DeFi-ing the Financial Sector

DeFi-ing the Financial Sector

Decentralised Finance (DeFi) is an emerging financial infrastructure on distributed ledgers that has enjoyed enormous growth in the last two years, growing from around $1 billion to around $200 billion in assets locked in this ecosystem (Figure 1).

Figure 1 – Total Value Locked (USD) in DeFi

Source: Defillama (downloaded on 31/03/2021).

DeFi aims to provide new and existing financial services and products in a decentralised way by adopting open source, permissionless protocols built on public smart contract platforms such as Ethereum. Contracts are executed by codes in a transparent, secure and immutable manner and recorded on the public blockchain. DeFi challenges the old financial system based on intermediation and centralised institutions. Already now, it provides many traditional financial services, from payment processing to trading infrastructure and borrowing and lending.

The rapid expansion of this market has prompted an important debate, that we touched on in a previous article, “The Challenges of Decentralised Finance”. In this article, we offer an introduction to DeFi, some examples of the financial services offered, and an overview of some of the opportunities and limitations.

What is DeFi?

The key vision of DeFi is intermediation without centralisation. DeFi is born out of the interconnection of different building blocks in the crypto space:

  1. The blockchain that allows for distributed ledgers of transactions

  2. Automated contracts with pre-defined protocols hosted on blockchains, commonly referred to as “smart contracts”, made popular by the Ethereum smart contract platform1

  3. Open-source financial protocols for investing, lending, and trading using smart contracts and that operate independently on a blockchain network, without the need for a centralised financial intermediary

  4. Stablecoins, i.e. cryptoassets which are pegged to fiat currencies such as USD, are used to facilitate fund transfers and the settling of contracts by removing the volatility of other cryptocurrencies

A smart contract is an irreversible, self-executing agreement that is written in computer code, and runs on an open source, permissionless, distributed ledger. Originally proposed by Szabo (1994), smart contracts are the heart of DeFi because they offer protocols that function based on a programming code, without the intervention of, or intermediation by, a trusted centralised third party.

The Architecture of DeFi

DeFi combines the building blocks discussed above in a hierarchical multi-layered architecture that creates a transparent infrastructure stack (Figure 2). The hierarchy of layers can be understood as follows (see Schär, 2021):

  • The settlement layer consists of the distributed ledger and its native cryptocurrency (e.g. BTC, ETH etc).

  • The asset layer consists of all assets that are issued on top of the settlement layer, both native protocol assets (cryptocurrencies) and other tokens issued on this ledger.1

  • The protocol layer provides standards for the specific financial product, implemented as a set of smart contracts.

  • The application layer is the user-oriented front end usually accessible via web browser

  • The aggregation layer is a user-friendly platform connecting several applications and protocols (e.g. to aggregate the interest rates offered by different protocols and in some cases automatically allocate capital to the interest rate protocols)

Figure 2 - The DeFi Stack

Source: Schär (2021)

Financial Services in DeFi

DeFi comprises a broad range of financial services. Below are some of the common DeFi services currently available.

  • Decentralised Lending Platforms solve the problem of ensuring that borrowers do not deliberately default using two different approaches. First, credit can be provided as flash loans that are repaid atomically. This means that the borrower receives the funds, uses, and repays them within the same blockchain transaction. Second, loans can be fully secured with overcollateralisation. The collateral is larger than the loaned amount to insure against fluctuations in the value of the crypto collateral, locked in a smart contract, and only released once the debt is repaid.

  • Decentralised Exchange Protocols offer a solution to the shortcomings of centralised crypto exchanges. In requiring the assets to be first deposited with the platform, centralised exchanges present counterparty credit risk to platform users and are also attractive targets for cyberattacks. Decentralised exchange protocols instead execute trades through a smart contract where the two legs of the trade are performed in one indivisible transaction. This mitigates counterparty credit risk. There are different models for Decentralised Exchange Protocols:

    • Decentralised Order Book Exchanges with on-chain or off-chain order books

    • Constant Function (Automated) Market Maker are smart contract liquidity pool that holds two or more cryptoassets in their reserve and allows users to deposit tokens of one type and withdraw tokens of the other types in a given ratio (i.e. FX rate). The smart contract set rates as function of the smart contract’s token reserve ratio, hence making sure that the pool remains liquid in all the cryptoassets traded. Everyone effectively trades against the automated market marker, instead of other traders

    • Smart Contract-Based Reserve Aggregation consolidate liquidity reserves through a smart contract allowing liquidity providers to connect and advertise prices for specific trades

    • Peer-to-Peer Protocols, also called over-the-counter (OTC) protocols, match participants given their trade requests and then the parties negotiate the exchange rate bilaterally

  • Decentralised Derivatives are smart contracts that determine the value of token conditional on an underlying asset’s performance (Asset-Based Derivative Tokens), the outcome of an event, or some observable variable (Event-Based Derivative Tokens). They usually require an oracle to track these variables by doing so they introduce centralised components.3,4

  • On-Chain Asset Management work as a traditional investment funds, allowing users to invest in a portfolio of cryptoassets. The investors do not control over their funds and can liquidate their positions at any time. The cryptoassets are locked up in a smart contract that dispenses from the presence of a custodian. The trading happens following a variety of automated strategies.

Many of these services (and several others) are informally grouped under the blanket term of yield farming that stands for all the DeFi activities which generate a yield on cryptoasset collateral. These potentially include:

  • Lending

  • Providing cryptoassets to liquidity pools

  • Generalised mining, becoming a participant in a distributed ledger protocol

  • Trading in DAO tokens

  • Margin exchange trading and

  • Trading in the gaming space

Towards DeFi 2.0

DeFi 2.0 has become a popular term to describe a new generation of DeFi applications. The "second generation" of DeFi strives to improve on the shortcomings of the earlier implementations (a.k.a. DeFi 1.0):

  1. Scalability in DeFi is low. Protocols on ledgers that deal with high traffic and require gas fees provide slow and expensive services. Trades tends to be inefficient and only cost effective for larger trades.

  2. Liquidity tends to be low and volatile due to the fragmented market across different smart control platforms and DeFi applications. Users providing liquidity lock up funds and are unable to use them anywhere else. This implies capital inefficiency.

  3. Centralisation of control is a key shortcoming of DeFi 1.0 applications and is contrary to its ambition for the true disintermediation of financial intermediaries. It happens in several ways. First, stablecoins are needed to reduce volatility but they are an element of centralisation due to the need of a company holding reserves, with the counterparty risks that this entails. Second, external information needed by Oracles introduce further dependency on centralised sources of data. Third, many projects still don’t have a DAO in place and have centralised teams.

  4. Hidden Risks that consumers with limited technical experience may not be able to understand. While protocols are open source and reviewable by anyone, their actual mechanics may still escape most of the users. One needs a coding background to read and understand the computer code.

DeFi 2.0 has tested several solutions to these issues. For example:

  • Insurance covered smart contracts and insurance for “impermanent” losses can mitigate risks 5

  • Self-repaying loans that use interest earned on the deposited collateral to pay off the loan over time

  • Effective DAO structures that offer ownership and participation into the project's evolution, furthering decentralisation

  • Protocol managed and owned liquidity pools, backed by a portfolio of assets6

Conclusions

DeFi has the ambition to create an accessible, transparent and immutable financial infrastructure. It has spurred a wave of innovation in financial services both re-imagining traditional instruments and creating new ones. DeFi only recently achieved the proof-of-concept stage of market level evolution and is evolving quickly. The next generation of DeFi infrastructure and applications aims to improve upon the limitations, issues and risks which manifested themselves at the current stage of implementations.

Bibliography

Aramonte, Sirio, Wenqian Huang and Andreas Schrimpf, “DeFi risks and the decentralisation illusion,” BIS Quarterly Review, December 2021

www.bis.org/cpmi/publ/d187.pdf

Szabo, Nick. “Smart Contracts.” 1994

http://www.fon.hum.uva.nl/rob/Courses/InformationInSpeech/CDROM/Literature/LOTwinterschool2006/szabo.best.vwh.net/smart.contracts.html

Szabo, Nick. “The Idea of Smart Contracts.” 1997

https://nakamotoinstitute.org/the-idea-of-smart-contracts/

Footnotes

1 Ethereum was the first smart contract on the blockchain. At present, many others are available – for example, Algorand, Solana, Binance Smart Chain, Cosmos.

2 The process of adding new assets to a blockchain is called tokenisation. The token is the blockchain representation of the asset.

3 The oracle is a connection between the blockchain and outcome in the actual world. They work as on-chain APIs that query information – prices, events, weather – to input it into smart contracts.

4 There are some centralised components In DeFi for various reasons, particularly the logic layer, which Is required for efficiency. However, the key issues DeFi is trying to solve for is not centralisation per say, but the issues this typically brings with it, which are market power and counterparty risk, which can be limited when DeFi is designed well.

5 Impermanent losses refer to the drop in price of a deposited asset to a liquidity pool. The larger the drop at the moment of withdrawal as compared to the time of deposit, the larger the loss.

6 By directly owing most of its liquidity in the form of assets, these liquidity pools do not have to pay out high farming rewards to incentivize liquidity providers. This in turn can allow for higher and lover “renting” fees. See, for example,

https://docs.olympusdao.finance/main/basics/basics

Disclaimer

Aaro Capital is the trading name of Aaro Capital Limited (“Aaro”), a private limited company, registered in England and Wales with number 11419585, whose registered office is at 5th Floor 14-16 Dowgate Hill, London, United Kingdom, EC4R 2SU. Aaro is not authorised or regulated by the Malta Financial Services Authority ("MFSA") or any other financial regulator.

The material provided in this article is being provided for general informational purposes. Aaro does not provide, and does not hold itself out as providing, investment advice and the information provided in this article should not be relied upon or form the basis of any investment decision nor for the potential suitability of any particular investment. The figures shown in this article refer to the past or are provided as examples only. Past performance is not reliable indicator of future results.

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