Decentralized Finance to upend global financial establishment

2021 marks a defining year for decentralized finance (DeFi) as it asserts strong global presence, competes with traditional banks and forces regulators to understand the rapidly growing novel space.

Decentralized Finance to upend global financial establishment

Why it’s here to stay

Introduction

2021 marks a defining year for decentralized finance (DeFi) as it asserts strong global presence, competes with traditional banks and forces regulators to understand the rapidly growing novel space. Traditional financial establishments have been jumping on board the Bitcoin bandwagon following bullish views on how it can evolve into a global asset.  Recently, a JP Morgan investment strategist published a note to its clients with a “bold” long-term price target of $146,000 for Bitcoin, claiming it may compete with gold 1. Will these establishments also embrace the idea of DeFi and what it is set out to do?

We’ll first start with a common understanding of what DeFi means before discussing the disruptive aspects of the different protocols that exist today.  DeFi is a category of protocols that are mostly built on top of the Ethereum network. The network allows for programmable decentralized protocols and its’ transactions to be automatically executed using smart contracts.  DeFi leverages such technology and traditional financial concepts (e.g., money markets, exchanges and derivatives) to help anyone with an internet obtain financial accessibility and full control over their financial assets.  As described, DeFi shares the attributes of blockchain technology, which has no central authority, and traditional financial concepts.

DeFi is a continuum, and the below mapping includes projects with varying degrees of decentralization.  Let’s review some of them in greater detail.

Stablecoins: the underlying asset

In traditional finance, the primary instrument that is used to exchange value is fiat money.  The value of fiat money is derived from the relationship between supply and demand and the stability of the issuing government. The equivalence of such instrument in the DeFi world is called “Stablecoins”.  They emerged from the more volatile cryptocurrencies to achieve “stability” and were mainly used by traders to hedge against volatility, allowing cryptocurrency traders to move funds frequently, in and out of exchanges at low costs.

There are two main stabilization mechanisms for stablecoins:

1) Asset-linked stablecoins which are backed by physical or financial assets (e.g., currency, commodity or cryptocurrencies) and

2) Algorithmic based stablecoins which use protocols to control supply and demand.

Both stabilization mechanisms remove the role of governments and the risks inherent to financial intermediaries (e.g., banks) which can serve as a single point of failure. We will take a deeper look into complex models of the stabilization mechanisms.

Collateralized Debt Models

The collateralized debt position (CDP) model generally works by collateralizing the pegged asset (stablecoin) with a more volatile asset (typically another cryptocurrency).  Since the “more volatile” asset has “more risk”, the pegged asset is over collateralized. The model also has a safety margin built to liquidate the stablecoin when it becomes undercollateralized. Maker.Dao and Synthetix are examples of protocols that leverage the the CDP model.

Below is an example of how debt works when Synthetix (SNX), the more volatile asset, is staked as collateral with a target ratio of 600% to absorb significant price volatility.  Stakers act as a pooled counterparty to all and take on the overall debt in the system. By incurring this risk and enabling trading on their exchange, stakers earn fees that are generated by the system. They may also hedge the risk by taking external positions.  The pegged asset in the example is represented by SUSD.

Seigniorage share models

Unlike the CDP model, Seigniorage share model does not rely on collateralized debt and was modeled after central banks management over their countries’ money supplies.  They are algorithmic based and use smart contracts to automatically expand and contract the supply of non-collateralized currency to maintain a stable value.  In addition to the stablecoin itself, there are investment tokens (held by seigniorage shareholders) specifically designed with properties to incentivize a stable value.  When demand for stablecoins increases, new stablecoins are issued to offset the demand and keep price flat. The new stablecoins are issued proportionally to seigniorage shareholders based on the percentage of shares they own. Accordingly, when demand decreases and price falls, shares are put for sale in exchange for stablecoins, which are subsequently burnt from supply.  Basis and Reserve are examples of protocols that leverage the seigniorage share model.

Below is an example of how the Seigniorage share model is leveraged along with collateralization in Reserve.  Because the stablecoin is fully collateralized, the system can maintain the peg through arbitrage.  If the underlying collateral depreciates in value, the protocol mints and auctions off a secondary token RSR in exchange for additional collateral—RSR is sold through an auction. If the protocol cannot attract a sufficient number of RSR buyers, it will gradually lower the peg. RSR holders can also use RSR to mint additional RSV, as long as the demand is high enough to support it.  Reserve solves one of the major issues of the “pure” seigniorage share model— the necessity to estimate the size of the required expansion or contraction of supply. Because the peg is fully maintained by arbitrage, RSV will be minted or burned exactly as long as there is profit to be made.

Source: Reserve Protocol

Past, Present and Future Growth

The explosive growth of stablecoins can be attributed to the following factors:

· Offerings of high yield relative to traditional markets by a variety of decentralized exchanges such as Uniswap and Curve.

· Relative to other cryptocurrencies, stablecoins are a safe place to park ones’ assets without cashing out to fiat currency and incurring fees.

· With geo-political uncertainty, stablecoin’s are seen as a way to mitigate volatility in ones’ investment portfolio (individual or corporate).

· Approval from the federal banking regulator confirming the use of stablecoins by U.S. financial institutions for payments and the participation as nodes in a blockchain2.

Central Bankers are starting to rethink the fundamentals of the payment system in light of the rise of stablecoins and blockchain technology.  This is demonstrated by a recent Federal Reserve paper by Wong and Maniff explores the potential benefits Central Bank Digital Currencies can have and discuss how programmable digital assets may change monetary policy 3.

Without a doubt, Ethereum has become the settlement layer for DeFi and stablecoins have become the reserve currencies.  As stablecoins continues to grow with regulatory approval, it will have significant implications for DeFi.  DeFi lending platforms such as Compound and Yearn Finance should see increased participation using stablecoins in the near future.

Exchanges

In traditional finance, markets are typically created by centralized exchanges which serve as a platform for the public to buy and sell financial securities. These financial markets include the stock market, bond market, forex market and derivatives to name a few. They are an essential part of the financial ecosystem helping to facilitate liquidity of capital and efficient price discoveries.  These markets use vast amount of computing power to ensure smooth and sound execution.

Similarly, there are centralized cryptocurrency exchanges (CEX) for investors to buy and sell cryptocurrency holdings.  New Investors are typically attracted to centralized exchanges because they feel safe trusting the middle-man to handle their assets.  They find comfort in having the option to reach out to customer support and knowing their assets are secure and monitored.  They also provide easy on-ramps from fiat to cryptocurrency whereas in a decentralized exchange you would often leverage stablecoin pairs.  Some of the popular centralized exchanges include Coinbase, Robinhood, Kraken and Gemini.

In DeFi, decentralized exchanges (DEX) are an alternative approach to buying and selling cryptocurrency holdings.  They cut out the middle man and are often thought of as a "trustless" environment. They function as peer-to-peer exchanges where assets are never held by an escrow service; transactions are entirely done based on smart contracts and atomic swaps.  Several models of decentralized exchanges exist today which have made trade-offs between functionality, scalability and decentralization.

On-chain settlements/Off-chain orders

These protocols closely resemble its centralized counterparts and reflects a blend of both centralized and decentralized exchanges. The model represents a non-custodial exchange with centralized processing and off-chain matching; trade settlements are done in parallel on-chain within a smart contract. An example of this model, which also happens to be the first semi-decentralized exchange, was EtherDelta.  Unfortunately, as a result of it not being fully decentralized, it was not censorship resistant.  There were also regulatory and technical challenges that made it difficult to succeed. Therefore, new models have emerged to address some of these challenges.

Reserve Networks

These protocols are based on reserves that supply liquidity to the trader.  A reserve for any asset may be created by any entity large enough to provide liquidity. They may be large token holders and centralized or decentralized exchanges.  The smart contract that sits between the trader and the reserves would query all the reserves that provide liquidity for the trade, determines best

rate6and executes the trade.  The reserve owners would pay a fee for each trade that occurred on the protocol which, unfortunately, creates significant barriers of entry.  Low liquidity providers (retail) are unprofitable due to high fees exceeding profits from any reasonable bid and ask spread.  Effectively the model is considered inefficient due to its dependence on a small number of large liquidity providers.  As a result, smaller entities and individuals have seeked elsewhere. This type of model enhanced some of its predecessors but did not drastically improve or create any new market dynamics. The Kyber Network was an example that utilized the reserve network model.

Pool-Based exchanges (automated market makers)

These protocols address some of the short comings mentioned above, by engaging both large and small liquidity providers while also facilitating markets that self-regulate. The protocol utilizes tokenized pools for market making by allowing many individual liquidity providers to pool their capital together.  The tokenized pools are used to source liquidity while the protocol serve as a vehicle for price discovery and entry point for trading.  The protocol uses mathematical formulas to calculate the rate rather an order book as seen in centralized exchanges.  As such, there is no need for counterparties as the price of the cryptocurrency is automatically determined by the contract (this interaction is called peer-to-contract rather peer-to-peer).  Although the formula takes into consideration the relative pool sizes to calculate the rate, an unfortunate circumstance is created. When discrepancies exist with other markets, arbitrage opportunities are created.  However, this also creates risks for liquidity providers called “impermanent loss” which is an opportunity cost since the liquidity providers did not technically lose money (loss is relative to a benchmark of simply holding the assets).  Liquidity providers are incentivized with a fee as they play a pertinent role for the protocol to work.  Therefore, one will need to assess on a case-by-case basis the benefits and risks of being a liquidity provider (incentivized fee vs opportunity costs). Uniswap is a prime example of an automated market maker.   Bancor, another example, has attempted to address the issue of impermanent loss by opting to use Chainlink as the pricing oracle. On the flip side, oracles introduce additional attack vectors which may potentially break the protocol.  Other protocols such as Curve, Balancer and Mooniswap have emerged recently and are in development to address the issue of “impermanent loss” without the use of oracles.

Layer 2 Non-custodial exchanges

All DeFi protocols that exist as a set of smart contracts on-chain are limited by the chain’s scalability.  Ethereum’s existing gas prices respond to the relatively limited number of transactions that one can facilitate using a single block on the network.  In such scenarios miners can choose the highest-priced transactions as their priority, effectively resulting in increased gas prices. As a result, the recent growth we’ve witnessed in DeFi has caused Ethereum network transaction fees to surge and dampen usage and experience for retail players.

Fortunately, layer 2 networks are separate from the main network (also called layer 1) and have their own nodes to address the scalability issue.  Most DeFi protocols on Ethereum are being built on “rollups” to tackle this pertinent issue.  When performing transactions on a “rollup” the confirmations are made in aggregate which excludes Ethereums native currency from being involved for the vast majority of transactions.  We will review more in depth the different layer 2 solutions that have emerged in a separate section.

Money Markets

Borrowing and lending are one of the most important elements in any financial system.  The equivalent of such instruments in the cryptocurrency space are accessible by DeFi protocols and CeFi (centralized finance) companies.  For the purpose of this research, we will focus on the mechanics of the DeFi protocols.

Users of DeFi become lenders (depositors) and borrowers (loan takers) in a completely decentralized and permissionless way while maintaining custody over their assets. Lending is often automated based on tokenized pooling, overcollateralization and market liquidation. Tokenized pooling is a pool of particular asset (or assets) associated with a list of users that own a particular share of the pool.  Ownership of the pool is tracked using a separate liquidity token which is minted and represents the added liquidity relative to the pool.  When exciting the pool (or removing liquidity) pool tokens are burned and the corresponding share of total liquidity is sent to the user.  For borrowers, overcollateralization and market liquidation mechanics are governed and enforced through smart contracts. Borrowers will put up some level of collateral that covers the value of the borrowed assets with a safety margin. If the ratio of collateralization falls below the defined target, the borrower may add collateral or repay the loan. If the borrower fails to intervene, market liquidation would occur by selling the collateral at a possible discount and repaying the loan with accumulated interest.  Essentially, market-based liquidation aims to keep the protocol well capitalized while ensuring lender safety.

There are two forms of loans based on its purpose:

1) General purpose overcollateralized loans and

2) Specialized leveraged borrowing for margin trading

General purpose collateralized loans

General purpose collateralized loans put up excessive collateral to guarantee repayment, with market liquidation used to monitor solvency and convert collateral asset to the lent asset.  At first, it may seem like overcollateralization is an inefficient use of capital, however DeFi allows it to be posted as a separate yield generating asset for the borrower.  The protocol locks the collateral into a contract and the borrower does not relinquish the ownership of it as long as the loan is properly capitalized and the capitalized factor is maintained.  When liquidation occurs (value of collateral falls below required collateral level) as a result of significant market fluctuations the collateral is ultimately returned to the borrower.  The interest that lenders receive and the interest that borrowers have to pay are determined by the ratio between supplied and borrowed tokens in a particular market.  The interests are typically calculated per Ethereum block and as a result, DeFi lending provides variable interest rates that can change dramatically depending on the demand for particular tokens.  Examples of protocols that utilize general purpose overcollateralized loans are Compound and Aave.

Leveraged borrowing

Leveraged borrowing for margin trading allows a trader to add borrowed (loaned) assets to their own and enter a position in traditional finance; allowing for increased exposure to an asset with limited capital.  Examples of protocols that utilize leveraged borrowing for margin trading are Fulcrum and dYdX.  Some of the benefits include users not wanting to sell their tokens but require funds to cover unexpected expenses.  Another reason may include avoiding or delaying paying capital gains taxes on their tokens using borrowed funds.

In summary, general purpose overcollateralized loans would give up custody of assets to borrowers while specialized leverage loans used in margin trading would hold custody of lent assets within the protocol, instead offering control over the leveraged positions.

Flash loans

Flash loans are recent mechanisms that do not require any form of collateral but only that the sum (plus interest) is returned by the end of the same blockchain transaction.  If the sum is not returned all transactions would simply be reverted.  This allows the loan provider to guarantee that the funds are always returned.  The capital is essentially free as long as the operation it was used in was somewhat profitable.  Flash loans can be used to engage in risk free transactions such as arbitrage, liquidations, swapping collateral or staking.  Examples of protocols that offer flash loans are Aave and dYdX.

Source: Aave Protocol

Risk Management and Hedging

Hedging is an important concept in traditional finance to strategically mitigate investment or business risk using financial instruments or market strategies.  The concept is also relevant in DeFi and are offered through protocols such as insurance mutual funds, options and prediction markets.

Insurance mutual funds

Similar to how traditional insurance funds work, the fund pools assets from investors to create a fund that promises insurance against catastrophic events, in return for premiums that take into account the probability of insurance claims. However, payouts after “insurance covered” events are not instant and guaranteed as both the buyer or insurance company may try to defraud each other. The buyer may fake catastrophic events while insurance companies may debate the “insurance covered” event.  Nexus Mutual is an example of an insurance fund that covers losses from smart contract failure through the use of its native token (NXM) and voting process for claims.

Options

Options are derivative contracts that give one the right, not the obligation, to buy or sell an asset at a pre-agreed price level and expiry time.  Options can be used to hedge business risks or investor risks. Options are a natural choice for hedging in DeFi as it is not only specific to smart contract failures, such as Nexus Mutual, but also presents less counterparty risks (options can be exercised regardless of reason). An example of a protocol that provides collateralized option writing is Opyn.

Prediction markets

In prediction markets, individuals bet on certain events which are typically binary.  They can be used to hedge against unforeseen events and the payout would be inversely proportional to the probability of the event. An example of a protocol that provides a decentralized prediction market is Augur.

 

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Infrastructure and Ecosystem

In DeFi, a solid infrastructure that supports its’ ecosystem by providing optimal positive utility is key to its future success.  The saying “the whole is greater than the sum of its parts” holds true for the DeFi ecosystem as well.  It once started out with limited liquidity and siloed Dapps (decentralizes apps) provided by the instruments themselves but as the vast array of use cases grew, so too did the need for more liquidity and robust modes of interaction and analysis. There are several protocols that have emerged to support these narratives.

Data Sourcing

In traditional financial markets, analytical tools such as SQL (structured query language) help manage data faster than one would if done manually.  Similar challenges exist in DeFi today, therefore such tools that can aggregate on-chain data into tangible metrics would serve useful when combining metrics across multiple protocols.  Protocols that provide easily accessible on-chain data to end users would be most prominent as cost of synchronizing blockchain nodes and parsing blockchain state are complicated. The Graph is an example of a protocol that aims to provide an infrastructure layer by indexing data from on-chain contracts.

Retail products

A good user interface is key for DeFi adoption by the retail community.  Due to recent popularity of DeFi, many protocols have been adding DeFi functionality but with poor user interfaces.  Therefore, several protocols have emerged to address the complex interactions experienced by users of DeFi.  An example of a protocol that provides a simple user interface to DeFi is Dharma.  It places all funds in the wallet into Compound to earn interest while connecting to individual bank accounts and twitter handles to help facilitate the transfer of assets.

Connector tools

In addition to addressing the needs of the retail community there are needs from those that are more experienced for advanced features.  These users typically require the ability to move capital efficiently across assets and protocols.  Examples of a protocol that combines ones’ wallet to several major protocols with advanced features are InstaDapp, Dedge and Zapper.

Optimization tools

Optimization tools implement automated decision making to improve portfolio performance based on aggregated DeFi data. These tools implement complex strategies to improve ones’ portfolio performance.  Examples of a protocol that implements complex strategies to improve ones’ portfolio performance are Yearn Finance, 1inch and Dca.land.

These products and tools attempt to abstract away the complex nature of interacting with DeFi today. Simplified user experiences will allow the average user base to grow and entice the community to continue building out the most optimal DeFi ecosystem.  Inevitably, traditional institutions will need to embrace or compete with these products for their retail business to succeed in the future.

 

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Layer 2Solutions

Rollups are solutions that bundle or "roll up" sidechain (Ethereum compatible, independent blockchains) transactions (e.g., signature verification, contract execution) into a single transaction and generate a cryptographic proof, known as a SNARK (succinct non-interactive argument of knowledge).  Only this proof would be submitted to the main chain where transaction data is stored.  The solution requires relayers who have staked a bond in the rollup contract to incentivize rollups accuracy.  The solution is generally useful for reducing fees for users, opening participation and creating fast transaction throughput.

There are two main types of rollups with different security models:

· Zero knowledge: runs computation off-chain and submits a validity proof 4 to the chain and

· Optimistic: assumes transactions are valid by default and only runs computation, via a fraud proof 5, in the event of a challenge

Zero knowledge rollups

Zero knowledge rollups (ZK-Rollups) bundle hundreds of transfers off-chain into a single transaction through a smart contract.  As a result of less data being included on-chain, validating a block becomes quicker and cheaper. From the data submitted, the smart contract will verify all of the transfers that were included; a process also known as a “validity proof”.  The sidechain where ZK-Rollups happen can be optimized even further by reducing the transaction size. Transactions can be reduced from 32 bytes to just 4 bytes by representing it by an index rather than an address.  Transactions are also written to Ethereum as calldata, further reducing gas.

Pros

Cons

No delay as proofs are already considered valid when submitted to the main chain.

Limited to simple transfers, not compatible with the (Ethereum Virtual Machine) EVM.

Less vulnerable to the economic attacks that Optimistic rollups 6 can be vulnerable to.

Validity proofs are intense to compute – not worth it for applications with little on-chain activity.

 

Slower subjective finality time (10-30 min to generate a ZK proof) (but faster to full finality because there is no dispute time delay like in Optimistic rollups).

Optimistic rollups

Optimistic rollups use a side chain that sits in parallel to the main Ethereum chain. They can offer improvements in scalability because there are no computations that are being done.  Instead, transactions are simply “notarized”.  Similar to ZK-Rollups, Optimistic rollups transactions are written to the main Ethereum chain as calldata, optimizing transactions further by reducing the gas cost.

As computation is the slow and expensive part of using Ethereum, Optimistic rollups offer up to 10-100x improvements in scalability dependent on the transaction. This number may increase even more with the introduction of the Eth2 upgrade: shard chains 7; there will be more data available in the event that a transaction is disputed.

Optimistic rollups don't actually compute transactions, therefore in order to ensure transactions are legitimate and not fraudulent, “fraud proofs” are necessary.  If someone notices a fraudulent transaction, the rollup will execute a “fraud proof” and run the transactions computation, using the available state data. As a result, you may have longer wait times for transaction confirmation than a ZK-rollup, because it could potentially be challenged.

Pros

Cons

Anything you can do on Ethereum layer 1, you can do with Optimistic rollups as it's EVM and Solidity compatible.

Long wait times for on-chain transaction due to potential fraud challenges.

All transaction data is stored on the layer 1 chain, meaning it's secure and decentralized.

Potentially vulnerable to attacks if the value in an Optimistic rollup exceeds the amount in an operator's bond.

Plasma

A plasma chain is a separate blockchain that is anchored to the main Ethereum chain, and uses fraud proofs, similar to Optimistic rollups, to arbitrate disputes.

Pros

Cons

High throughput, low cost per transaction.

Does not support general computation. Only basic token transfers, swaps, and a few other transaction types are supported via predicate logic.

Good for transactions between arbitrary users (no overhead per user pair if both are established on the plasma chain).

Need to periodically watch the network (liveness requirement) or delegate this responsibility to someone else to ensure the security of your funds.

 

Relies on one or more operators to store data and serve it upon request.

 

Withdrawals are delayed by several days to allow for challenges. For fungible assets this can be mitigated by liquidity providers, but there is an associated capital cost.

Validium

Validium uses validity proofs like ZK-rollups but the data is not stored on the main layer 1 Ethereum chain. This can lead to 10k transactions per second per validium chain, allowing multiple chains to run in parallel.

Pros

Cons

No withdrawal delay (no latency to on-chain/cross-chain tx); consequent greater capital efficiency.

Limited support for general computation/smart contracts; specialized languages required.

Not vulnerable to certain economic attacks faced by fraud-proof based systems in high-value applications.

High computational power required to generate ZK proofs; not cost effective for low throughput applications.

 

Slower subjective finality time (10-30 min to generate a ZK proof) (but faster to full finality because there is no dispute time delay).

Conclusion

The total value locked in DeFi instruments have grown 21x year-to-date, from $687 million in January 1, 2020 to $14.6 billion.  Yet, the growth of DeFi protocols doesn’t seem to be slowing down as more are planned to roll out this year.  Improvements to the Ethereum platform (Ethereum 2.0) will also help fuel DeFi growth by improving scalability, throughput and security of the entire network. During this critical stage of DeFi, it is important to note that there are risks involved.  One may even argue that there is far greater risk now than before. Therefore, it is pertinent for new participants to understand DeFi and the specific mechanics of the protocols they interact with.

Will these traditional financial establishments embrace the idea of DeFi and what it is set out to do? Knowing what we know today, it seems unlikely that traditional banks will stay silent.  They will need to respond whether they embrace or forcefully reject the thesis of DeFi.  Despite the regulatory hurdles DeFi may encounter, its main goal is to ultimately be decentralized - meaning it can’t be shut down by a central authority.  One may argue this currently isn’t the case, but with all new technology, full adoption will take some time. Additionally, DeFi will allow the unbanked to not only survive but financially grow.  Globally, about 1.7 billion adults (0.3 billion increase since 2014) remain unbanked in 2017 – without an account at a financial institution or a mobile money provider 8.  DeFi and its underlying technology will remove the barriers to banking by removing fees and friction that often weigh down the unbanked as demonstrated by the Reserve protocol in Venezuela.  If regulators can’t stop DeFi and positive utility continues to be delivered to those that are unbanked, traditional banks will need to embrace DeFi and integrate it into their business.