralize our trust to a single body, we have to worry about the centralized trust deteriorate. This is what decentralized finance aspires to address.
The other background problem is the centralized payment and clearance system. When you need to send money from one country to another, there are not only high fees involved, but also days holding for clearance. This is another opportunity for decentralized finance.
Decentralized Finance (DeFi)
The technologies in DeFi falls under three categories based on the level of decentralization:
- Centralized: custodial, uses centralized price feeds, centrally determined interest rates
- Semi-Decentralized: non-custodial, decentralized price feeds
- Completely Decentralized: every component is decentralized.
Most DeFi dapps are sitting in the semi-decentralized category. There is no DeFi protocol that is completely decentralized yet. DeFi involves protocols that covers financial sectors such as Lending & Borrowing, Exchanges, Derivatives, Lottery, Payments, Insurance, etc. This all sounds futurism, but there are a few protocols already at play.
The majority of the DeFi Dapps are built on the Ethereum blockchain, a global, open-source platform for decentralized applications. You can think of it as a world computer that cannot be shutdown. Developers can also deploy smart contracts to the Ethereum network, where it will run 24/7. Smart Contract is a programmable contract that allows two counterparties to set conditions of a transaction without needing to trust another third party for the execution. Whenever a certain condition is fulfilled, the smart contract will carry out the operation as programmed, and the process is transparent to all involved parties, bypassing the need for a trusted third party intermediary.
Ether is the native currency of the Ethereum blockchain so Ether is similar to Bitcoin. Ether is also used to pay for the fee that allows smart contracts and Dapps to run on the Ethereum network. Ether is also evolving to become its own unique reserve currency and store of value.
Dapps (decentralized applications) are interfaces that interact with the blockchain through the use of smart contracts. On Ethereum, all transactions and smart contract executions require a small fee to be paid. The fee is called Gas. In technical terms, Gas refers to the unit of measure on the amount of computational effort required to execute an operation or a smart contract. Gas fees are paied entirely in ETH. The price of gas can fluctuate from time to time depending on the network demand.
Ethereum can also be used for two other functions: creating DAO (Decentralized Autonomous Organization), or issuing other cryptocurrencies. A DAO is a fully autonomous organization which is not governed by a single person but is instead governed through code. This code is based on smart contracts and enables DAOs to replace how traditional organizations are typically run. As it runs on code, it would be protected from human intervention and will operate transparently. Governance decisions or rulings would be decided via DAO token voting.
There are currently two popular protocols for tokens on the Ethereum Network: ERC-20 and ERC-721
A wallet is a user-friendly interface to the blockchain network. It manages your private keys, which are basically keys to the lock on your cryptocurrencies’ vault. Wallets allow you to receive, store and send cryptocurrencies.
Custodial wallets are wallets where third-parties keep and maintain control over your cryptocurrencies on your behalf. By using a custodial wallet, you trust an external party to store your coins safely. However, by trusting a third party with your cryptocurrencies, you open yourself up to the risk of the custodian losing your cryptocurrencies through mismanagement or hacks (Mt. Gox)
Non-custodial wallets are wallets where you take full control and ownership of your cryptocurrencies. By using a non-custodial wallet, you trust no external party and only yourself to ensure safe storage. However, you pass the burden of security to yourself and you have to be fully equipped to store your private keys safely. If you lose your private keys, you will lose access to your cryptocurrencies too. Example of non-custodial wallet: Argent
Stablecoins are pegged to other stable assets such as the USD. The top 5 cryptocurrency stablecoins as of Feb 2020 are:
- Tether (USDT)
- USD Coin (USDC)
- Paxos Standard (PAX)
- True USD(TUSD)
- Dai (DAI)
Not all stablecoins are the same as they employ different mechanisms to keep their peg against USD. There are two types of pegs: fiat-collateralized (e.g. USDT)and crypto-collateralized (e.g. DAI). Most stablecoins are the former.
USDT pegs itself to $1 by maintaining reserves of $1 per Tether token minted. While Tether is the largest and most widely used USD stablecoin, Thether reserves are kept in financial institutions and users will have to trust Tether as an entity to actually have the reserved amounts that they claim. Tether is therefore a centralized, fiat-collateralized stablecoin.
Dai (DAI) on the other hand, is collateralized using cryptocurrencies such as Ethereum (ETH). Its value is pegged to $1 through protocols voted on by a decentralized autonomous organization and smart contracts. At any given time, the collateral to generate DAI can be easily validated by users. DAI is a decentralized, crypto-collateralized stablecoin.
DAI has a smaller market capitalization but is increasing tremendously. DAI is the native stablecoin used most widely in the DeFi ecosystem. It is the preferred USD stablecoin used in DeFi trading, lending and more. DAI operates on Maker, a smart-contract platform that runs on the Ethereum blockchain and has three tokens:
- Sai – aka Single Collateral Dai, backed only by Ether(ETH) as collateral. It is legacy Dai, and will be phased out.
- Dai – aka multi-collateral Dai. Currently backed by Ether (ETH) and Basic Attention Token (BAT) as collaterals with plans to add other assets
- Maker (MKR): is Maker’s governance token and users can use it to vote for improvements on the Maker platform via the Maker Improvement Proposals. Maker is a type of DAO.
MKR holders have voting rights proportional to the amount of MKR tokens they own in the DAO and can vote on parameters governing the Maker Protocol. The parameters that MKR holder vote on are vital in keeping the ecosystem healthy, which in turn helps ensure that Dai remains pegged to $1.
The amount of Dai that can be minted is dependent on the collateral ratio (150% worth of ETH or BAT to mint Dai). There is a stability fee and Dai Saving Rate (DSR).
Lending and Borrowing
Compound Fiannce is an Ethereum-based open-source money market protocol where anyone can supply or borrow cryptocurrencies frictionlessly. Many tokens (BAT, ETH, USDC, DAI, and more) can be supplied or used as collateral on the Compound platform.
Compound operates as a liquidity pool that is built on the Ethereum blockchain. Suppliers supply asset to the pool and earn interest, while borrowers take a loan from the pool and pay interest on their debt. In essense, Compound bridges the gaps between the lenders who wish to accrue interest from idle funds and borrowers who wish to borrow funds for productive or investment use. Suppliers and Borrowers interact directly with the protocol for interest rate.
Anyone with a supported cryptocurrency wallet such as Argent can start using Compound immediately. To earn interest, you have to supply assets to the protocol. Once you have deposited your asset into Compound, you will immediately begin to earn interest on the assets you have put in. Upon deposit, you will receive corresponding amounts of cTokens. If you supply DAI, you will receive cDAI. If you supply Ether, you will receive cETH. Interest is not immediately distributed to you, but rather accrues on the cTokens which you now hold and are redeemable for the underlying asset and interest it represents. cTokens represents your balance in the protocol. cTokens become convertible into an increasing amount of the underlying asset it represents over time.
If you want to borrow, you have to first supply assets into the system as collateral for your loan. Borrowed assets are sent directly to your Ethereum wallet and from there you can use them. Do not that borrowing incurs a small fee of 0.025% to avoid spams and misuse of the Compound protocol
DEX (Decentralized Exchanges)
Uniswap Exchange is a decentralized token exchange protocol built on Ethereum that allows direct swapping of tokens without the need to use a centralized exchange. On Uniswap, you can simply swap your tokens directly from your wallet without having to go through centralized exchange.
dYdX is a decentralized exchange protocol for lending, borrowing and margein/leveraged trading. It supports ETH, USDC, and DAI. You can enter either short or long positions with leverages up to 5x.
Other Use Cases
Derivatives: A derivative is a contract whose value is derived from another underlying asset such as stocks, commodities, currencies, indexes, bonds, or interest rates. There are several types of derivatives such as futures, options and swaps, each serving a different purpose. In DeFi, the biggest derivative protocol is Synthetix
Fund Management: In DeFi, fund management is conducted in a manner where it removes the investment manager and lets you choose the asset management strategy that best suits your financial need. TokenSets is a platform that allows crypto users to buy Strategy Enabled Tokens
Payments: Lighting Network, Request Network, xDai and Sablier
Insurance: Nexus Mutual is a decentralized insurance protocol built on Ethereum that currently offers cover on any smart contract on the Ethereum blockchain.
Dashboard: a dashboard is a simple platform that aggregates all your DeFi activities in one place.