What is all this DeFi stuff

DeFi is an acronym of Decentralized Finance, which refers to a technology set that aims to replicate and innovate on current financial services models/products using decentralised blockchain technology.

These financial services range from Digital assets that may or may not represent assets in the real world, to financial smart contracts that can replicate derivative products found in traditional finance markets.

Separate DeFi solutions can be linked together, using their exposed API’s, to compose complex systems, that in a trust-less way, create complex financial derivatives and services.

DeFi is currently one of the fastest growing sectors of the Blockchain industry and is certainly slurping up more than its fair share of the Buzz and excitement among the Ethereum Elite’s and Tech Bro’s of Silicone Valley.

Despite the current Buzz it has to be stated that this is a highly experimental technology and, even if ultimately successful, has the potential to fail in spectacular ways over the next few years. Vitalik stated that although he finds DeFi “exciting” and “very powerful” it has a “risk of breaking, as shown in the conversation below:

For more information, lets look at an example of a DeFi use case:

Loans

Traditional loans are usually “under collateralised” – meaning the borrower gets more value in the loan than they put in as collateral, with the lender taking into account future earnings and knowledge of the customers finances/credit history to assess the risk of providing the loan.

In DeFi, a KYC check or even vague knowledge of the customer is not a pre-requisite, and is also not needed due to the decentralised/trustless nature of the protocol. As a result, loans are “over collateralised” and automatically liquidated once this collateral falls below a certain threshold.

Hey? A loan where you leave more in collateral than you are actually borrowing – whats the point in that is what users could be asking?

Over collateralisation is used in traditional finance markets, usually for borrowing against illiquid assets to get better interest/funding rates.

Use cases of loans in the DeFi sector include:

1) Create liquidity for trading without actually selling any Ether, therefore not triggering a capital tax gains event.

E.g. If you have used up your tax free capital gain allowance (£12K in the UK) for the year you could use your holdings to borrow another asset for investment but because you haven’t sold any of your original asset you are not liable to pay any capital gains tax on the base asset. You may on the borrowed asset if your trade is profitable.


2) dApps automatically borrowing GNT to purchase computing power on the Golem network

In this case the dApp is scaling when required in an fully automated way as demand hits the service


3) Traders looking to short a token can borrow it, send it to an exchange and sell the token

This is a great mechanism for assets without a traditional margin markets and with wider use will allow better price discovery on what was before a one way market.

4) Leverage investments/trades by borrowing Ethereum, with users utilising their existing portfolio as collateral.

You have Assets other that Ether and want to invest in a new ICO. Again without triggering a capital gains events you can use your assets to borrow ether and participate in the coin sale. You can then pay down this loan in a more tax efficient timeframe.

Under collateralised loans

At the moment under collateralised loans are not an option in DeFi as without the collateral safety net a borrower could just not repay the loan and disappear into the ether.

In a worst case somebody could create lots of fake addresses, take out loans and then default on all of them – the Sybil Attack.

Under collateralised loans may start to appear in the DeFi sector when identity and reputation can be attached to loans. This could be through traditional KYC implementations or Biometrically Owned Account (BOA) which uses biometric information from smart phones to prove an address is owned by an actual human.

The use of linking an account to an actual human then building up a reputation over time while also locking people who has defaulted on loans out of the ecosystem would in theory make an efficient market where lending rates were calculated based on the risk profile of the BOA.

We have not seen much progress in the under collateralised space yet so this will take some time to develop and implement.

Compound Protocol

Compound protocol was released in February 2019 with its whitepaper being written by Robert Leshner (CEO) and Geoffrey Hayes (CTO).

It consists of a protocol (clearly) and set of in-house and external apps that aim to stop crypto currency balances sitting idle in user wallets.

Taken from the Compound white paper:

“The majority of cryptocurrencies sit idle on exchanges and in wallets, without yielding interest. We’re on a mission to change that.

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.

Each money market is unique to an Ethereum asset (such as Ether, an ERC-20 stablecoin such as Dai, or an ERC-20 utility token such as Augur), and contains a transparent ledger, with a record of all transactions and historical interest rates.”

This allows users to access the money markets listed at https://app.compound.finance/, although many other similar marketplaces exist or are in development such as Zerion, DeFi Saver, Pool Together among others.

There are already well over $100 million of assets pledged to the markets in the native app with the largest markets being in Ether and Dai.

Current market size on app.compound,finance as of 25/09/2019

Compound’s version 2 of their platform was released on May 23rd 2019 and with this release comes a new way to represent users tokens on the platform. Lets run down all the concepts and acronyms that users need to know.

cTokens

When users deposit their compatible crypto assets on Compound, they receive cTokens, which are ERC-20 tokens that represent the balance and set the limit on what users can borrow from the other assets on the protocol.

E.g. Deposit ETH and get cEth – Swap some of your cEth for cDAI (ERC-20 stable coin)

Holding cDAI allows users to collect interest from lenders on the compound protocol and by using rDAI, users can direct the flow of any earned interest to other parties while retaining control of the principle DAI that is staked.

DAI

An algorithmic stable token that represents $1 US created by Maker DAO. this token is very commonly within DeFi and its market size is only bettered by Ether itself.

Users can lend DAI on Compound and receive back DAI in interest payments, which are represented as cDAI on the Compound platform.

cDAI

Any deposited DAI into the Compound platform results in cDIA being issued at a rate of 50:1 and this exchange rate reduces over time as the interest on the token accumulates.

This cToken rather than being locked into a smart contact is then free to be transferred off the Compound platform and can be swapped back to DAI at any time.

This allows users to trade cDAI on any listed markets or hold them in another wallet.

rDAI

Redeemable DAI (rDAI) is backed one to one with real DAI. Users can lend their DAI at the best interest rate on the Compound platform and receive rDAI in return.

rDAI allows users to transfer just the interest from an interest bearing instrument, leaving the instrument untouched until the contract terminates.

LSDai

This is a token that represents a fixed term futures contract based on the lending rate of the DAI token on the Compound platform.

By leveraging Market Protocol which takes on the approach of constructing index futures via “iron-cross options” approach, LSDai de-couples the risk of the two sides via long and short position tokens

https://devpost.com/software/lsdai

LSDai is a tool to eliminate interest rate risk of a certain asset which have in the past seen large swings.

Conclusion

This is the first time we have looked into the DeFi sector and DeFi appears to be the new buzzword amongst tech circles in 2019 and beyond.

As with any new emerging technology utilising the blockchain, it is natural for healthily skepticism concerning the stability and safety of platforms and instruments, around what is truly a break neck speed development and innovation cycle in this emerging field.

One of the main concerns around DeFi is the impact that instruments and contracts may have on the underlying assets.

The rapid swings in valuation of the price of Ether and other crypto currencies on 24th September cause a service named DeFI Saver to issue the below statement

This shows that while these financial instruments are happy prodding along during relatively calm periods, they can be quite fragile to the volatility that is second nature in the crypto space.

However, these are the expected and required parts of a rapid growth stage in FinTech and will only make the innovation more secure for the future as more instruments are created and utilised.

One of the positive elements around the growth of the DeFi sector is the opportunities it offers for development of assets and instruments in the crypto industry.

Stay tuned for part 2