What is DeFi? Newbie Instruction
What is DeFi? Newbie Instruction
Decentralized finance, also known as "DeFi" or open finance, aims to reconfigure the current financial system (e.g., lending, financial derivatives, and trading), using automation to replace intermediaries. Once fully automated, the different financial modules used to build DeFi can be repeatedly combined to achieve more complex logic and functionality. Today, theEtheris the preferred choice for decentralized finance, though in principle, any smart contract platform can implement this type of application.
Our Decentralized Finance ("DeFi") Tutorial for Beginners will cover the following.
- Stable coins - an important building block of decentralized finance. Unlike bitcoin or ethereum, which are more volatile in price, such numbers or are designed to anchor the value of one unit of fiat currency. Most stablecoins are anchored to the U.S. dollar, and a portion of stablecoins anchored to the Chinese yuan exist on the market.
- Decentralized lending - get a loan from the blockchain through a programmed process, without going through any bank account.
- Decentralized exchange - buying and selling cryptographic currencies on the blockchain, rather than through a centralized exchange like Coinbase. In principle, scripted access is supported to automate transactions.
- Collateral - Borrowers must pledge digital assets in order to lend out a centralized loan, ensuring that they can still repay the lender in the event of a borrower default.
- Decentralized identity - the identity picked up in a smart contract to evaluate the user's credit in a decentralized loan.
- Composability - similar to various libraries in software development, combining different DeFi functions to achieve complex functionality. For example, if there is already a smart contract that can save coins and earn interest, you can implement another contract to automatically reinvest the interest (without the permission of the first contract).
- Risk Control - High returns on DeFi usually come with high risk. Fortunately, many new tools have emerged to minimize the risk of investing.
We will then introduce the above concepts one by one.
If we want to move traditional financial products to the blockchain, the first problem we have to solve is price volatility. In the case of Ether (ETH), which is native on Ether, for example, the price of USD/ETH trading pairs is oftenRoller CoasterSometimes the fluctuations exceed 10% in a single day.
Digital currencies that fluctuate so dramatically in price are not applicable to most traditional financial products. If you get a loan, you don't want the amount due to fluctuate by more than 10% on the eve of repayment. Such high price volatility can disrupt your future plans.
A stable currency is a solution. It was designed to achieve price stability and maintain a 1:1 exchange rate with one unit of fiat currency.Stablecoin Index (Stablecoin Index).Stablecoin Stats (Stablecoin Stats)These two pages list the mainstream stablecoins.
Stable coins are usually divided into three categories: stable coins backed by centralized fiat currencies, stable coins backed by decentralized digital assets, and stable coins implemented by decentralized algorithms.
1.Centralized fiat-backed stablecoins Backed 1:1 by fiat currency held in a bank account. Take Coinbase's stablecoin USD Coin (USDC)For example, for every USDC issued, Coinbase deposits $1 in a bank account. As long as you trust the issuer and the fiat currency that serves as collateral, there is little risk in holding and using this type of stablecoin. Another advantage of these coins is that if something goes wrong, there is always an institution or entity to take responsibility. As a result, this type of stablecoin has gained a lot of popularity among companies and individuals. In the United States, the FDIC has a $250,000 savings insurance payout floor, and other countries have their ownSavings InsuranceTerms. While this may seem wonderful, not all users are eligible to use centralized stablecoins. For example, USDC'sUser TermsJust declare that you only supportSelected countries and regionsThe USDC is strictly limited in scope and scenarios for use by users.
2.Decentralized digital asset-backed stablecoin There is no such thing as a centralized operator or user terms. This means that anyone can directly use such stablecoins without having to obtain permission from a particular company or government. However, the absence of fiat backing adds to the complexity of maintaining price stability. Unlike centralized models with 1:1 anchored fiat currencies, decentralized stablecoins backed by crypto assets usually require an excess guarantee to be issued due to the high price volatility of digital currencies.
As an example, the Maker The system then issues decentralized stable coins DAIThe goal of DAI is to anchor dollars 1:1, so a special "minting" process is required: one needs to lock the cryptocurrency (usually Ether) as collateral in the Maker system before a DAI can be lent. The value of the collateral must be higher than the loan amount, and is therefore an over-collateralized loan.
Assuming you have $200 worth of Ether locked up as collateral, you can lend about $100 worth of DAI to trade. Borrowing DAI is primarily for leverage -- if you believe that the price of Ether will not plummet, you can pledge Ether to lend $100 USD to trade freely. If the original $200 worth of Ether plummets and the collateral ratio falls below the liquidation ratio, then Maker's smart contract will confiscate your collateral and sell it on the market to pay off the $100 lent. This way, the Maker system won't have any bad debts.
While Maker is much more complex than USDC, in theory, end users of DAIs that do not perform minting operations do not need to understand the principles of the system - after all, the average person using fiat currency on a daily basis does not need to understand the complexities of monetary policy. Nonetheless, there are some risks associated with DAI, including potential vulnerabilities in the Maker smart contract and the risk of the DAI being de-anchored from the US dollar.
3.Stable coins implemented by decentralized algorithms It is the third type. This category of tokens does not have any asset backing and relies solely on algorithms to maintain price stability. Representatives of algorithmically stable coins include Basis, it was declared a failure on the eve of its launch. Some questioned the ability of financially strong malicious institutions to attack algorithmic stablecoins, causing panic in the market and de-anchoring of the stablecoins, eventually triggering a death spiral where the value of the stablecoins went to zero.
Overall, the first two stablecoins are more popular. What people care most about is the price stability of the token, whether it is backed by fiat or digital currency. Nevertheless, there are still people working on a third type of stablecoin, trying to combine algorithmic elements with cryptographic asset pledges.
Decentralized lending services
With well-functioning stablecoins like USDC and DAI, we can use automated smart contracts to reconfigure various parts of the traditional financial system. The most fundamental of these is lending.
There are a number of DeFi platforms that enable ethereum lending directly through smart contracts, let's say Compound , ,dYdX and Dharma . One of the most interesting aspects of these smart contracts is that neither lender nor borrower needs to actively seek counterparties. In fact, the smart contract replaces the function of an intermediary and the interest generated by the lending is automatically calculated by an algorithm based on supply and demand.
Centralized lending order book
Before explaining the principle, let's take a look at how a centralized cryptocurrency exchange enables lending and borrowing transactions. Here is Bitfinex'sFunds Book: The
Let's look at the left half of this book. The first line shows someone in the market who would like to borrow a 30-day loan for $4,421.48 at a daily rate of 0.0265%. The second row shows another person who wants to borrow a 30-day loan for $34,292.38 at a slightly lower daily rate of 0.0263%.
On the right half is the lender. The first line indicates that a user is willing to lend a 2-day loan for $8,199.32 at a daily rate of 0.027418%. The second line shows a 2-day loan for $255.68 at a daily rate of 0.027436%.
The rest of the data and so on. This is how the centralized lending and borrowing order book works. In the example above, the borrower is willing to accept a daily rate of no more than 0.0265%, while the lender is willing to accept a daily rate of no less than 0.027418%. Bitfinex provides such an order book service to match users, and then takes a cut.
Decentralized debit and credit order book
Some decentralized lending platforms go a step further and instead of using an order book to match lenders and borrowers, they let users borrow directly through smart contracts that dynamically adjust the interest rate to round out the order. For example, if someone lends a large sum of money from a smart contract, the interest rate on the loan will increase. In addition, the borrower must lock in collateral within the smart contract in order to borrow, and the value of the collateral must be higher than the amount borrowed in order to achieve over-collateralization.
But why did the decentralized lending service make it? The answer is that DeFi applications are extremely scalable. deFi can offer higher savings rates than traditional banks with lower risk, and could theoretically attract billions in capital. compund already manages120 million USDassets, while other platforms are also gaining momentum. Despite the risk of smart contract vulnerabilities and cryptographic asset price volatility, DeFi's savings rates far exceed those of traditional banks with less than 2%. The chart below shows LoanScan data showing the interest rates available for lending stablecoins on different platforms.
Decentralized cryptocurrency exchanges try to move services like Coinbase Pro to the blockchain, i.e., to facilitate transactions between different digital currencies.
To better understand decentralized exchanges, let's take a look at how a centralized exchange does it. Take Coinbase Pro, for example, which is actually an intermediary and custodian between buyers and sellers that hosts assets and brokers transactions. While centralized exchanges facilitate billions of dollars in transactions, it still suffers from single points of failure due to hacking, transaction censorship, and barriers to trading.
Decentralized exchanges aim to solve these challenges by replacing or reducing the intermediary aspect through smart contracts. The ideal form of a decentralized exchange is one that supports all digital assets and is completely peer-to-peer. There are currently many decentralized exchanges that support Ether-based tokens, such asUniswap, ,0x and KyberUniswap, for example, uses an algorithm called an automated market maker (AMM) to provide liquidity to the token. Uniswap, for example, uses an algorithm known as automated market maker (AMM) to provide liquidity to tokens. Uniswap calculates the price regardless of the size of the buy order, and instead increases the price of the token incrementally based on the volume of buy orders.
Currently, decentralized exchanges are able to handle only a fraction of the volume of centralized exchanges and are unable to support large transactions. In addition, most decentralized exchanges only support tokens on ethereum, and therefore cannot access high-cap tokens on other chains. However, with atomic swaps (atomic swap) and zk-STARKs With the development of technology, I believe these limitations will not be a problem in the future.
In the case of the decentralized lending services mentioned above, a major pain point is the need to provide a large amount of collateral. This over-collateralization mechanism can result in too inefficient use of funds -- and many borrowers simply don't have the extra funds to pledge.
As a result, decentralized identity and reputation systems were created, designed to reduce the requirement for collateral. At first, people moved fiat-based credit scoring agencies such as Experian, TransUnion, and Equifax onto the blockchain.
But this approach is clearly flawed, as traditional credit scoring agencies score groups such as young people and overseas users low. However, new services such as Lending Club have solved this problem by moving away from an over-reliance on individual credit scores (FICO) and instead scoring them based on a combination of data such as property status, income level, and years of employment.
A decentralized identity and reputation system can provide a similar service, scoring a user's credit by combining data such as social media reputation, history of loan repayment, and guarantees from other reputable users. There is still a lot of experimentation and trial and error to be done on specific data points before landing on the application, and perhaps adding a pledge system, so we can say we are still in the early exploration stage.
In the long run, the combination of DeFi and decentralized identity systems can liberate people from the traditional financial system. As an example, there are currently 1 billion peopleThere are no official IDs, and about 50% women in low-income countries do not have IDs, but most of them have smartphones. So once decentralized identity systems can be applied to developing countries, it may lead to leaps and bounds - just like smartphones.
We've already covered decentralized stable coins, lending services, exchanges, and identities. But perhaps the most important point of building a decentralized financial system on a smart contract platform like Ether is described belowCombinability. Like the various libraries used in software development, the smart contracts used by different decentralized financial applications can be combined with each other to build complex systems like Lego blocks.
Suppose you want to add a tokenized asset trading function to your own platform, just directly access the decentralized exchange protocol. Various smart contracts can restructure new concepts that are simply not possible in the traditional financial world.
For example, a new project that combines the concepts of DeFi and social media 2100This allows participants to use their Twitter accounts to "mint" new tokens and leverage their social capital to generate digital dollars. Big V's can cash in on the fan economy by making some premium content visible only to token holders. After tokenizing individual accounts, people can even build prediction markets and bid on which accounts will become more popular.
Another concept that has never existed in traditional finance is PoolTogetherIt combines DeFi and lotteries to create a "no-lose" lottery. Users buy tickets on the chain and then earn interest on all the money they spend on tickets by depositing it into Compound. At each lottery draw, each purchaser gets his or her money back -- but one lucky person gets to take home all the interest generated by the pool. In essence, it's using the lottery mechanism to increase savings and create wealth!
As the DeFi system becomes more mature, these smart contract libraries will gradually break the circle and affect the ecology outside of the coin world. Eventually, we can access the entire decentralized marketplace with just one line of code added to the game, or add a line of code to allow merchants in the online marketplace to use their balances to earn interest.
As wonderful as DeFi is, the risks that come with it cannot be ignored. Some of the problems that can arise with DeFi are listed below.
- Smart Contract RiskMany DeFi systems have not been around long. Many DeFi systems have not been around long and will need to be tested over a longer period of time. The risk of smart contracts multiplies as contracts call each other. If there is a programmatic vulnerability in a key smart contract in the protocol, it can directly cause systemic risk. It is wise not to invest too much money in these systems in their early stages.
- Collateral and price volatility risk. There are also risks associated with the digital asset collateral that underwrites the loan. While overcollateralization reduces the risk associated with price volatility, if the price of the collateral plummets, the borrower may be closed out before it has time to make a margin call. Choosing a reasonable pledge rate and vetted collateral can reduce this risk. Another potential risk is that many DeFi platforms have interest rate fluctuations that are not conducive to user participation. Interest rate swaps and other means of locking in interest rates are possible in the future, but this would add complexity to the system.
- Policy RiskDeFi platforms vary in their degree of decentralization, and there is no court precedent to verify whether these systems live up to their name. Only time will tell.
In the DeFi field, theNexus Mutual and Convexity Decentralized insurance such as this can effectively hedge against the above risks. And Augur Prediction markets such as these allow users to hedge their risk by betting on the probability that the smart contract they are using is vulnerable.
Nevertheless, these hedging instruments themselves are still in their infancy, and their smart contracts themselves can be risky. But we believe they can mature. And, as the DeFi ecosystem grows, so will traditional insurers' products.
The DeFi ecosystem is growing and evolving. With hundreds of millions of dollars worth of digital currency already deployed in DeFi systems, the future potential is unlimited. This article is just a quick introduction to a few DeFi use cases, with some reading material listed below for readers to learn more about DeFi and keep up with the latest developments.
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