The layers build on each other and create an open and highly composable infrastructure that allows everyone to build on, rehash, or use other parts of the stack. It is also crucial to understand that these layers are hierarchical: They are only as secure as the layers below.
If, for example, the blockchain in the settlement layer is compromised, all subsequent layers would not be secure. Similarly, if we were to use a permissioned ledger as the foundation, any decentralization efforts on subsequent layers would be ineffective. Figure 2 The DeFi Stack This section proposes a conceptual framework for analyzing these layers and studying the token and the protocol layers in greater detail.
The settlement layer Layer 1 consists of the blockchain and its native protocol asset e. It allows the network to store ownership information securely and ensures that any state changes adhere to its ruleset.
The blockchain can be seen as the foundation for trustless execution and serves as a settlement and dispute resolution layer. The asset layer Layer 2 consists of all assets that are issued on top of the settlement layer. This includes the native protocol asset as well as any additional assets that are issued on this blockchain usually referred to as tokens.
The protocol layer Layer 3 provides standards for specific use cases such as decentralized exchanges, debt markets, derivatives, and on-chain asset management. These standards are usually implemented as a set of smart contracts and can be accessed by any user or DeFi application. As such, these protocols are highly interoperable. The application layer Layer 4 creates user-oriented applications that connect to individual protocols.
The smart contract interaction is usually abstracted by a web browser-based front end, making the protocols easier to use. The aggregation layer Layer 5 is an extension of the application layer. Aggregators create user-centric platforms that connect to several applications and protocols. They usually provide tools to compare and rate services, allow users to perform otherwise complex tasks by connecting to several protocols simultaneously, and combine relevant information in a clear and concise manner.
Now that we understand the conceptual model, let us take a closer look at tokenization and the protocol layer. After a short introduction to asset tokenization, we will investigate decentralized exchange protocols, decentralized lending platforms, decentralized derivatives, and on-chain asset management.
This allows us to establish the foundation needed for our analysis of the potential and risks of DeFi. Usually, a ledger is used to track the native protocol asset of the respective blockchain. However, when public blockchain technology became more popular, so did the idea of making additional assets available on these ledgers.
The process of adding new assets to a blockchain is called tokenization, and the blockchain representation of the asset is referred to as a token. The general idea of tokenization is to make assets more accessible and transactions more efficient. In particular, tokenized assets can be transferred easily and within seconds from and to anyone in the world. They can be used in many decentralized applications and stored within smart contracts.
As such, these tokens are an essential part of the DeFi ecosystem. However, most of these options can be ignored, as the vast majority of tokens are issued on the Ethereum blockchain through a smart contract template referred to as the ERC token standard Vogelsteller and Buterin, These tokens are interoperable and can be used in almost all DeFi applications.
Almost 90 percent of all listed tokens are issued on the Ethereum blockchain. The slight deviation in terms of market cap originates from the fact that a relatively large portion of the USDT stablecoin has been issued on Omni. From an economic perspective, I am more interested in the asset's nature than in the underlying technical standard used to implement the asset's digital representation.
The main motivation for adding additional assets on-chain is the addition of a stablecoin. While it would be possible to use the aforementioned protocol assets BTC or ETH , many financial contracts require a low-volatility asset. Tokenization enables the creation of these assets. However, one of the main concerns with tokenized assets is issuer risk. In contrast, when someone introduces tokens with a promise, for example, interest payments, dividends, or the delivery of a good or service, the corresponding token's value will depend on this claim's credibility.
If an issuer is unwilling or unable to deliver, the token may become worthless or trade at a significant discount. This logic also applies to stablecoins. Generally speaking, there are three backing models for promise-based tokens: off-chain collateral, on-chain collateral, and no collateral.
Off-chain collateral means that the underlying assets are stored with an escrow service, for example, a commercial bank. On-chain collateral means that the assets are locked on the blockchain, usually within a smart contract. In this case, the promise is entirely trust-based. On-chain collateral has several advantages. It is highly transparent, and claims can be secured by smart contracts, allowing processes to be executed in a semi-automatic way.
A disadvantage of on-chain collateral is that this collateral is usually held in a native protocol asset or a derivative thereof and, therefore, will experience price fluctuations. Take the example of the Dai stablecoin, which mainly uses ETH as its on-chain collateral to create a decentralized and trustless Dai token pegged to the value of 1 USD.
Whenever anyone wants to issue new Dai tokens, they first need to lock enough ETH as underlying collateral in a smart contract provided by the Maker Protocol. If the value of the underlying ETH collateral at any point falls below the minimum threshold of percent of the outstanding Dai value, the smart contract will auction off the collateral to cancel the debt in Dai.
Figure 3 shows some key metrics of the Dai stablecoin, including price, total Dai in circulation, and the stability fee, that is, the interest rate that has to be paid by anyone who is creating new Dai see Section 2. There are also several examples of off-chain collateralized stablecoins. They are both available as ERC tokens on the Ethereum blockchain.
Off-chain collateralized tokens can mitigate exchange rate risk, as the collateral may be equivalent to the tokenized claim e. However, off-chain collateralized tokens introduce counterparty risk and external dependencies.
Tokens that use off-chain collateral require regular audits and precautionary measures to ensure that the underlying collateral is available at all times. This process is costly and, in many cases, not entirely transparent for the token holders. While I am unaware of any functional designs for unbacked stablecoins, that is, stablecoins that do not use any form of collateral to maintain the peg, several organizations are working on that idea.
Note that rebase tokens such as Ampleforth or YAM do not qualify as stablecoins. They only provide a stable unit of account but still expose the holder to volatility in the form of a dynamic token quantity. Although stablecoins serve a vital role in the DeFi ecosystem, it would not do justice to the subject of tokenization to limit the discussion to these assets.
There are all kinds of tokens that serve a variety of purposes, including governance tokens for decentralized autonomous organizations DAO , tokens that allow the holder to perform specific actions in a smart contract, tokens that resemble shares or bonds, and even synthetic tokens that can track the price of any real-world asset. Another distinct category are so-called non-fungible tokens NFTs. NFTs are tokens that represent unique assets, that is, collectibles.
They can either be the digital representation of a physical object such as a piece of art, making them subject to the usual counterparty risk, or a digitally native unit of value with unique characteristics. In any case, the token's non-fungibility attributes ensure that the ownership of each asset can be individually tracked and the asset precisely identified. The following sections discuss the protocol layer and examine how tokens can be traded using decentralized exchanges Section 2.
While most of them are economically irrelevant and have a negligible market cap and trading volume, there is a need for marketplaces where people can trade the more popular ones. This would allow owners of such assets to rebalance their exposure according to their preferences and risk profiles and adjust portfolio allocations.
In most cases, cryptoasset trades are conducted through centralized exchanges. Centralized exchanges are relatively efficient, but they have one severe problem. To be able to trade on a centralized exchange, traders must first deposit assets with the exchange. They thereby forfeit direct access to their assets and have to trust the exchange operator.
Dishonest or unprofessional exchange operators may confiscate or lose assets. Moreover, centralized exchanges create a single point of attack and face the constant threat of becoming the target of malicious third parties.
The relatively low regulatory scrutiny intensifies both problems and the immense scaling efforts many of these exchanges had to go through within a short time. Accordingly, it is no surprise that some centralized cryptoasset exchanges have lost customer funds. Decentralized exchange protocols try to mitigate these issues by removing the trust requirement. Users no longer must deposit their funds with a centralized exchange. Instead, they remain in exclusive control of their assets until the trade is executed.
Trade execution happens atomically through a smart contract, meaning that both sides of the trade are performed in one indivisible transaction, mitigating the counterparty credit risk. Depending on the exact implementation, the smart contract may assume additional roles, effectively making many intermediaries such as escrow services and central counterparty clearing houses CCPs obsolete.
Early decentralized exchanges such as EtherDelta have been set up as walled gardens with no interaction between the various implementations. High network fees, as well as cumbersome and slow processes to move funds between these decentralized exchanges, have rendered supposed arbitrage opportunities useless.
More recently, there has been a move toward open exchange protocols. These projects try to streamline the architecture of decentralized exchanges by providing standards on how asset exchange can be conducted and allowing any exchange built on top of the protocol to use shared liquidity pools and other protocol features.
However, most importantly, other DeFi protocols can use these marketplaces and exchange or liquidate tokens when needed. In the following subsections, I compare various types of decentralized exchange protocols, some of which are not exchanges in the narrow sense but have been included in the analysis, as they serve the same purpose.
The results are summarized in Table 2. Decentralized Order Book Exchanges. Decentralized order book exchanges can be implemented in a variety of ways. They all use smart contracts for transaction settlement, but they differ significantly in how the order books are hosted.
One has to distinguish between on-chain and off-chain order books. On-chain order books have the advantage of being entirely decentralized. Every order is stored within the smart contract. As such, there is no need for additional infrastructure or third-party hosts.
The disadvantage of this approach is that every action requires a blockchain transaction. Therefore, it is a costly and slow process for which even the declaration of the intent to trade results in network fees. Considering that volatile markets will require frequent order cancellations, this disadvantage becomes even more costly. For this reason, many decentralized exchange protocols rely on off-chain order books and only use the blockchain as a settlement layer.
Off-chain order books are hosted and updated by centralized third parties, usually referred to as relayers. They provide takers with the information they need to select an order they would like to match. While this approach indeed introduces some centralized components and dependencies to the system, the relayers' role is limited. Relayers are never in control of the funds and neither match nor execute the orders.
They simply provide ordered lists with quotes and may charge a fee for that service. The openness of the protocol ensures that there is competition among the relayers and mitigates potential dependencies. The dominant protocol that uses this approach is called 0x Warren and Bandeali, The protocol uses a three-step process for trades. First, the maker sends a pre-signed order to the relayer for inclusion in the order book.
Second, a potential taker queries the relayer and selects one of the orders. Third, the taker signs and submits the order to the smart contract, triggering the atomic exchange of the cryptoassets. Constant Function Market Maker. A constant function market maker CFMM is a smart contract-liquidity pool that holds at least two cryptoassets in reserve and allows anyone to deposit tokens of one type and thereby to withdraw tokens of the other type. To determine the exchange rate, smart contract-based liquidity pools use variations of the constant product model, where the relative price is a function of the smart contract's token reserve ratio.
The earliest implementation I am aware of was proposed by Hertzog, Benartzi, and Benartzi Adams has simplified the model, and Zhang, Chen, and Park provide a formal proof of the concept. Martinelli and Mushegian generalized the concept for cases with more than two tokens and dynamic token weights. Egorov optimized the idea for stablecoin swaps. In fact, any exchange corresponds to a move on a convex token reserve curve, which is shown in Figure 4A.
A liquidity pool using this model cannot be depleted, as tokens will get more expensive with lower reserves. When the token supply of either one of the two tokens approaches zero, its relative price rises infinitely as a result. It is important to point out that smart contract-based liquidity pools are not reliant on external price feeds so-called oracles. Whenever the market price of an asset shifts, anyone can use the arbitrage opportunity and trade tokens with the smart contract until the liquidity pool price converges to the current market price.
Anyone who provides liquidity to the pool receives pool share tokens that allow them to participate in this accumulation and to redeem these tokens for their share of a potentially growing liquidity pool. Liquidity provision results in a growing k and is visualized in Figure 4B. Prominent examples of smart contract-based liquidity pool protocols are UniSwap, Balancer, Curve, and Bancor.
Smart Contract-Based Reserve Aggregation. Another approach is to consolidate liquidity reserves through a smart contract that allows large liquidity providers to connect and advertise prices for specific trade pairs. A user who wants to exchange token x for token y may send a trade request to the smart contract.
The smart contract will compare prices from all liquidity providers, accept the best offer on behalf of the user, and execute the trade. It acts as a gateway between users and liquidity providers, ensuring best execution and atomic settlement.
In contrast to smart contract-based liquidity pools, with smart contract-based reserve aggregation, prices are not determined within the smart contract. Instead, prices are set by the liquidity providers. This approach works fine if there is a relatively broad base of liquidity providers.
However, if there is limited or no competition for a given trade pair, the approach may result in collusion risks or even monopolistic price setting. As a countermeasure, reserve aggregation protocols usually have some centralized control mechanisms, such as maximum prices or a minimum number of liquidity providers.
In some cases, liquidity providers may only participate after a background check, including KYC know your customer verification. The best-known implementation of this concept is the Kyber Network Luu and Velner, , which serves as a backbone protocol for a large variety of DeFi applications.
Peer-to-Peer Protocols. An alternative to classic exchange or liquidity pool models are peer-to-peer P2P protocols, also called over-the-counter OTC protocols. They mostly rely on a two-step approach, where participants can query the network for counterparties who would like to trade a given pair of cryptoassets and then negotiate the exchange rate bilaterally.
Once the two parties agree on a price, the trade is executed on-chain via a smart contract. In contrast to other protocols, offers can be accepted exclusively by the parties who have been involved in the negotiation. In particular, it is not possible for a third party to front-run someone accepting an offer by observing the pool of unconfirmed transactions mempool. To make things more efficient, the process is usually automated. Additionally, one can use off-chain indexers for peer discovery.
These indexers assume the role of a directory in which people can advertise their intent to make a specific trade. Note that these indexers only serve to establish a connection. Prices are still negotiated P2P. AirSwap is the most popular implementation of a decentralized P2P protocol. It was proposed by Oved and Mosites There are a large variety of protocols that allow people to lend and borrow cryptoassets. Decentralized loan platforms are unique in the sense that they require neither the borrower nor the lender to identify themselves.
Everyone has access to the platform and can potentially borrow money or provide liquidity to earn interest. As such, DeFi loans are completely permissionless and not reliant on trusted relationships. To protect the lender and stop the borrower from running away with the funds, there are two distinct approaches: First, credit can be provided under the condition that the loan must be repaid atomically, meaning that the borrower receives the funds, uses, and repays them—all within the same blockchain transaction.
Suppose the borrower has not returned the funds plus interest at the end of the transaction's execution cycle. In this case, the transaction will be invalid and any of its results including the loan itself reverted. These so-called flash loans Wolff, ; Boado, are an exciting but still highly experimental application. While flash loans can only be employed in applications that are settled atomically and entirely on-chain, they are an efficient new instrument for arbitrage and portfolio restructuring.
As such, they are on track to become an essential part of DeFi lending. Second, loans can be fully secured with collateral. The collateral is locked in a smart contract and only released once the debt is repaid. Collateralized loan platforms exist in three variations: Collateralized debt positions, pooled collateralized debt markets, and P2P collateralized debt markets.
Collateralized debt positions are loans that use newly created tokens, while debt markets use existing tokens and require a match between a borrowing and a lending party. The three variations are discussed below. Collateralized Debt Positions. Some DeFi applications allow users to create collateralized debt positions and thereby issue new tokens that are backed by the collateral.
To be able to create these tokens, the person must lock cryptoassets in a smart contract. The number of tokens that can be created depends on the target price of the tokens generated, the value of the cryptoassets that are being used as collateral, and the target collateralization ratio. The newly created tokens are essentially fully collateralized loans that do not require a counterparty and allow the user to get a liquid asset while maintaining market exposure through the collateral.
The loan can be used for consumption, allowing the person to overcome a temporary liquidity squeeze or to acquire additional cryptoassets for leveraged exposure. Subsequently, they call a contract function to create and withdraw a certain number of Dai and thereby lock the collateral. This process currently requires a minimum collateralization ratio of percent, meaning that for any USD of ETH locked up in the contract, the user can create at most This rate is set by the community, namely the MKR token holders.
As shown in Figure 3, the stability fee has been fluctuating wildly between 0 and 20 percent. To close a CDP, the owner must send the outstanding Dai plus the accumulated interest to the contract. The smart contract will allow the owner to withdraw their collateral once the debt is repaid.
If the borrower fails to repay the debt, or if the collateral's value falls below the percent threshold, where the full collateralization of the loan is at risk, the smart contract will start to liquidate the collateral at a potentially discounted rate. In exchange, MKR holders assume the residual risk of extreme negative ETH price shocks, which may lead to a situation in which the collateral is insufficient to maintain the USD peg.
In this case, new MKR will be created and sold at a discounted rate. As such, MKR holders have skin in the game, and it should be in their best interest to maintain a healthy system. It is important to mention that the MakerDAO system is much more complicated than what is described here. Although the system is mostly decentralized, it is reliant on price oracles, which introduce some dependencies, as discussed in Section 3.
MakerDAO has recently switched to a multi-collateral system, with the goal to make the protocol more scalable by allowing a variety of cryptoassets to be used as collateral. Collateralized Debt Markets. Instead of creating new tokens, it is also possible to borrow existing cryptoassets from someone else.
For obvious reasons, this approach requires a counterparty with opposing preferences. To mitigate counterparty risk and protect the lender, loans must be fully collateralized, and the collateral is locked in a smart contract—just as in our previous example. Matching lenders with borrowers can be done in a variety of ways. The broad categories are P2P and pooled matching.
P2P matching means that the person who is providing the liquidity lends the cryptoassets to specific borrowers. Consequently, the lender will only start to earn interest once there is a match. The advantage of this approach is that the parties agree on a time period and operate with fixed interest rates.
Pooled loans use variable interest rates that are subject to supply and demand. The funds of all borrowers are aggregated in a single, smart contract-based lending pool, and lenders start to earn interest right when they deposit their funds in the pool. However, the interest rates are a function of the pool's utilization rate. When liquidity is readily available, loans will be cheap. When it is in great demand, loans will become more expensive.
Lending pools have the additional advantage that they can perform maturity and size transformation while maintaining relatively high liquidity for the individual lender. There is a large variety of lending protocols. Figure 5 shows the asset-weighted borrowing and lending rates for Dai and ETH. For Dai, the figure also includes the MakerDAO stability fee, which should always be the highest rate in the system.
Surprisingly, this is not always the case, meaning that some people have paid a price premium in the secondary market. As of September , Dai accounts for almost 75 percent of all loans in the DeFi ecosystem. They usually require an oracle to track these variables and therefore introduce some dependencies and centralized components. The dependencies can be reduced when the derivative contract uses multiple independent data sources. We differentiate between asset-based and event-based derivative tokens.
We call a derivative token asset-based when its price is a function of an underlying asset's performance. We call a derivative event-based when its price is a function of any observable variable that is not the performance of an asset. Both categories will be discussed in the following sections. Asset-Based Derivative Tokens. Asset-based derivative tokens are an extension of the CDP model described in Section 2. Instead of limiting the issuance to USD-pegged stablecoins, the locked collateral can be used to issue synthetic tokens that follow the price movements of a variety of assets.
Examples include tokenized versions of stocks, precious metals, and alternative cryptoassets. The higher the underlying volatility, the larger the risk of falling below a given collateralization ratio. A popular derivative token platform is called Synthetix Brooks et al. It is implemented so that the total debt pool of all participants increases or decreases depending on the aggregate price of all outstanding synthetic assets.
This simple condition is very easy to replicate with smart contracts, eliminating human error, greed, and the middleman from the equation, offering up a truly decentralized way of fundraising. Applications built with smart contracts are called decentralized apps or dapps.
What are ERC20 Tokens? A very important feature of Ethereum is the ability to create new tokens on the Ethereum blockchain. These tokens are sent to Ethereum addresses, not addresses of a new cryptocurrency's blockchain. It is because of this that tokens aren't really a cryptocurrency per se, but the result of logic executed via a smart contract.
Saying a token is a cryptocurrency is actually just as inaccurate as claiming that a program is a programming language. A token can be a concert ticket, loyalty points in a shop, in-game currency, etc. As more and more tokens started to appear, their format was standardized into ERC20 — a set of rules on how to develop them to make them easily consumable by various exchanges and systems.
This means that all ERC20 tokens have some common features like a ticker symbol for exchanges, an icon, etc. Creating ERC20 tokens in combination with smart contracts is Ethereum's revolutionary feature which is poised to completely change the way we do business. Tokens make autonomous companies possible, they allow for partial purchases of digital goods or land, they even allow for the creation of autonomous cars which drive themselves, pick up customers, drop them off, collect payment, and effectively pay themselves off.
The number of potential use cases is so large we haven't even scratched the surface. With bitcoin , a unit of proof of work is the hash gained by doing massive calculations. We'll publish a separate post about PoW and PoS soon, but for now suffice it to say that a PoS system isn't wasteful as far as electricity goes, which is an important feature considering China's mining dominance.
PoS has its own problems, of course. In this system, a user of Ethereum trying to be a node this new type of miner stakes their Ether to guarantee the correctness of their calculations. If they try to game the system and fake some calculations that aren't valid, the other nodes will call the node out, and the stake gets lost.
Otherwise, the staker gets their stake back after a few months yes, months! The size of the stake deters malicious actors — the initial stake is said to be Ether. Conclusion it'll soon transition to Proof of Stake instead of Proof of Work it'll soon be quantum-proof we're working on a post about this it supports the creation of sub-tokens on the network instructions on making your own coming up in an article soon!
ETH: Bitcoin is gold. It's complicated to obtain, expensive and slow to transfer, but highly deflationary and finite for now. This makes it a good long-term investment, depending on who you're asking. Ethereum isn't silver to Bitcoin's gold as many would assume. Ethereum is oil. Other products are made with the help of Ethereum, and ERC20 tokens correspond to plastics, make-up, paint, rubber… Ethereum is the base of an entire new industry and while there are several alternatives Tezos, EOS, Rootstock, NEO , none of them have a developer or user community as wide and strong as Ethereum does.
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