Decentralized Finance (DeFi) Seminar

Seminar 5: Decentralized Finance (DeFi)

• Readings for the seminar include "A Beginner's Guide to Decentralized Finance", "CeFi vs. DeFi: Comparing Centralized to Decentralized Finance" (optional), and "How to NFT_PDF" (optional).
• The agenda includes areas of Cefi v.s. Defi, Money in Defi system, Dex, Decentralized Lending, and NFT

The Evolution of Finance

• Modern financial systems evolved from historical institutions like the Bank of Saint George.
• Mobile banking applications represent a contemporary advancement in finance.

Is the Current System Failing?

• The existing financial system faces challenges of high costs with credit card transactions, taking 300 bp every time it is swiped.
• Money transfers are often expensive, slow, and insecure, impacting efficiency.
• There are delays in ownership transfer after buying shares, often taking up to two days.
• Institutions have required bailouts during global crises.
• Approximately 1.7 billion people worldwide are unbanked.

Decentralized Finance (DeFi)

• DeFi is a blockchain-based form of finance that disintermediates traditional financial entities by using smart contracts on blockchains.

Foundation of DeFi

• The DeFi foundation shifts from the self-custody of money (Bitcoin) towards programmable money and financial assets (Ethereum).

CeFi v.s. DeFi

• Centralized Finance (CeFi) is permissioned, using closed-source systems on centralized databases that require third-party approval.
• CeFi assets are held by licensed third parties, governed by a central entity with upgrade and admin control, and mandates users register with real identities for KYC/AML.
• Decentralized Finance (DeFi) is permissionless, built on open-source systems using permissionless blockchains, it allows anyone to use, build, and interoperate freely.
• DeFi assets are not held by third-parties, and it operates trustlessly with no single entity controlling upgrades and admin, and uses pseudonymous, private identities generally.

High-Level Architecture of CeFi & DeFi

• CeFi involves central banks, regulators, traditional banks, exchanges, and brokers.
• DeFi involves protocols for pegged assets, leveraged loans, automated market makers, and lending/borrowing platforms; it is supported by oracles and wallets.

The Money in DeFi System: Stablecoins

• Stablecoins are an important aspect of the DeFi system.
• DAI, USDT, and USDC are all stablecoins.

Deep Dive: DAI

• DAI is a stablecoin cryptocurrency on the Ethereum blockchain, which is maintained and regulated by MakerDAO.
• DAOs (decentralized autonomous organizations) consist of rules encoded in computer programs to promote fair, transparent governance.
• To mint DAI, deposit 150% of ETH as collateral to mint 100% debt in DAI (step 1: deposit collateral with over collateralization).
• Step 2: Draw debt in DAI
• Step 3: Pay back in DAI
• Step 4: Unlock ETH

Deep Dive: DAI - Update in late 2024

• MakerDAO rebranded to Sky Protocol in August 2024.
• A new stablecoin, USDS, to succeed DAI was introduced.
• Discussions emerged about forking the Solana codebase for a native blockchain.
• DAI remains decentralized, while USDS shifts towards an RWA-backed model, similar to USDC or USDT, but with built-in yield.

DEX (Decentralized Exchange)

• In a financial exchange Alice provides stock A for flat currency in exchange for Bobs Fiat currency for stock A

Trade Matching: Order Book

• Order books match bids and offers to facilitate trading.
• Buyers bid (left) and sellers offer (right).

Liquidity Pool: Let Smart Contract Do Market Making

• Liquidity pools utilize smart contracts for market making, where users like Alice add liquidity by providing assets X and Y.
• Users who provide X plus a fee receive Y in return.

Automated Market Maker (AMM)

• Constant product AMMs have a constant formula of calculating k in the formula x * y = k
• With the purchase of asset Y increases its price and decreases the price of X

AMM Examples

• State Before: x₀ = 10, y₀ = 50, and k = x₀ * y₀ = 500.
• State After: x₁ = 20, y₁ = 25, and k = x₁ * y₁ = 500.

Expected Slippage

• Expected price increase or decrease is based on trading volume and available liquidity.

Unexpected Slippage

• Unexpected slippage leads to worse or better execution prices.

Slippage Protection

• Slippage protection configures a threshold to prevent unacceptable slippage.
• A transaction can fail when crossing the slippage limit.

Impermanent Loss Example

• Realisation of IL: Alice lost 100 USD when 1 ETH + 100USD == 500 USD
• 1 ETH == 100 DAI
• Add liquidity: 1 ETH, 100 DAI == 200 USD == 10% of pool
• Price increase of ETH: 1 ETH == 400 DAI
• Withdraw liquidity: 10% == 0.5 ETH, 200 DAI == 400 USD

Liquidity Mining == Incentive

• Trading fees (e.g., 0.03% in Curve) are a part of rewards in DeFi Pools.
• Liquidity mining rewards are apart of the 2 rewards that are in DeFi Pools
• Liquidity Mining serves as an incentive to provide liquidity to a pool, offering proportional rewards and possible retrospective airdrops.

Arbitrage

• Arbitrage involves multiple markets with the same assets X and Y but different prices.
• Prices are synchronized by "arbitrageurs" who profit from the price difference, they perform spread trades that require at least one transaction.

Arbitrage on two markets

• Example of arbitrage on two markets: exchange USDC for DAI on Curve Y Pool and DAI for USDC for Curve sUSD

Arbitrage (with Flash Loan)

• Arbitrage can be performed with flash loans, where the flash loan amount must be repaid.

Trade Settlement

• Trade settlement involves exchanging assets without traditional intermediaries.
• Non-custodial trade settlement.

Centralised Exchange vs. Decentralised Exchange

• A visual is shown detailing how centralised exchange is a centralised point wheras decentralised exchange is spread out

A Failure of Centralised Brokerage/Exchange

• Visual showing how with centralisation there can be failures

Pros and Cons of an AMM

• Pros: (+) No order book maintenance, but arbitrage is required, (+) Simple implementation for CP AMM, and Low gas costs
• Cons: (-) Danger of impermanent loss, total loss of funds possible, (-) High slippage for low liquidity markets, please do observe your slippage tolerance
• (-) users vulnerable to sandwich attacks and are given a security issue

DEX Volume Share %

• Solana DEXs and Aerodrome gained share through the year

Liquidation

• On-Chain Lending & Borrowing, where Borrowers Collateralize before borrowing, and Lenders, Deposit Principal, Liquidators liquidate
• Terminology Collateral, assets that serve as a security deposit

Lending

• Over-collateralization Borrower has to provide the value greater than value (granted loan
• Under-collateralization: value (collateral) less than value debit, E.d., the borrower collateralizes ETH and borrows DAI, the value of DAI, debit is more than the value of ETH ( collateral.
• Liquidation: if value (collateral) LESS THAN = to 150% as value debt, so anyone can liquidate the debt provision

Health Factor

• Used to assess borrowing risk.

Over-collateralized Borrowing

• Lender collateralizes ETH and borrows DAI.
• The value of ETH exceeds the value of DAI.

Under-collateralized Borrowing.

• The value of ETH exceeds the value of eth, so the borrower collateralizes ETH and borrows DAI

Solidity

• Solid Contracts is a restricted to B used with design smart contracts typically forming contracts
• Value can be used to manage assets

NFTs

• A Fungible good is an item that is mutually interchangeable with another.
• Non Fungible items are unique and non interchangeable assets such as Art, vehicles or property
• Non-fungible can be Tradable on markets place games collectibles
• The first blockchain-based mortgages were developed.

Intrinsic Value?

• Collectibles can come in the form of NBA Top Shot, Pokémon trading cards.
• You can see how a added valued NFT contains memorabilia values and recognitions

Other DeFi Building Blocks and Services

• Decentralized derivatives, Decentralized Insurance and, On-chain Asset Management

Conventional Methods

• Valuation methods includes Discounted cash flow DCF, value to account what's happening in the background
• Some of the Top 7 Metrics for Valuing Cryptocurrencies includes
• Stores of Value, Token Velocity, Mettcalfe's Law, NVT Ratio

Token Velocity

• The relation of total transaction to average Network Value

Tokens

• There are a number of Features of Tokens
• Such as facilities the ecosystem, is resistant to inflation and as social and technical scalability