Editor’s note: With the continuous penetration of blockchain technology, DeFi has become popular. This technology originally appeared in 2018, but it really became hot in 2020.
Chen Yongwei/Text
Since the blockchain technology entered people’s field of vision, the controversy surrounding it has never ceased. Those who are optimistic about the blockchain believe that because the blockchain has many excellent properties such as decentralization, traceability, and independence from trust, it is entirely possible to reshape the entire society like the current Internet. Those who are pessimistic about the blockchain point out that although the blockchain has many good features in theory, it also has serious technical flaws, so it is difficult to have practical uses. For a long time, the “pessimistic” view seems to be more reasonable: Although blockchain technology has been hyped up in various media, in practice, there are few really valuable applications. Even a phenomenon-level product like Bitcoin is far from the effect in the publicity. In fact, due to the high transaction cost of Bitcoin, it can hardly be used as a currency, but only as a special Assets to invest.
However, as people’s understanding of blockchain technology deepens, Tianping seems to be leaning toward the “optimists”. Many practical applications based on blockchain have been developed one after another, beginning to prove to people that blockchain is not a dragon-killing technique.
Among the recent blockchain products, the one that deserves the most attention is a type of application called DeFi. The so-called DeFi is short for “Decentralized Finance” (Decentralized Finance). Generally speaking, it is a type of financial product built on blockchain technology. Its goal is to develop and operate in a decentralized manner, providing all types of financial services on a transparent and trustless blockchain network. .
The earliest appearance of the concept of DeFi can be traced back to 2018, but at that time there were relatively few people concerned and there was no social impact. In 2019, DeFi suddenly started to catch on. The total value of locked positions in DeFi transactions in the entire market once exceeded $150 million, so 2019 was also called the “first year of DeFi.” By this year, DeFi has continued its hot trend, and thousands of De-Fi products have been designed.
Why is DeFi going from obscurity to popularity in just two years? Compared with traditional financial products, what are its unique advantages? What potential risks will its development bring?
Why DeFi became popular
There are many reasons why DeFi has become popular in the past two years, the most important of which is that it can overcome the shortcomings of the existing financial system to a large extent.
In reality, the financial system we are familiar with is mainly constructed in a centralized way, which strongly relies on the support of financial institutions living in centralized nodes. For example, if you want to send a sum of money to a friend, then you need to transfer the money to the bank, and then the bank transfers the money to your friend’s account; another example, if you want to borrow money, then you need to ask the bank Make an application, go through the relevant procedures, and then the bank will take out the money other people have in the bank and lend it to you. In all these financial activities, there is always a financial institution in the middle.
This centralized financial system has many drawbacks:
First, it requires people to pay additional costs. As we all know, financial institutions are very rich. Where does this money come from? A large part of it comes from commissions and other fees collected from transactions. From the perspective of financial institutions, these commissions are their income, and for users, it is a real cost.
Second, it may affect the efficiency of transactions. When there is a financial institution as an intermediary, all financial transactions are not completed directly, but require a turn. For example, in the past, we had to send a sum of money to someone. It is very likely that one day’s money was sent here, but the other side had not received it. The reason was that we had to make a big turn in the bank. Of course, with the digitization of financial institutions, the time gap between remittance and receipt has been greatly shortened, and the entire process may have been reduced to a few minutes or even a few seconds-but for professional financial transactions, these few seconds It can still be extremely deadly, so there is still room for improvement.
Third, for users, the choice of centralized financial products is relatively small. In reality, our requirements for financial services are actually very diverse. For example, when we try to obtain a loan, we may wish to realize the pledge in a special way, and then repay the loan in some special way. Obviously, if the loan occurred between specific people, then these requirements can be written down in the form of a contract, and then executed by both the borrower and the lender. But if we borrow from a bank, it is unlikely to meet these individual needs.
Finally, the accessibility of the centralized financial system is relatively weak. In a centralized financial system, people must meet certain conditions to use financial services. For example, if you want to apply for a credit card, you need to meet certain credit qualifications; if you want to engage in securities trading, you also need to provide certain property certificates. Under this design, a large number of people are excluded from the financial system and cannot enjoy the corresponding financial services. In fact, they may be the ones who need these financial services most.
So, can we avoid these financial intermediaries? Under traditional conditions, this is unrealistic, because without these financial institutions as intermediaries, credit problems would be difficult to solve.
However, when the blockchain technology appeared, the situation changed. Due to the technical characteristics of the blockchain, it can guarantee the transaction security of both parties without relying on a third party, and the credit issue will subsequently become less important. In this situation, DeFi, a decentralized form of finance, becomes possible.
When DeFi appears, all the disadvantages of centralized financial services mentioned above will become the point where DeFi can surpass centralized finance.
First of all, because DeFi can achieve peer-to-peer financial transactions, its transaction costs will be greatly reduced, and transaction efficiency can be greatly improved. Secondly, because DeFi transactions occur more directly between the two parties, the so-called design of transaction details between them can be more detailed and more diversified, which allows people’s financial needs to be more fully satisfied. Thirdly, compared to traditional centralized finance, the threshold of DeFi is much lower. In a centralized financial system, an important reason for setting a threshold for traders is to screen out high-quality traders and avoid possible financial risks. Blockchain technology can achieve similar effects while lowering this threshold.
It is precisely because of the above characteristics that DeFi products have emerged as an important blockchain application. Of course, we should admit that behind the popularity of DeFi, there are some hype factors that are fueling the flames. In fact, after the popularity of cryptocurrency such as Bitcoin, the speculators of the blockchain concept have been looking for new speculation targets, and DeFi is undoubtedly a good target. However, from an overall point of view, these hype should be secondary factors. If there is no “1”, which is the excellent attribute of DeFi itself, then adding more “0” after it is useless.
The ecological composition of DeFi
In a sense, the current development of DeFi is actually a decentralized reproduction of a real financial world in the blockchain world. In other words, what kind of financial products are available in reality can be replicated in the blockchain world. Of course, to shuttle between the real world and the blockchain requires channels, and synthetic assets and oracles can play such a role. The so-called synthetic assets are the mapping of real assets in the blockchain world. For example, in the real world you hold a certain amount of U.S. dollars, but these U.S. dollars cannot be used directly, so you need to exchange them for the corresponding Bitcoin world currency, such as USDT. USDT here is the synthetic asset we are talking about. . The oracle machine, in general, is the translation of the real world information to the blockchain world. For example, in the real world, we have the rise and fall of stock prices, but these rise and fall data cannot be understood by the blockchain world, so we need an oracle to complete this information conversion.
When we have synthetic assets and oracles, we can imitate the real world in the blockchain world and build the entire financial ecology with the help of smart contracts-after all, in essence, all financial products can be understood as a complete set Contracts, and using smart contracts on the blockchain to replicate them, I’m afraid it’s more appropriate.
From now on, only on Ethereum, people have developed thousands of DeFi applications. Recently, the blockchain venture capital firm Outlier Venture released a report trying to classify the current DeFi applications. According to this report, the current DeFi applications can be divided into three categories, nine subcategories:
The first category of applications is distribution. Here, issuance is in a broad sense. It refers to the creation of financial assets that can be traded, transferred and meet the needs of users. Blockchain technology has greatly reduced the cost of creating and verifying financial assets, which makes issuance an important application of DeFi.
Under the issuance application, there are three applications: stable tokens, lending, and the issuance of securities, insurance and non-fungible tokens (non-fungible To-ken). (A) Stable token. For any transaction, a stable currency is an important foundation. With the help of blockchain technology, people can easily and safely issue decentralized stable tokens according to demand, and adjust the supply of currency through algorithms to ensure the stability of currency values. Currently, DAI coins and AMPL coins on Ethereum are applications of this type. (B) Borrowing. The openness, security and transparency of the blockchain determine that DeFi can provide lending services to more people than traditional centralized finance. At the same time, the interoperability of the blockchain also contributes to the creation of new loan products and services. Provides possibilities.
Among the lending DeFi applications, the most famous is now Compound. Compound is a mortgage loan application. Any user who has idle digital assets can put their idle assets in the Compound pool for other users to borrow. The borrower needs to mortgage another asset he owns to lend the digital asset he hopes to obtain. Com-pound automatically monitors the mortgaged assets according to pre-determined rules. When the market value of the mortgaged asset drops to a critical point, the Compound smart contract will automatically issue a margin call notice to the user. If the user fails to cover the position in time, Compound will automatically execute the contract to sell the mortgaged assets to prevent the loss of the lender’s assets. The above process is completely automatically executed based on the rules determined in the smart contract, without any human intervention. (C) Issuance of securities, insurance and non-homogeneous certificates. In theory, blockchain technology can easily allow people to digitize securities assets to realize the issuance of securities, insurance, and non-homogeneous tokens (NFT), but their development is still limited by some important factors. Securities and insurance are already very familiar to everyone, so we won’t repeat them, but we can focus on NFT. The so-called non-homogeneous token is the opposite of homogenous token. We are familiar with Bitcoin, Ethereum, etc., which are all homogenized tokens, and the value of each unit of this type of token is equal. But non-homogeneous tokens are different, and each token represents a different value. This type of token is very suitable for representing assets. For example, in reality, the value of each painting and each house is different, and they can all be chained in the way of NFT. Although there are few DeFi applications currently used for NFT, the imagination is huge.
The second category of applications is trading. Specifically, it is divided into three types of sub-applications: decentralized transactions, derivatives, swap transactions and prediction market transactions, and liquidity provision. (A) Decentralized transactions. Due to important features such as instant custody and no withdrawal restrictions, decentralized transactions are becoming more and more popular. At present, many decentralized exchanges have emerged to help people realize decentralized transactions. For example, Binance, IDEX, DDEX, etc. are all well-known decentralized exchanges. (B) Derivatives, swap transactions and forecast market transactions. At this stage, such DeFi applications are still in the early stages of development. (C) Liquidity provision. In practice, an exchange is likely to have the problem of not having the necessary liquidity to process large orders. In order to solve this problem, there have been some DeFi applications that provide liquidity for exchanges. For example, Uniswap is an automatic market making application. Any user can use Uniswap on Ethereum to establish a trading pair between any two digital assets and provide initial liquidity. Any other user can trade the asset pool for this transaction. The commission paid for each transaction is returned to this liquidity pool. The more trading volume, the more profit this liquidity pool will generate. After this initial liquidity pool is established, other users can continue to provide more asset liquidity to this liquidity pool. If some providers recover the assets they provide, then they can get the corresponding commission income earned by this liquidity pool based on the proportion of the liquidity they provide in the total flow.
The third category of applications is ownership management. Further, it can be divided into three self-applications: wallet, asset management, and payment network. (A) Wallet. At present, more and more users hold assets on the blockchain, and the demand for effective storage and transfer of these assets is becoming increasingly prominent. In this context, many DeFi applications with wallet functions have been developed. For example, MetaMask is an open source Ethereum wallet that can help users easily manage their own Ethereum digital assets; Coinbase provides a Bitcoin online wallet that allows users to support sending and receiving Bitcoin. (B) Asset management. When people have assets on the chain, the need to manage these assets so as to achieve value-added is highlighted. At present, there have been many applications that help users manage these digital assets, such as ICONOMI, Melon-port, Iconomi, CoinDash, Etherplan, etc., which are all typical representatives. (C) Payment network. Now, there are also some DeFi applications dedicated to improving the speed and efficiency of on-chain payments, as well as the realization of payments between chains.
It should be pointed out that although OutlierVen-ture’s report is very detailed, the above nine categories are far from enough to cover the functions that DeFi can currently achieve. In reality, the transactions that many DeFi contracts can achieve are far more complex than the above-mentioned functions, so how do they achieve it? The secret is “Lego-style combination”.
DeFi: “Currency Lego”
Among people studying finance, there is a famous joke: a student is not very fond of learning, and always chooses the so-called “water courses” when choosing courses, and avoids those “hard courses”. Once, he saw a class on the class schedule called “Options, Futures and Other Derivatives” (Options, Futures and Other Derivatives), thinking that this must be a “water class” that talks about ideals and fills in chicken soup. Class. But after the course started, he discovered that this course is not only “water”, but also very “hard core”. In each class, the professor pushes formulas from blackboard to blackboard, and there is no chicken soup at all. When I asked someone to find out, I realized that I had completely misunderstood the title of the course. It turned out that this course was actually “Options, Futures and Other Derivatives”, a famous and difficult course in the Finance Department.
I don’t know how other people feel about the course “Options, Futures and Other Derivatives”, but for me, the most fascinating part of this course is that it tells people to use bonds, stocks, Simple financial tools such as options and futures can be combined to form a variety of weird financial products, and use them to achieve the goal of hedging risks and even risk-free arbitrage. For example, if we only use one bond and one option, we can combine a convertible bond; and if we give me a few more options, I can combine a high-interest capital-guaranteed bond. All of these are like Lego bricks. In fact, the design of financial products in reality is done in this way.
With the blockchain, people naturally move this idea of combining to achieve complex financial functions to DeFi applications. Specifically, in the entire DeFi ecosystem, some financial functions are basic. For example, the major types of applications pointed out in the Outlier Venture report actually implement most of the basic financial functions. In computer terminology, those program blocks used to complete a particular function have a special name called “primi-tives”. Following this tradition, these basic financial programs are called “financial principles”. Language” (fi-nancialprimitives).
As mentioned earlier, these “financial primitives” are essentially smart contracts written in programs, and these contracts are open source, so people can easily combine and modify them. In this way, in the blockchain world, people can use these “financial primitives” to assemble a variety of financial applications just like in the real world. The difference is that in the real world, the combination of financial products will be more restricted. For example, you will be restricted by buying and selling units—for individuals, you cannot use half shares to construct financial products. Therefore, in the real world, creating new financial products is usually just the prerogative of large institutions. But in the DeFi world, with the help of smart contracts, the threshold for individuals to create financial products has been greatly reduced. People can design their own financial products more freely according to their unique needs and use them for transactions very conveniently. It is precisely because DeFi applications can be implemented through combination so freely, some people also affectionately refer to DeFi as “MoneyLego”.
The risks of DeFi
Through the previous introduction, we can easily see that with the help of blockchain technology, DeFi can well overcome many shortcomings of the traditional centralized financial system, thereby greatly improving the operational efficiency of the financial system and better satisfying people’s diverse financial needs. Financial needs. However, there are so-called advantages and disadvantages in everything. While seeing the advantages of DeFi, we should also see the risks it may bring:
One is availability risk. As mentioned earlier, DeFi has strong freedom, and people can realize very complex products by combining financial primitives like Lego. This aspect can certainly meet the unique financial needs of a wider range of users, but on the other hand, it may also increase the difficulty for people to identify products, thereby reducing the use of products. What is even more troublesome is that overly complex product design may make it difficult for people to see the risks behind the product, and it is likely to increase fraud and other problems unexpectedly.
The second is the risk of centralization. Although theoretically speaking, DeFi has the characteristics of decentralization, in fact, some basic functions of the purchased DeFi system are developed by some companies, so in fact, it is still difficult to avoid the risk of centralization. For example, on Ethereum, the DeFi loan protocol Compound is designed to allow central administrators to upgrade it. Obviously, under this design, it is difficult to achieve true decentralization.
The third is liquidity risk. For finance, liquidity is crucial. However, if DeFi is built on a certain blockchain, when the transaction volume of the system expands rapidly, and the scalability of the blockchain system cannot keep up with the increase in transaction volume, congestion may occur, which will have a huge impact on liquidity.
The fourth is the risk of hacker attacks. The operation of the DeFi system needs to be guaranteed by a smart contract, but it is not so easy to review the code of the smart contract. As long as there are any loopholes in the smart contract, it may be called the target of hacker attacks. The characteristics of the blockchain determine that if fraud and false transactions are reached, they will be almost irreversible, which makes the possible harm caused by hacker attacks greater than in the traditional environment.
What needs to be pointed out here is that under traditional conditions, hackers mainly rely on their advantages in computer technology when attacking the financial system. Under the existing DeFi ecosystem, due to the differences between the chains and applications Interoperability is not so good, so the arbitrage opportunities between cross-chain and cross-application may be great. At this time, even a person with less computer skills, as long as he has sufficient financial knowledge and sufficient market sense, can become a hacker and attack the DeFi system.
In fact, this risk is no longer a hypothetical assumption, but a very real threat. For example, on Valentine’s Day on February 14 this year, an event called “bzx attack” occurred on Ethereum. In this incident, hackers did not spend great efforts to crack various programs and make money from the system as people are used to. Instead, they flashed back and forth between DeFi applications such as Flashloan, Compound, and DyDx, borrowing, repaying, and using the interest difference between different applications to successfully cash out 350,000 US dollars. It not only saves time and effort, but is also reasonable and legal.
Based on the above analysis, we can see that although DeFi is good, it is not perfect. While actively developing and exploring DeFi applications, we must also see its hidden risks, and then design systems in a targeted manner to maximize strengths and avoid weaknesses. Only in this way can we make DeFi serve us better.
