Chapter 4: Decentralized Finance (DeFi) PDF

[[Chapter 4: decentralized finance (DeFi)]]{.smallcaps} =================================================================== Introduction ------------ - \"With a good perspective on history, we can have a better understanding of the past and present, and thus a clear vision of the future....

[[Chapter 4: decentralized finance (DeFi)]]{.smallcaps} =================================================================== Introduction ------------ - \"With a good perspective on history, we can have a better understanding of the past and present, and thus a clear vision of the future.\" - Carlos Slim What is DeFi? ------------- - Investopedia: \'Decentralized Finance is **an emerging financial technology** based on **secure distributed ledgers** similar to those used by **cryptocurrencies**.\' Features of Dei --------------- - **Decentralized Finance** (DeFi) aims to **recreate** and **improve** traditional financial systems **using blockchain based protocols** and **smart contracts.** - Main features include: - Decentralization - Open access - Transparency - Programmability - Trust lessness - Interoperability - Immutability Traditional Finance ------------------- - Traditional Finance (TradFi) refers to the financial system that's been in place for decades, such as banks, governments and other financial institutions. - Main features include: - Centralized institutions - Regulation - Intermediaries - Access limitations - Physical/Tangible infrastructure - Cost structure DeFi vs Traditional Finance (TradFi) ------------------------------------ TradFi: ------- - Pros: - Established infrastructure/products - Widely accepted/Easy to use - Existing legal framework - Deposit insurance - Professional advice/support - Cons: - High fees - Transaction's speed - No full control (custody) - Documentation to provide DeFi ---- - Pros: - Accessible to all - Low fees - Full control (self-custody) - High interests' rates (but high risks too) - Cons: - Quite complex to use/understand - Your own responsibility - No client supports - Not fully regulated (yet) Risks (hacks, smart contracts, etc.) Centralized Finance ------------------- - Blockchain Council: "Centralized finance (CeFi) is a financial activity in which individuals can earn interest and obtain loans on their cryptocurrency via centralized exchanges." - Traditional finance refers to the conventional financial system, while CeFi refers to centralized crypto-related services. - However, outside the cypto context, TradFi and CeFi often refer to the same concept, as traditional finance is centralized. 9. What are CBDCs - ECB: "A central bank (CB) is a public institution that manages the currency of a country or group of countries and controls the money supply -- literally, the amount of money in circulation." - Main mechanisms used by central banks: - 1\. Interest rates: Rate at which commercial banks can borrow money ("its cost") to influence lending/borrowing activities. - 2\. Currency intervention: Buying or selling its own currency in foreign exchange markets to influence its rate. - 3\. Open market operation: Buying or selling government bonds to increase/decrease the quantity of money. - 4\. Money printing: Issuing coins and banknotes. 10. DeFi Services - DeFi platforms offer various services such as:\ - Lending and borrowing\ - Automated market makers (AMMs)\ - Yield farming\ - Decentralized exchanges\ - Derivative trading\ - Synthetic assets\ - Staking\ - Insurance 11. Lending and Borrowing in DeFi - Investopedia: "**Crypto lending** is the process of depositing cryptocurrency that **is lent out to borrowers** in return for regular interest payments. Payments are made in the form of the cryptocurrency that is deposited typically and compounded on a daily, weekly, or monthly basis." - Crypto lending allows users to deposit cryptocurrency and lend it out for interest payments. Borrowers, however, must typically over-collateralize due to price volatility. 12. Risks in Lending and Borrowing Risks for **lenders:** - Borrower default - Collateral volatility - Liquidity and platform risks Risks for **borrowers:** - **Over-collateralization** - **Collateral liquidation** - **Interest rate increases** 13. Decentralized Exchanges (DEXs) - Chainlink defines a DEX as **a peer-to-peer marketplace** where users trade cryptocurrencies without **intermediaries**. Incentives for participation include **trading fees** and **liquidity rewards**. 14. Automated Market Makers (AMMs) - Automated Market Makers (AMMs) are decentralized exchanges that use algorithms" robots - automated trading" to provide liquidity and price assets. -------------------------------------------------------------------------------------------------------------------------------------------------- - Role: To make sure the ratio of assets (trading pairs) in liquidity pools remains as balanced as possible and to eliminate discrepancies in the pricing of pooled assets. ------------------------------------------------------------------------------------------------------------------------------------------------------------------------- - Slippage (Investopedia): Refers to the difference between the expected price of a trade and the price at which the trade is executed. It is mainly caused by price volatility and low liquidity. ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ DEX Business Models ------------------- - Most DEXs fall under the following model: - **Trading fee** on swaps are accrued toward **liquidity providers** (LPs), stakers of the protocol token and the **protocol/governance.** This creates incentives to provide liquidity and to hold the token (buying pressure) but also some selling pressure. Impermanent Loss ---------------- - Ledger defines "It refers to a situation in which the profit you gain from staking a token in a liquidity pool is less than what you would have earned just holding the asset." **The loss is permanent** - It occurs when the market price of the crypto pair is changing. The pool needs to be rebalanced to maintain the initial ratio SEE ON THE PP HOW TO CALCULATE IMPERMANENT LOSS Staking in DeFi --------------- - **Coinbase**: "Staking is a way of earning rewards while holding onto certain cryptocurrencies." - The deposited cryptocurrency is used by the blockchain **nodes to validate blocks** (PoS consensus mechanism). - A portion of the earned transaction fee is distributed (cryptocurrency) to "stakers" as a **reward.** - Main risks: : Market risk, liquidity risk, lockup period, reward duration, validator risk. Accessing DeFi Platforms ------------------------ Users can access DeFi platforms through Web3 wallets, such as MetaMask, Trust Wallet, and Ledger Live. Conclusion ---------- DeFi is transforming the financial sector by introducing decentralized services across banking, asset management, insurance, and trading. It represents an innovative shift towards accessible and trustless financial systems.