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As a decentralized agreement, DeFi is essentially a combination of debt contracts and equity contracts, which has the same risks as the subprime mortgage crisis.
Original Title: “DeFi Life: Looking at the Industry Trend from the 2008 US Subprime Mortgage Crisis, Technology and Design Architecture”
Written by: Qu Junjie, Chief Technology Officer of PlatON Source: Mars Finance
DeFi is the abbreviation of Decentralized Finance, that is, decentralized finance. Unlike traditional centralized finance which relies heavily on financial intermediaries, DeFi refers to a decentralized protocol used to build an open financial system, designed to allow anyone in the world to conduct financial activities anytime, anywhere, including lending and asset transactions , Investment and financing, etc. Based on the machine trust of blockchain and smart contracts, DeFi replaces the trust of people and third-party institutions, creating a new generation of transparent, efficient, and open financial system, bringing greater liquidity, inclusiveness and Product innovation.
Since the second half of this year, the DeFi ecosystem has developed vigorously. From stable coins, decentralized exchanges, lending platforms, oracles, payment networks, to synthetic assets and asset management, various star projects have emerged one after another, and the total market value has continued to hit new highs. , Has become one of the fastest growing areas in the cryptocurrency market.
However, the infrastructure required for DeFi has not been built on the market. Due to the high dependence on Ethereum, the prosperity and development of DeFi has made Ethereum overwhelmed, resulting in increasing network congestion and increasing handling fees. In addition, under the influence of the in-depth adjustment of the global capital market recently, the crypto asset market has also seen a large retracement. Coupled with the large profits of early investors, the bubble of some DeFi projects has burst, and the prices of related assets have seen a large increase. fluctuation.
Against this background, how does DeFi break the boundaries and get out of the dilemma of the niche? This article will focus on DeFi’s current projects and industry trends from several perspectives, and strive to provide you with diverse thinking.
DeFi ushered in a “small explosion” in the industry in the short term, achieving exponential growth from hundreds of millions of dollars to billions of dollars.
There is no obvious difference between the structure of DeFi and traditional finance. If the Ethereum public chain is likened to a central bank that issues currency, and a commercial bank that issues various currencies in the form of ERC-20, DeFi is about central bank currency and various other currencies. Financial services. Such as banks, asset management, brokerage firms, exchanges, insurance, etc.
Based on the characteristics of public chain transactions, permissionless, non-custodial, low threshold, and encouragement of innovation, DeFi has achieved “inclusive” finance to a certain extent. In other words, all asset holders can participate, and the products are rich and diverse and the options are extremely strong. Some innovative products even allow participation without asset pledge, such as Flashloan based on smart contract atomization. At the same time, the bubble will trigger the vampire attacks that Uniswap encounters. For example, Sushiswap uses LP Token pledged by Uniswap to mine liquidity. But the bubble that nurtures innovation is a healthy bubble after all. We should embrace it and distinguish the pearls under the light and shadow of the colorful bubbles.
Because of the ease of joining and inclusive nature, users pay more attention to safety, mobility and experience. In other words, ease of use, immediate execution effect and risk control based on abundant liquidity are some key indicators. This article will focus on DeFi’s current projects and industry trends from several perspectives, and strive to provide you with diverse thinking.
Looking at DeFi from the US subprime mortgage crisis in 2008
The culprit of subprime mortgage-the design logic of MBS/CDO/Synthetic CDO
MBS is the earliest asset securitization product. It was first produced in the United States in the 1960s. It is mainly a kind of asset securitization product issued by American housing professional banks and savings institutions using their mortgage loans. Its basic structure is to gather the loans that meet certain conditions in the mortgage loans to form a pool of mortgage loans, and use the cash inflows of principal and interest that occur regularly in the loan pool to issue securities, and The securities are guaranteed by government agencies or financial institutions with government background.
CDO (guaranteed debt certificate) is an innovative derivative based on mortgage debt credit, based on various asset securitization technologies, to restructure bonds, loans and other assets, and re-divide investment returns and risks to meet the needs of different investors Securities products. Here, it can be seen that some of MBS’s Tranche (backed mortgage bonds) enter the CDO’s asset pool once again “packaged” into a transaction structure.
In traditional fixed-income structured products, the risks and returns can be achieved through the design of transaction structure. The higher the Tranche (backed mortgage bond), the later the default loss of the underlying asset pool, the lower the risk, the lower the return, and the lower. The earlier Tranche suffers from default losses from the underlying asset pool, the higher the risk and the higher the return, as shown in the following figure:
Pictures from the Internet
Pictures from the Internet
The figure above shows how this kind of structured debt products developed from MBS (asset pool for housing mortgage loans), and then some Tranche (Senior or Equity can be used) of MBS into the CDO asset pool to form a transaction structure again, and then develop By Synthetic CDO (CDO’s Tranche is packaged again), the entire ecosystem has formed a very strong leverage effect, and leverage has a natural procyclicality. During the period when housing prices have been rising, the entire business has flourished, mortgages are valuable, MBS is valuable, and leverage The tool CDO is more valuable, but with the fall in housing prices in the United States in 2007, liquidity risks erupted, Lehman Brothers, which held many positions in Synthetic CDO, closed down, and the subprime mortgage crisis broke out. The first layer of MBS has the practical significance of this structured product, and it still exists in the market, while CDO and Synthetic CDO are both created leveraged gambling tools and have now disappeared in the market.
The essence of DeFi-debt contracts and equity contracts: the same risks as the subprime mortgage crisis
As a decentralized protocol, DeFi is essentially a combination of debt contracts and equity contracts.
The blockchain is a trustless environment. The address is essentially anonymous, and there is no necessary connection with the identity and reputation mechanism outside the blockchain. The credit risk assessment methods of mainstream finance are invalid. Credit risk management in DeFi , It is highly dependent on over-collateralization, whether it is MakerDAO or Compound. If we regard each DeFi project as a structured product, then the design protocol is to design a structured product transaction structure, and the main function of the platform currency is to adjust the core of this structured product through a community approach Parameters, or become equity certificates to obtain future cash flows.
The most important thing in the DeFi ecosystem is to understand the debt contract. The debt contract is the basis of lending, leverage and derivatives. The design of the debt contract in DeFi enables the time value of digital assets to be reflected in the form of Per Block floating rate debt, and the debt is realized The value of the contract is based on over-collateralization, and the borrowing rate reflects the market risk (opportunity cost) and default risk of the collateral project. For example, the following picture shows the lock-up rate and borrowing rate of the Compound market on September 3, 2020:
Pictures from the Internet
It is also a stable currency. Why is the USDT borrowing rate of 8.69 higher than USDC’s 5.53? It implies that the market believes that Tether’s default probability is higher than USDC. Similarly, BAT’s 25% loan interest rate also implies its high token market risk and high project default risk.
We have seen that in Compound’s asset pool there are still assets DAI, ETH, USDC, USDT, ZRX, BAT with relatively low credit risk and market risk. Even so, due to the leverage characteristics of structured products, COMP tokens are on the market Performance characteristics will also be leveraged, that is, if the underlying asset ETH rises by 5%, COMP may rise by 12%, while ETH falls by 5%, and it may fall by 14%. As shown in the figure below, the market performance on September 2 :
Pictures from the Internet
What happens if we re-mortgage the platform tokens of the lowest equity tranche in similar structured products of the DeFi project as assets? Is it very similar to Synthetic CDO? The famous YAM project that increased 50M USD a day’s lock-up and zeroed out due to code vulnerabilities is the case. Let’s take a look at what assets in YAM’s asset pool: WETH, YFI, MKR, LEND, LINK, SNX, COMP, these high The use of risky assets as collateral will make the loan interest rate in YAM very attractive. With the addition of the loan mining mechanism, the project spreads very quickly. However, just like the situation encountered in the subprime mortgage crisis, the price of basic assets BTC and ETH Leveraged products such as the up cycle will be very popular, but once the down cycle is reached, there will be great risks.
Looking at DeFi from Basic Technical Ability
Unlike traditional financial infrastructure and financial products, DeFi uses blockchain technology and is based on tokenized assets to achieve equal, efficient, highly transparent, and highly credible financial services. Thanks to the application of smart contracts, DeFi contracts are automatically executed, so they are highly equal and credible. It is also precisely because of the use of blockchain technology that DeFi risk events occur frequently, and are largely restricted by the underlying platform technology. The blockchain technology currently seems to be immature, and it is still under exploration in the financial application field. Many security incidents It also reflects the “dependence” on blockchain technology. DeFi is also restricted by the performance and security of the underlying infrastructure, and the basic technical capabilities still need to be consolidated.
Therefore, in many DeFi projects in the market, how to build a basic technology matrix is the primary consideration of the DeFi team. Ecological support DeFi requires the following capabilities in addition to the core functions of public chain consensus and governance.
One is the technical capabilities of asset (Token) issuance (such as the ERC-20 method) and the cross-chain introduction of technical capabilities for assets (such as: notary mechanism, side chain/relay mechanism, hash locking, support for WalletConnect protocol, etc.). And actively import MPC application scenarios);
Second, based on the ecology of smart contracts for lending, asset management, securities firms, exchanges, and insurance services, the essence of the DeFi agreement is a combination of creditor’s rights contracts, equity contracts and other derivative contracts, and the rationality and economic effects of the design agreement;
The third is ecological entrance (wallet, website front-end and back-end, etc.);
The fourth is the construction of ORACLE oracles, and the access of external ORACLE oracles.
The “complete body” of DeFi-the “three-stage” evolution under the blessing of technology
With the improvement of basic technical capabilities, the evolution of DeFi can be divided into three stages:
Provide basic Lego modules and Token issuance in the first stage , including asset creation, asset cross-chain import, stable currency issuance, liquidity mining, etc. (such as: BTC, USDT, USDC, ETH); loan pledge payment (basic commercial banking services) ) (Note: Simple CDP engine enters the Token loan, pledge, re-pledge, etc.); basic DeFi protocol standards, tools (such as Uniswap, renamed pairswap).
The second stage provides financial services, such as: asset management (various tool groups, including wallets, etc.); trading (distributed exchanges, liquidity promotion, credit trading and other brokerage services, etc.); fixed income and derivatives trading Class (Money Market, Yield farming, SWAP, Futures/Options, Arbitrage, Multi-Collateral Lending, Hedging, Interest Rate SWAP, etc.).
The third stage is ecological improvement, including: DeFi insurance as a risk hedging entry, wide application of reliable and credible information and data aggregation services (basic of ORACLE), and credit management services based on distributed digital identities.
Looking at DeFi from the design architecture of the project
Look at the design considerations of the project from the classic products of transaction and loan respectively.
By 2020, with the explosion of the DeFi concept, the overall DEX transaction volume and the number of daily active users on each platform have increased significantly. Competition in the market has become increasingly fierce. IDEX’s user popularity (the number of daily active users) will drop again in 2020. Uniswap and Kyber, the up-and-coming projects in 2019, will catch up with the established projects in 2020.
Figure of the number of active users from 2018 to 2020; Source: TokenInsight
In the first half of the year, the development scales of DEX platforms were quite different, with Uniswap (the highest transaction volume) and Curve (the fastest growth) developing brightly. Curve, Uniswap V2 and Balancer belong to automatic market makers (a type of AMM: constant function market makers), which performed well in June and accounted for half of the market’s trading volume.
The constant function market maker can be divided into four types from its underlying mechanism (formula): constant product market maker, constant total market maker, constant average return market maker and mixed constant function market maker. Curve, Uniswap V2 and Balancer are typical representatives of constant function market makers, and their basic information is shown in the table below.
Horizontal comparison chart of market makers; Source: TokenInsight
Uniswap (V1 launched in November 2018) performed even better and has become a leader in DEX. The Uniswap V2 launched by the project team in May of this year has won attention once it was launched, and its trading volume was the first in the DEX industry in June. The market performance of the two in the first half of 2020 is shown on the left. In the first half of 2020, the overall performance of V1 opened higher and lowered. V2 performed strongly in June
Uniswap V1&V2; Source: TokenInsight
The biggest difference between Uniswap V1 and V2 is that all liquidity pool Tokens of V1 rely on ETH links, and exchanges between different Tokens need to be exchanged for ETH beforehand; while V2 is upgraded to directly realize the exchange between different ERC20 Tokens. exchange. But the two have the same limitations, that is, there is a fixed ratio between the Tokens in the liquidity pool, 50%: 50%
Liquidity: Core AMM formula: X * Y = K Suppose the liquidity of ERC-20 trading pair tokenA/tokenB is X and Y respectively. Uniswap V2 trading pairs can be formed using any two ERC-20 tokens.
One advantage of this is that it can reduce the slippage of the exchange rate, because each transaction pair will charge a certain fee as a conversion fee, and the exchange through two transaction pairs is twice the cost. V2’s support for ERC-20/ER-C20 transaction pairs eliminates the need to exchange between two transaction pairs when DAI is exchanged for USDC, which reduces the cost by half, and the exchange rate slippage will be lower.
If there is no direct transaction pair between the two ERC-20 Tokens, the V2 routing protocol can find an optimized exchange path between multiple transaction pairs, and complete the exchange between multiple transaction pairs. In order to realize the conversion from A to D, it can be completed by converting A to B, B to C, and C to D. The current routing protocol in the code is version 01, and the path needs to be calculated under the chain and submitted to the routing protocol for processing.
The improvement of Uniswap V2 is that history stores the price on the chain and adds time weight. Its storage method is to save a cumulative price on the chain. By using the difference between the two cumulative prices and the time difference, an average price with time weight can be calculated.
We know that Uniswap’s price changes follow transaction changes. If there has been no transaction, then this price will be a fixed value. Assuming that the interval between two transactions is 10 seconds, the price P1 generated after the first transaction will continue to exist, and will not become P2 until the second transaction occurs (10 seconds later). Therefore, the cumulative value of P1 is P1 * 10. Cumulative price (priceCumulative) is the product of price and time difference. In countless price changes, the time interval of each is T1, T2, T3…, there are:
With the cumulative price, divide the cumulative price by time to get a time-weighted average price TWAP (Tx, Ty) in a certain period of time.
Why is Uniswap popular in the DeFi ecosystem? Uniswap has the following characteristics:
- Uniswap V2 directly realizes the exchange between different ERC20 Tokens;
- Free token issuance, the work completed by ICO is realized;
- Provides oracle service after listing (this is very important for DeFi)
For a new DeFi project, such as YAM as the founding team, I want to put MKR, COMP, etc. into my asset pool. From a technical point of view, the fastest way to play is to use 0 pre-mining, no private placement, no crowdfunding, and no team The rewards can be directly uploaded to Uniswap, and then use Uniswap oracles such as MKR and COMP in the project, which is very convenient.
DeFi lending fluctuated drastically in the first half of 2020. After 3.12 extreme market conditions, the total lock-up value of DeFi has shrunk from US$880 million to US$550 million in one day, a drop of more than 37%. In June, the total lock-up value of DeFi continued to rise and exceeded US$1.6 billion, of which the loan platform Compound locked in value of US$486 million, surpassing Maker’s US$419 million, and took the top spot in the DeFi agreement.
DeFi lending ecology; Source: TokenInsight
Different from traditional lending, DeFi lending has the characteristics of trustlessness, distributed, transparent and open source. Its current main application scenarios are similar to the banking business model in the traditional financial sector. Among DeFi lending projects, the number of projects built on the underlying public chain platforms of Ethereum, EOS and Bitcoin is far ahead, with Ethereum being the most.
In the first half of 2020, the DeFi lending market currently accounts for 70%-80% of the total lock-up volume, and lending projects are still the main force in the DeFi market.
Proportion of DeFi lending; Source: TokenInsight
Compound and liquidity mining
The enthusiastic response of the market to lending and mining reflects the rigid demand of users for the guarantee of digital asset income. It also reflects that after a period of development in DeFi lending, the market has gradually matured and is no longer satisfied with a single lending model. In this environment, it is reasonable that a model that can meet user needs and obtain liquidity for the platform itself is enthusiastically sought after.
The figure below shows the supply and loan amount of the Top30 active addresses on Compound from February to July 10, 2020. It can be seen from the figure that the loan capital scale of the Compound platform has been relatively flat from February to May; after the launch of liquidity mining in June, its capital scale has increased at a phenomenal level.
Supply and loan amount of Compound Top30 active addresses from February to July; Source: TokenInsight&Dappradar
According to Dappradar data, in June, the top 30 active addresses accounted for 71.11% of deposits; loans accounted for 54.19%; as of July 10, the top 30 addresses on the Compound platform accounted for 54.01% of deposits and 67.27 of loans. %. In other words, more than half of the COMP mining rewards have become exclusive to “big players”.
High-yield arbitrage opportunities have even attracted the participation of centralized lending platforms. According to DeBank data, after the start of the 15th incentive activity, the centralized platform NEXO has deposited approximately 60 million USDT funds into Compound for mining arbitrage. But based on the rate of return on deposit, the annualized rate of return can reach 55.36%, while the interest rate for investors to deposit USDT on NEXO is only 10%.
The core of Compound’s liquidity mining is that as long as users provide liquidity to the Compound fund pool, they can get COMP as a reward. However, for investors, the liquidity mining of DeFi projects also faces risks such as smart contract security risks, platform risks (team management keys), exchange rate risks, and leveraged transactions that lead to increased asset liquidation risks and liquidity tightening in the later stage. And other risks.
To sum up: Compound as an innovative version of MakerDAO. Stable currency borrows USDT. With borrowing, mining innovation. For the time being, it is likened to a Pool based many-to-many P2P platform with the borrower secured and liquid mining Comp currency attributes.
Role division: asset holder host user, liquidator, platform side (borrowing spread interest, Comp currency price, liquidation return), ORACEL price service, definition of excess mortgage rate, definition of liquidation boundary. Comp token holders participate in governance. Such as managing borrowing interest rates.
Thinking about the DeFi position of the public chain
The new generation of public chains may build a data transaction market that will exceed trillions of dollars in the future. Token will assume the important task of clearing and settlement tools in the data transaction circulation market. This is an important scenario for the future financial infrastructure. At the same time, Token will also be used to strengthen the coupling relationship between economic activities in the blockchain and the economic activities supported by the blockchain (including the data and computing power circulation market, DeFi), making the DeFi scenario on the public chain more advanced. With quality pledged assets, after the completion of the first stage of DeFi infrastructure construction, more developers can be empowered to create a more innovative next-generation DeFi ecosystem.