Decentralized Finance (DeFi) Seminar

• Seminar 5 is about Decentralized Finance
• Readings include "A Beginner's Guide to Decentralized Finance", and optionally "CeFi vs. DeFi: Comparing Centralized to Decentralized Finance" and "How to NFT_PDF

Agenda

• Cefi versus Defi will be compared
• Money in the Defi system will be covered
• Dex will be examined, including exchange basics, AMM, Arbitrage, and Liquidity mining
• Decentralized Lending will be discussed, including terminology, over-collateralized loans, under-collateralized loans, and liquidation
• NFT will be covered

The Evolution of Finance

• The Bank of Saint George is an example of traditional finance
• Mobile Banking Applications are an evolution in finance

Is the Current System Failing?

• Credit card swipes cost 300 bp
• Transfer of money can be expensive, slow, and insecure
• Transfer of ownership after buying shares can take two days
• Institutions sometimes need bailouts during global crises
• There are 1.7 billion unbanked or underbanked people

What is Decentralised Finance?

• Decentralized Finance involves blockchain, fiat money transfers, and financial services
• It is a blockchain-based finance form that does not rely on central financial intermediaries like brokerages, exchanges, or banks
• It employs smart contracts on blockchains

Foundation of Defi

• From the self custody of money into programmable money and a financial asset

Cefi v.s. Defi

• Centralized Finance (CeFi) is permissioned, with closed-source systems on centralized databases
• CeFi needs approval and agreement for third-party use
• Assets in CeFi are custodied by licensed third parties
• CeFi has centralized trust and governance, with a single entity responsible for upgrade decisions and admin privileges
• CeFi requires users to register with real identity for KYC/AML compliance
• Decentralized Finance (DeFi) is permissionless, with open-source systems on permissionless blockchains
• Anyone can use or build on DeFi without third-party approval
• Assets in DeFi are not custodied by a single third-party
• DeFi has decentralized trust and governance; it is trustless
• DeFi has no single entity responsible for upgrade decisions or admin privileges
• DeFi is pseudonymous, with users not usually providing real identities

High-Level Architecture of Cefi & Defi

• CeFi includes Central Bank, Regulator, Bank, Broker, and Exchange
• DeFi includes Reserve of Pegged Asset, Stablecoin, Leveraged Loan, Algorithmic, Automated Market Maker, Lending/Borrowing, Oracle, and Wallet

The Money in DeFi System: Stablecoins

• Not Bitcoin or Ethereum
• But DAI, USDT, USDC

Deep Dive: DAI

• DAI is a stablecoin cryptocurrency on the Ethereum blockchain maintained and regulated by MakerDAO
• A decentralized autonomous organization (DAO) is an organization constructed by rules encoded as a computer program that is often transparent and controlled by members
• DAOs can be member-owned communities without centralized leadership, with financial transaction records and program rules maintained on a blockchain

DAI Creation and Management

• Step 1: Over-collateralization - 150% ETH is deposited as collateral to mint 100% debt in DAI
• Step 2: Draw debt in DAI

Pay Back and Unlock

• Step 3: Pay back in DAI
• Step 4: Unlock ETH

DAI Update

• In August 2024, MakerDAO rebranded to Sky Protocol
• A new stablecoin named USDS was introduced, intended to succeed DAI, while DAI remains operational
• MakerDAO discussed forking the Solana codebase to develop a native blockchain
• DAI continues to be decentralized, while USDS is shifting to an RWA-backed model, resembling USDC or USDT with built-in yield

DEX

• Some slides are adapted from UC Berkley DeFi course

Financial Exchange

• Involves Alice, Bob, Stock A, Fiat Currency, Trade Matching and Trade Settlement

Trade Matching: Order Book

• Order books are used for trade matching, showing bids, offers, quantities, and order details for assets like SIEMENS

Liquidity Pool

• Liquidity pools use smart contracts for market making
• Alice adds liquidity X and Y to liquidity pool. Bob provides X + Fee, for Y

Automated Market Maker (AMM)

• AMMs include constant product AMMs
• Purchase of asset Y increases price of Y and decreases the price of X
• xy=k, where x = Asset X quantity, y = Asset Y quantity and k=Constant

AMM Example

• In the pool
• Amount y of asset Y State Before: x₀ = 10 and y₀ = 50 and k = x₀y₀ = 500 State After: x₁ = 20 and y₁ = 25 and k = x₁y₁ = 500

Expected Slippage

• The expected price increase or decrease based on the trading volume and available liquidity.

Slippage Protection

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

Impermanent Loss Example

• ETH/DAI Pool: 1 ETH == 100 DAI, adding 1 ETH, 100 DAI == 200 USD, which is ==10% of pool
• Price increases to 1 ETH == 400 DAI
• Withdraw liquidity as 10%== 0.5 ETH, 200 DAI == 400 USD Alice lost 100 USD
• Realisation of IL:
• 1 ETH + 100USD == 500 USD

Liquidity Mining

• Liquidity Mining is an incentive
• There are two types of rewards in DeFi Pools:
• Trading fees (e.g., 0.03% in Curve)
• Liquidity Mining rewards
• An incentive to provide liquidity to a pool:
• Proportional rewards in terms of liquidity
• Retrospective airdrops

Arbitrage

• Prices are synchronized by “arbitrageurs" with multiple markets with the same assets X and Y but with different prices
• It includes a profit from the price difference, which is also referred to as "spread" and requires to perform at least one transaction

Arbitrage on two markets

• Exchange 2.048M USDC for 2.028M DAI at price 1.010 USDC/DAI and Exchange 2.028M DAI for 2.064M USDC, at price 1.018 USDC/DAI = Profit is: 16.182k USDC

Arbitrage with flash loan

• It is Atomic!!
• dYdX (flash loan provider) δΥ/δΧ
• Flash Loan 2.048M USDC
• Exchange 2.048M USDC for 2.028M DAI at price 1.010 USDC/DAI
• Repay 2.048M USDC
• Exchange 2.028M DAI for 2.064M USDC at price 1.018 USDC/DAI Profit is 16.182k USDC

Trade Settlement

• Trade Matching with Non-custodial Trade Settlement

Centralised Exchange vs. Decentralised Exchange

• Centralised exchange vs Decentralised exchange
• A Failure of Centralised Brokerage/Exchange - Gamestop (NYSE: GME) and Robinhood vs. Uniswap

Pros and Cons of an AMM

• Pros: (+) No Order Book maintenance; But arbitrage required (+) Simple implementation for CP AMM; 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; Security issue

Spot DEXs over time

• In 2024, spot DEXs modestly improved their share against CEXs in volume, increasing from ~9.4% of monthly CEX spot volume in January to ~11.4% in November, peaking at ~13.9% in October
• Solana DEXs and Aerodrome gained share through the year

Searchers in Blockchain

• Searchers win exclusive rights to submit transactions
• Searchers compete for MEV opportunities through an order flow auction instead of a gas auction
• The steps include Transaction Initiation, Order Flow Auction and Submission

Decentralized Lending

• Some slides are adapted from UC Berkley DeFi course

On-Chain Lending & Borrowing

• Lender, Deposit Principal and Redeem Principal + Interest
• Borrower, Collateralize, Borrow
• There is an Oracle reporting prices
• With a Vault between the Lender and Borrower

Terminology

• Collateral: Assets that serve as a security deposit
• Over-collateralization: Borrower has to provide value(collateral assets) > value(granted loan)
• Under-collateralization: value(collateral) < value(debt)
• Liquidation: If value(collateral) <= 150% x value(debt)Anyone can liquidate the debt position

Types of Borrowing

• Over-collateralized Borrowing means that E.g., the borrower collateralizes ETH and borrows DAI; The value of ETH exceeds the value of DAI; The borrower can use the borrowed DAI arbitrarily/freely
• Under-collateralized Borrowing means that that E.g., the borrower collateralizes ETH and borrows DAI; The value of DAI (debt) can exceed the value of ETH (collateral); The collateralized ETH and borrowed DAI are restricted to be used with pre-designed smart contracts; Those are typically farming contracts and The vault remains in control of all assets.

Health Factor

• 0 is less than Liquidation Threshold which is less then 1
• The liquidation threshold provides a “secure" margin
• When the health factor declines below 1, a borrowing position becomes liquidatable

Health Factor Calculation Example

• Liquidation == Selling collateral from the borrower and Health Factor = 1.2 (Healthy) when: 1ETH = 2000DAI, Debt - 1250DAI, Collateral 1500DAI
• Health Factor = 0.96 (Liquidatable) when: 1ETH = 1600DAI, Debt 1250DAI and Collateral 1200DAI

Liquidation == Selling collateral

• Liquidation Spread = Bonus, or discount for liquidator; Fixed spread, or variable (auction based)

Fixed Spread Liquidation

• Repays debt and Acquires Collateral
• There is a blockchain transaction
• Involves Repaying the debts of a borrowing position + Acquiring the collateral at a discounted price from the position in return; Typical discounts are e.g., 5-15% in Aave

Terminology

• Liquidation Spread LS: bonus, or discount, that a liquidator can collect when liquidating collateral and Value of Collateral to Claim = Value of Debt to Repay × (1 + LS)
• Close Factor CF: the maximum proportion of the debt that is allowed to be repaid in a single fixed spread liquidation and Value of Debt to Repay < CF × Total Value of Debts

Fixed Spread Liquidation - Example

• Liquidation Threshold = 0.75 and Close Factor = 0.5 and Liquidation Spread = 0.1
• If A fixed spread liquidation: Repay 625Dai and Claim 0.43ETH(= 687.5DAI)
• Then: HEALTH FACTOR = 0.96 Liquidatable; debt 1250DAI/collateral 1200Dai will become: HEALTH FACTOR = 1.095 Healthy; debt 625DAI/collateral 684.375DAI

NFT

• Fungible good is an item that is mutually interchangeable with another, like Money and gold
• Non-fungible items are unique and non-interchangeable, like Art, a vehicle, and property
• Non-Fungible Tokens (NFTs) are Non-interchangeable
• Fungible Tokens (BTC/ETH) are Interchangeable, Uniform and Divisible

NFT example

• Everydays: The First 5000 days by Beeple was worth $69 million
• Stephen Curry's twitter profile picture was worth : $180,000
• there is online NFT market place through opensea.io
• Other NFTs are Louis The Game and Bored Ape Yacht Club

Different NFT Use Cases

• NFTs have Art, Music, Collectibles, Games, Sports, Metaverse, Utility, and Financial Use Cases
• The first blockchain-based mortgages occurred on 21 April 2021, when, the company successfully executed its first MakerDAO loan for $181,000 by using a house as collateral, effectively creating one of the first blockchain-based mortgages.

Intrinsic NFT Values

• Collectibles, e.g. NBA Top Shot and Pokémon trading cards can represent Intrinsic value
• Intrinsic value is Marketing/capitalizing influence like membership cards or tickets
• Value assessments include Rarity, Utility, Game assets and tickets, applications in virtual lands, membership cards, and Tangibility.
• Added values include Memorial value and Recognition

Other DeFi Building Blocks and Services

• Decentralized derivatives: Asset-based derivatives exist (e.g., Synthetix, Mirror and Event-based derivatives exist (e.g., Augur)
• On-chain asset management:
• Non-custodial, different from traditional asset management
• Semi-automatic rebalancing of portfolios, trend trading
• E.g., Yearn, Set protocol
• Decentralized Insurance

Conventional Methods

• This sections describes self-reading materials
• Discounted cash flow (DCF is a valuation method).
• Replacement Cost
• Multiple
• Strategic/competitive value

DeFi Banks and Valuation

• Banks are evaluated in terms of Efficiency of capital, net interest margins, Return to assets and measuring returns that accrue to shareholders
• These approaches primarily take into account the business model of a bank, which basically runs on the spread between deposit and loan rates while managing defaults and maintaining an efficient capital structure
• These are all self-reading

Asset and Wealth Management Valuation

• Asset and wealth management have their own means of evaluation
• Each of these are self-reading materials
• Asset management companies (AMCs) are typically valued as a percentage of AUM
• Conceptually it would appear that WM firms are akin to AMCs and their valuation would be correlated with AUMs, revenue and fee rates

Crypto Valuation Framework

• A Digital asset valuation framework is used to measure crypto related technologies
• The following concepts are provided as self-reading
• The nature of the problem that it solves (something that wasn't possible earlier purely due to a breakthrough in technology)
• The ability to rapidly scale up across vast geographies without having the need to set up physical presence and infrastructure
• The lower cost due to lean structures that no longer needs vast physical IT infrastructure and manpower required by conventional banks

Top Crypto Valuation Metrics

• Top 7 Metrics for Valuing Bitcoin, Altcoins, and Cryptocurrencies include Store of Value, Token Velocity and Metcalf's Law as self reading materials
• For example, crypto-assets can potentially be evaluated in much the same way economists evaluate the currencies of small emerging market countries
• Token economics is a new subject to guide the exploitation of technology after the intersection of blockchain technology, economic theory, and cryptographic algorithms
• Token economy considers the creation and distribution of the value, the consumption, and the circulation
• The token is more than just investment vehicles or financing tools. Its purpose and utilities need to be thought through for the ecosystem to function well
• These are all additional self reading materials