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DeFi has a modular design concept that does not require permission, is censorship-resistant, and can be completely transparent.
Original Title: “Licenseless Modular DeFi Application Detonates the Next Round of Innovation”
Written by: Chainlink
- Modular DeFi applications allow developers to use permissionless and censorship-resistant infrastructure in development, thus focusing on core business logic.
- Multiple DeFi applications (ie “currency Lego blocks”) can be combined organically to create unprecedented application scenarios and financial products.
- Traditional financial systems require permission to enter, and access barriers and legal costs are very high, so it is difficult to achieve modularity in real applications.
- If DeFi applications are to be modularized, they must perform due diligence on each protocol to reduce the systemic risks of the entire DeFi ecosystem.
After Ethereum released programmable smart contracts, it gave birth to a new type of network without permission and without boundaries. Many decentralized applications (dApps) in the network can be parallelized at the same time.
The first application scenario is to generate digital tokens on the blockchain and track the ownership of the tokens. However, the recent round of dApp innovation has gone beyond the original tracking of token ownership, further expanded and innovated on top of traditional financial products, and developed a unique management and transfer model. This innovative financial system is also known as decentralized finance (DeFi) and is worth more than 300 million US dollars. It includes decentralized exchanges, mortgages, lending platforms, leveraged transactions, synthetic assets, prediction markets, and privacy hybrids. And various functions such as payment network.
The key element to accelerate the innovation and application of DeFi is to provide developers with permission-free modular functions. The modular design concept can combine the various modules in the system to meet specific application requirements. The uniqueness of DeFi is that it allows developers to arbitrarily combine DeFi agreements without any special permission, which will bring unprecedented innovation to the traditional financial industry.
At the beginning of this article, we will discuss the bottlenecks of the current traditional financial system; after that, we will share several practical application scenarios and discuss how modular DeFi applications can achieve a license-free financial infrastructure; at the end, we will focus on how to deal with this new model The systemic risks brought by.
Traditional financial applications vs DeFi applications
Modular financial applications are not a new concept. In fact, many mainstream user-oriented applications (such as Uber, Lyft, and AirBnB) have adopted a modular design concept. For example, the financial service Plaid and Stripe integrates many web applications to provide users with native payment functions. This greatly reduces the workload of developers and shortens the listing cycle, because developers do not need to develop a fiat currency payment infrastructure from scratch.
However, this model has certain limitations.
Access requires permission to obtain
Traditional centralized financial services require permission to establish, and both parties must sign legally binding financial contracts. This raises the barriers to entry, and it is difficult for developers to develop fully automated or completely fair financial applications, because access rights may be revoked at any time. Centralized entities can control key parts of applications, which cannot provide third-party developers with the high certainty they need.
The DeFi application uses a permissionless model, which completely subverts the traditional financial model and establishes an open platform. Any developer can immediately gain access to the financial infrastructure and is convinced that the financial infrastructure has a high degree of tamper-proof modification and reliability. This will give birth to truly fair and highly deterministic applications that will run strictly according to the code and cannot be shut down at all. Application access to the DeFi infrastructure does not require the permission of the original developer, which will lower the threshold for innovation and eliminate all intermediate bottlenecks.
Information is not transparent
Traditional financial services generally lack transparency or are prone to information asymmetry. It is difficult for the public to see clearly the back-end architecture. This will lead to unknown risks and affect the regulator’s ability to control risk. For example, financial institutions adopt a modular design concept to combine existing mortgage loans to create new mortgage securities. Many people feel that these financial products are very diversified, and rating agencies such as Moody’s, Standard & Poor’s, and Fitch have all given them 3A ratings, so the security must be very high. However, in 2008, everyone discovered that many securities were actually wrapped in toxic subprime assets, which also triggered a global financial crisis. If the information were more transparent at the time, this crisis could have been avoided.
In contrast, DeFi products are inherently open and transparent. They are developed using open source technology, and every transaction and every interaction between users and dApps is recorded on a non-tamperable distributed open ledger. . If a centralized cryptocurrency exchange goes bankrupt, it may not be discovered until months or even years (such as Mt.Gox and Quadriga), but the operation status of DeFi is open to the open source community and everyone can observe it at any time To any fraud and systemic risks.
High regulatory and legal barriers
If traditional financial entities want to launch financial products or services in a certain country, they generally need to comply with local compliance and regulatory requirements, including Know Your Customer (KYC) and anti-money laundering (AML) laws and regulations. Although regulatory norms contribute to the improvement of the market to a certain extent, financial institutions often have to pay huge compliance costs (such as legal consulting fees), and the market access threshold will be raised, resulting in only a small part of the background And only institutions with strong financial resources can compete in the market. If financial institutions operate across multiple jurisdictions, compliance costs will be even higher. In addition, compliance will involve more manual processes, which will hinder process automation.
DeFi uses a completely different model to achieve compliance without sacrificing innovation. The essence of the blockchain infrastructure is open source and decentralization, which means that it does not obey any profitable company, and anyone can easily verify and review transactions on the blockchain. All agreements are modules, which means that there is no need to build compliance tools from scratch, but to insert already developed compliance function modules to restrict the compliance behavior of users or enterprises. Combining the public chain ledger and the plug-and-play compliance block can meet the compliance needs of end users while maintaining the vitality of innovation.
In short, the traditional financial industry improves market efficiency by controlling infrastructure and establishing regulatory mechanisms, while DeFi improves market efficiency by establishing an open source framework, and eliminates all inefficient bottlenecks through a license-free innovation model.
Modular DeFi application
The DeFi ecosystem adopts a modular design concept, and developers can access key infrastructure at any time without permission, so they can focus on the development of core business logic. DeFi developers do not need to build their own trading platform when creating a new token, nor do they need to spend money to trade the token on a proprietary centralized platform. They can issue tokens on established decentralized exchanges (DEX), which have undergone security audits and have their own user groups. Pass holders can immediately trade the pass in hand and participate in various financial application scenarios, which will greatly enrich the functions of the pass.
The decentralized infrastructure that is developing DeFi applications includes:
- Smart contract blockchain (Ethereum)
- Anti-tampering oracle network (Chainlink)
- Permanent data storage / web hosting (IPFS)
- Censorship-resistant domain name (ENS)
- Reliable data query and index (The Graph)
Issuing tokens on decentralized exchanges is the simplest application scenario for modularization, but at the same time, new DeFi applications can be connected to existing applications, just like “currency Lego blocks”.
“Currency Lego blocks” in the DeFi field include:
- Decentralized exchanges (Kyber Network and Loopring)
- Automated market maker (Bancor and Uniswap)
- DeFi aggregator (1inch and Year)
- Stable coins (Maker and Kava)
- Currency market (Aave and DMM)
- Synthetic assets (Synthetix and UMA)
- Cross-chain assets (Ren and Keep)
Many modules can be combined to form a variety of architectures, so that each module has a synergistic effect and exerts greater value. Here is a reminder that many of the above applications cannot be completely classified into a certain category, which means that the same application can be combined in different ways and produce different effects.
“DeFi’s biggest value proposition is that it is interoperable. Our financial system can interact with the larger ecosystem, which means that anyone can combine two protocols (such as Aave and Synthetix) to create new products and Innovative user experience. Good products will soon produce network effects, because liquidity will also transfer to each other, which will completely subvert the traditional financial industry.”
—– Stani Kulechov, founder and CEO of Aave
A core function of modular DeFi applications is to connect various decentralized applications together. This will improve capital efficiency. Assets can be used for multiple applications at the same time, with almost no frictional costs and no licensing required. In addition, this can also expand the network effect, each new DeFi application can access existing DeFi applications, and enhance its functions and practicality.
For example, a user can build a decentralized stable currency by issuing over-collateralized loans and obtain working capital. However, if these stablecoins are deposited in the decentralized currency market and become non-custodial interest-bearing tokens, they will generate greater value. In other words, although the underlying stable currency in the currency market can earn interest through loans, the interest-bearing token created based on the ownership of the stable currency can also be used for other DeFi applications, or even to pay for products and services.
In addition, multiple users can also put interest-bearing stablecoins in the same fund pool to create a lossless savings game without permission. In this type of dApp, all the interest generated by the stable currency of the fund pool within a certain period of time will be rewarded to the lucky winner, and in the end everyone can withdraw their principal. This lossless savings game can turn user deposits into tradable tokens (that is, proof of ownership of deposits), and continue to promote the development of modular DeFi applications.
The above applications have been implemented in the DeFi field, with Ethereum, Chainlink, MakerDAO, Compound and PoolTogether all participating. PoolTogether uses Maker’s stable currency DAI, Compound’s currency market cTokens, and Chainlink’s VRF (Verifiable Random Function) to create innovative decentralized applications without the need to create stablecoins, develop currency market protocols, or be verifiable The random number on the chain.
A set of currency Lego bricks, showing the modular design concept of DeFi without permission
Decentralized exchange aggregates data
Another DeFi application that emphasizes modularity is 1inch.exchange. 1inch is a decentralized exchange aggregator that obtains price data from all decentralized exchanges on Ethereum to minimize the slippage of on-chain token transactions. 1inch divides large orders into multiple small orders and settles them on multiple different decentralized exchanges to obtain the most favorable exchange rate.
1inch provides users with an excellent trading experience. Users do not need to compare the current exchange rates of various decentralized exchanges. They only need to log in to a platform to immediately obtain all the trading prices on Ethereum.
Another application that adopts the modular concept is the decentralized currency market Aave. This platform has greatly improved asset liquidity through the launch of lightning loans, thereby improving capital efficiency and deposit income. A flash loan is a temporary unsecured loan that must be repaid in the same transaction, plus a small transaction fee. If the lender of the flash loan does not repay the loan in time, the transaction will be rolled back, so the agreement and the borrower will not bear the risk of default.
The concept of lightning loan is very powerful, not only has the characteristics of atomic transactions (note: the transaction is either successful or rolled back, there is no intermediate state), but anyone can borrow a large amount of money temporarily, which finally achieves fairness in the DeFi field Sex. The application scenarios of lightning loans are very rich, such as arbitrage between different decentralized exchanges, adding leverage to loans, or replacing collateral or debt in loans, etc.
Use “currency Lego” as collateral
In addition to the above, Aave also provides support for unique types of collateral, which are tokens from other DeFi applications. For example, the first unique collateral type is the liquidity pool share launched by Uniswap, which is an automated market maker (AMM) decentralized exchange. Aave launched this feature within a few weeks because they integrated the Chainlink oracle to provide them with the price data they needed. Aave accesses Chainlink price reference data and can insert advanced modules safely and seamlessly.
Let me introduce the background first: when users deposit funds in Uniswap’s liquidity pool (note: each fund pool requires depositing two kinds of tokens), they will receive the UNI fund pool token, which is Proof of ownership of funds. The UNI fund pool token is then deposited into the Aave money market and used as collateral for the loan. This can greatly improve the capital efficiency of market makers, because they can not only provide liquidity and obtain transaction fees on Uniswap, but also use funds as collateral to obtain loans. Then, they can continue to deposit the loan into Uniswap and establish leveraged long exposure to Uniswap transaction fees and assets in the fund pool.
The risks of modularity
Although modularity has the above-mentioned benefits, developers should also be careful to guard against risks when developing modular DeFi applications, so as not to build “buildings in the sky.” The risks that may be encountered when developing modular DeFi applications can be divided into four major categories.
First, the blockchain network where the decentralized application is located may have certain risks at the protocol level (such as Ethereum). If the basic layer cannot reach a consensus or is maliciously attacked, all applications running on the network will be at risk. This is not a problem unique to modular DeFi applications, but a common risk in decentralized applications.
Second, every smart contract application has special risks during its operation. In order to meet specific needs, each application will make different trade-offs in design. For example, use the administrator’s secret key to upgrade, use the oracle to obtain price data, establish a distributed token management system or other key contract functions. In addition, there may be bugs in the source code of the smart contract itself, which can lead to accidents in decentralized applications. In order to solve these risks and vulnerabilities, the Chainlink protocol has undergone multiple rounds of smart contract security audits, including auditing each new product function, issuing a bounty task for finding bugs, and making the code completely open source. This allows users to access the Chainlink oracle with complete confidence.
Third, connecting multiple smart contracts together will expand the attack surface of all the above dimensions. Two decentralized applications may each be secure, but when combined, there may be risks. An increase in the number of modules included in an application will result in a larger attack surface, and the overall attack surface is larger than that of a single application. This will cause more edge cases, which need to be processed in advance to ensure stable operation of the application. Another risk brought by modularity is that the collateral in a certain DeFi application (such as the currency market) may not meet the standard, which will directly affect the overall robustness.
Fourth, users lack sufficient cognition and information channels. If users do not understand the applications they use, they are more likely to take more risks without knowing it. Therefore, user education and risk disclosure are essential elements for maintaining healthy ecological development. Modular DeFi applications can become extremely complex in a short period of time, so the key is to decompose each link to a level that users can easily understand.
All members of the open source community must actively participate in the research of DeFi applications and modules, so as to effectively prevent the above risks in a timely manner. Modular DeFi applications include many movable constructions, each of which requires the highest quality assurance. In addition, industry standards must be established and implemented, best practices established in the entire ecosystem, and security levels must be continuously improved through various developer activities such as bug-finding bounty tasks, code audits, and hackathons. In this way, a more stable financial ecosystem can be established and the strongest security guarantee for user funds can be provided.
to sum up
DeFi has developed into a new type of financial ecology, keeping pace with the traditional financial system. DeFi has a modular design concept that does not require permission, is censorship-resistant, and can be completely transparent. Specifically, modular DeFi applications accelerate the pace of developers’ innovative financial applications, so that developers do not need to rebuild the core infrastructure, and do not need to rely on centralized financial services under the licensing system.
DeFi has the characteristics of open source and license-free, so it can create a fair environment for everyone, and participants need continuous innovation to maintain market share. Today’s DeFi applications adopt a modular design concept, laying the foundation for the next generation of dApps, and future dApps will contain more and more advanced functional modules. Modular financial products that do not require permission will realize countless innovative application scenarios, and the prospects are bright.