Deconstructing the Five Building Blocks of DeFi: DeFi Lego Infrastructure

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Over-guarantee, AMM, income automation, work token and liquidity mining, five building blocks play an important role in the evolution of DeFi.

Original Title: “Viewpoint | Five Building Blocks of DeFi”
Written by: Zeng Mi, EthFans Researcher

This article was written at the beginning of September 2020, when the liquidity mining boom was at that time, farmers were very busy, the ultra-high yield attracted a large influx of hot money, and the amount of DeFi locked-up funds also exceeded 10 billion US dollars. . Today, the craze for liquid mining has temporarily stopped, but for DeFi Lego, the evolution of the combination behind it has never stopped.

This article attempts to decompose the current dazzling array of DeFi Lego into five basic building blocks, and introduce the evolution and development of these five building blocks in turn along the following three questions:

  1. Where did the building block come from, and what problem is it designed to solve?
  2. What is the solution?
  3. What problems are still facing? Where is the road?

Excess guarantee-the cornerstone of DeFi trust-free

Trust-free is the golden signature of DeFi. The smart contract eliminates our trust in the platform party. The non-accessible nature of the blockchain makes DeFi open to everyone, but it introduces counterparty risks. How to exempt the counterparty’s trust? Maker gave a simple and effective answer-over-guarantee.

Maker’s vision is to issue a native on-chain stablecoin DAI. Unlike USDC which uses 1:1 USD as a guarantee, there are no USD assets on the chain, and there is no way to talk about USD guarantees. (If there are USD assets on the chain, what is the significance of DAI?) Therefore, Maker chose to use the original assets on the chain as collateral according to local conditions. However, the price of assets on the chain fluctuates greatly. In order to make DAI a 1:1 anchor to the U.S. dollar, Maker requires DAI’s casters to lock in assets of at least 1.5 times the value as excess guarantee. Once the price of collateral drops and the guarantee rate is lower than the liquidation line, the system will auction the collateral to avoid bad debts, never guaranteeing the anchor of DAI and USD.

The over-guarantee design was introduced by Maker, and it has been continuously applied to the design of many DeFi products. As a lending platform, Compound allows users to borrow without a threshold, and the lender never has to worry about not getting back the borrowed money. This is because the borrower has locked in collateral that is at least 1.5 times the value. dYdX goes a step further and extends the excess guarantee into the design of margin trading. You only need to maintain a mortgage rate of 115% and you can open a full position margin trading. The application of over-guarantee is much more than that. It seems to be the first principle of all trust-free protocols, which runs through the design of many products inside and outside Ethereum.

However, as the over-guarantee is introduced, new problems will follow.

In the first place is the so-called “ economic bandwidth ” problem : there is an upper limit on the market value of assets that can be used as collateral, and this upper limit will become the ceiling for the growth of the DeFi agreement. For example, Maker’s initial single mortgage DAI can only use ETH as collateral, but there is an upper limit on the market value of ETH, which restricts the scale of DAI issuance. The solution is naturally to expand the categories of collateral. From single-currency mortgages to multi-currency mortgages, to the introduction of cross-chain assets (WBTC/TBTC, etc.) as collateral, more protocols try to introduce NFT and real-world assets, all in an attempt to continuously expand the “economic bandwidth.”

Another key issue is capital inefficiency. Excess guarantee means that a large number of assets are locked in the agreement as collateral, and many of the idle borrowing capacity is not fully utilized. There are many solutions, but they are mixed. The solution of cToken/ytoken is great (detailed below), and Aave’s recently launched credit loan] is also eye-catching. It allows deposit users with idle borrowing capacity to authorize their credit lines to those they trust People to earn extra income. What’s more, unsecured lending has been proposed, trying to introduce centralized data providers and credit institutions to assess the credit risk of lenders, which runs counter to the original intention of DeFi. The trust-free nature of the agreement is no longer and it is undoubtedly a detour!

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All in all, as the core of trust-free, over-guarantee has always been an indispensable building block for DeFi Lego.

AMM-Token Vending Machine

In September, Uniswap’s monthly trading volume reached a staggering $15.4 billion, surpassing Coinbase and a 100-fold increase from April. After two years of launching, Uniswap has gone from being a small marginal DEX to achieving such outstanding results today. AMM has played a major role behind it.

What is an automated market maker (AMM)?

In the financial market, the market maker plays a very important role. It is responsible for providing sufficient liquidity for the market and matching buyers and sellers to facilitate transactions. Many DEXs that emerged in 2017 adopted the traditional order book form (OrderBook) market makers, that is, market makers continue to create and adjust orders on the exchange, waiting for opponents to take orders, so they are also called passive market makers.

AMM automatically calculates the token price of the target trading pair based on a preset pricing function. For users, there is no operation of placing orders, canceling orders, or waiting to take orders. Trading tokens is just like using a vending machine, selecting the target product, entering the quantity, and making money at one go. You can think of AMM as a fully automated market-making robot running on Ethereum. You only need to inject funds into the liquidity pool of the target trading pair, and leave the rest to the algorithm, which significantly reduces the difficulty of market makers.

Uniswap, launched at the end of 2018, is currently the most well-known on Ethereum and one of the first exchanges to adopt AMM. It uses the constant product market maker’s scheme to quote assets according to x * y = k, where x and y are the number of assets on both sides of the trading pair. Whenever a user wants to swap out an asset from a fund pool, the agreement itself will determine which asset you can swap out for another asset based on “the product of the two assets in the pool before and after the transaction is equal.” The specific quantity of an asset. You can read this article for a more detailed working principle.

After Uniswap, some new AMM exchanges appeared one after another. Curve, which went online at the beginning of the year, modified Uniswap’s pricing curve to provide a lower slippage, focusing on the exchange of stablecoins. Soon after the launch, the transaction volume surpassed Uniswap. Then there is Balancer. This rising star has a more complex pricing model and supports a variety of asset pools, and is committed to providing lower slippage and a better trading experience. Slippage is an important factor affecting user trading experience, and it is also the holy grail of DEX competition. Although adjusting the pricing curve can solve the problem to a certain extent, the level of slippage ultimately depends on the amount of funds in the liquidity pool. The emergence of liquid mining has given a good answer.

The fully automated market maker brings unmatched currency listing speed and market-making efficiency, which is a unique trick to help DEX overtaking in corners. CEX has always been the first choice of users due to its better order depth and lower transaction costs, but the cumbersome listing process has led to a large number of long-tail assets being ignored. The creation of trading pairs on Uniswap is extremely simple, without any manual intervention, a few transactions can be listed on the currency, silky smooth. There is no need to rely on professional market makers. No matter the size of the order or the small liquidity pool, the AMM exchange can provide liquidity at any time. This is a huge advantage in the recent environment of frequent new coins and enthusiastic investment sentiment. Uniswap has gradually become the first choice for many users’ transactions, and it is also the source of a large number of token price discoveries.

How does the public judge when DeFi won? The answer is: when price discovery moves from centralized exchanges to decentralized venues. —— Kyle Samani, Multicoin

cToken/yToken-revenue automation

If the liquidity provider in the loan agreement and AMM wants to use the locked funds, they must first withdraw the liquidity, and this will inevitably damage the liquidity of the agreement. The emergence of revenue automation tokens has solved this problem.

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In April 2019, Compound first proposed the concept of cToken when V2 was released. Before the advent of cToken, the lenders on Compound had to withdraw from the platform if they wanted to use deposits, and this would reduce the platform’s lending capacity. The emergence of cToken liberated the funds locked by the platform. It is the user’s deposit certificate on Compound, and it circulates freely in the open market in the form of tokens. Users can directly buy and sell cToken, or use it as collateral to participate in a new agreement without compromising the liquidity of Compound. In addition, the value of cToken itself will continue to grow with the block, because deposits on Compound will generate a steady stream of interest. Similar to iToken, you can read this article for a more detailed introduction.

yToken is an advanced version of cToken. It is a yearn certificate of deposit. Yearn itself is neither a lending platform nor an exchange, but an automated DeFi income aggregator. It will automatically find DeFi protocols with the best yield, such as Compound, Aave, etc., and then invest the user’s assets in the yearn. Earn income. As far as users are concerned, depositing money in yearn can get the highest profit from multiple platforms.

Now that we have tokens that automatically earn interest on the lending platform, if we can directly use these tokens to provide AMM with liquidity and earn transaction fees, wouldn’t we be able to do two jobs with the same amount of money? It’s time to put together DeFi Lego. The popular fried chicken Curve in this round of liquid mining debuts.

When you use stablecoins to provide liquidity in Curve’s yPool, what you do is actually deposit the stablecoins in year to get yToken, and then inject yToken into Curve’s liquidity pool to earn transaction fees. When users trade stablecoins in Curve’s yPool, they are actually trading y tokens, such as yDAI, yUSDT, etc., and yPool itself will deposit/withdraw the underlying token assets to complete the exchange.

Part of Curve’s liquidity pool accepts revenue automation tokens to provide liquidity

The income automation token adds AMM to squeeze the last drop of value of funds.

Work token-the ultimate form of protocol tokens

Designing the economic model of tokens is a technical task, which can neither make tokens useless nor increase transaction friction.

Previously, tokens were an important component of cryptographic protocols, and their function was mainly to act as a financing tool or transaction medium. A pure financing tool will cause a serious disconnect between the product and the token. The transaction medium can neither incentivize network participants to hold coins nor allow the tokens to capture the value of network growth. Imposing medium attributes on tokens will also greatly increase transaction friction. There have been many cases that prove this is not feasible. The emergence of Work token has given the token designer a new direction.

Work token is a well-designed financial instrument. In its model, network participants must hold or pledge a certain amount of tokens in exchange for the right to provide services on the network to earn income. Through appropriate incentives (usually additional tokens and network service fees), work token encourages token holders to actively contribute to the network (that is, work), with various types of work. For example, in the Livepeer network, nodes that pledge LPT tokens can earn service fees and inflation rewards by providing video transcoding services.

Synthetix is ​​the first DeFi protocol to introduce work tokens. Holders of its tokens can use SNX as collateral to mint synthetic assets or provide liquidity, and at the same time receive additional token rewards from the network. It not only requires network participants to invest money (to buy SNX), but also incentivize them to work (to play the token value and avoid inflation). This is essentially rewarding long-term long-term players of network value, while allowing tokens to better capture the value of network growth, which can kill two birds with one stone.

Work token is the most reasonable token form at the moment. There is no one that can kill a bunch of incurable governance tokens.

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Liquidity mining-from DeFi to “flying”

Synthetix can be regarded as a leading player in the field of token economics, and its contribution goes far beyond introducing the new model of work token into the DeFi protocol. By distributing tokens to encourage users to provide liquidity for the sETH/ETH trading pair on Unisawp, Synthetix has even opened the prelude to liquidity mining.

As the name suggests, liquidity mining refers to the act of obtaining protocol token rewards by providing liquidity for the DeFi protocol. In June of this year, Compound launched loan mining and rewarded users for borrowing through COMP tokens. In just one week, locked-up funds rose by 400%, officially bringing liquidity mining into the public eye. Players have realized that liquid mining is not only a novel way of token distribution, but also a trick to revitalize the network. Subsequently, a series of Defi agreements successively started liquid mining.

In July, the currency price of the governance token YFI broke the dust, starting the current round of liquidity mining boom. Those who provide liquidity for Curve’s yPool pledge their yCRV to the YFI staking contract to receive the governance token YFI. The soaring price of YFI currency attracted more funds to invest in it, and the liquidity of Curve increased rapidly, which also brought lower transaction slippage. With YFI’s wealth effect, a variety of novel liquid mining projects emerge in an endless stream, with various forms, rich gameplay, and amazing returns.

Viewpoint | Five Building Blocks of DeFiIn the boom of liquid mining, the amount of DeFi locked-up funds exceeded US$10 billion in September (Source: defipulse.com)

With its ultra-high yield, liquidity mining has attracted a large number of “farmers” to inject liquidity into the DeFi protocol. For DEX, higher liquidity means lower slippage and better user experience. For loan agreements, higher liquidity means higher capital utilization efficiency, and both borrowers and lenders benefit from it. At the same time, liquidity mining has become the new mainstream token distribution form. Compared with ICOs, the former distributes tokens in a fairer way and contributes to the cold start of the DeFi protocol, allowing it to quickly accumulate network effects. .

However, while detonating industry growth, liquidity mining has also exposed many problems. The first issue is the value of protocol tokens. Most of the tokens distributed by liquid mining projects are governance tokens, and at the beginning of the launch, they have attracted an influx of funds with their ultra-high yields. The vast majority of governance tokens are worthless (because there is nothing good to govern), and in the end it is just a silly game. However, a large number of unaudited smart contracts that have emerged in a short period of time relying on replication and forks have hidden great security risks behind them. Set aside backdoors, hacker attacks, a series of thunderstorms and road running in turn.

“These violent delights have violent ends.”

 Furious joy will surely bring a furious ending.

—— William Shakespeare, Romeo and Juliet

How to maintain the value of tokens and rely on this set of mechanisms to provide sustainable liquidity for the agreement is a question worthy of consideration by agreement designers.

Conclusion

In this slack season, looking back at the road the industry has taken in more than a year is really wonderful. The concept of DeFi has been in the public eye since the beginning of 2019 and has been developing in full swing. Over-guarantee, AMM, income automation, work token and liquidity mining, five building blocks play an important role in the evolution of DeFi. Some of them have been used in the design of most agreements and become an indispensable part; some have not been taken seriously; and some have just emerged and are being used more and more. Although the farmers’ enthusiasm for farming has dissipated, the wheels of DeFi are rolling forward and unstoppable. The most fascinating thing about this industry is that you never know when, where, and in what form the next building block will bring you greater surprises.

Thanks to teacher Ajian for the guidance provided during the writing of this article, and thank Uncle Miao and Snow for answering many of my questions about liquid mining.

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