Zou Chuanwei: Re-understanding DeFi from eight key perspectives and logic

In what direction will the DeFi ecosystem evolve? What logic does the evolution of DeFi follow?

Author: Zou Chuanwei, Chief Economist of Wanxiang Blockchain

There has been a lot of discussion about DeFi recently, and DeFi can be understood from multiple perspectives. This article proposes to understand DeFi from 8 key perspectives : 1. Financial function; 2. Discrete-time finance; 3. De-trust environment; 4. Oracles and information; 5. Liquidity; 6. Arbitrage; 7. Incentive; 8. Risk and interconnection.

This article attempts to answer two questions:

• DeFi developers to write intelligent addition to the contract, you also should grasp what tools?
• From the perspective of DeFi investors, in what direction will the DeFi ecosystem evolve, and what logic will the evolution of DeFi follow?

Financial function

Some researchers understand DeFi with reference to mainstream financial institutions, such as discussing what forms of banking, securities, and insurance in the DeFi field should be. In fact this analogy is not precise enough, because DeFi is based on the financial function module is built. This involves the relationship between financial institutions and financial functions.

Financial development has two main lines that intertwined and rise like double DNA strands. One is financial function and the other is financial institution. Zvi Bodie and Robert Merton have proposed 6 basic financial functions:

1. Payment and settlement . This is the most basic function of financial services for real economic activities. In addition to bartering, any economic activity depends on payment and settlement to form a closed loop of value.
2. Gather resources and shareholding breakdown . This can gather social resources to do larger or more adventurous undertakings, and share benefits and risks among participants. Joint-stock company is a typical embodiment of this function. Banks pooling scattered social funds to support national development and construction also reflects this function.
3. Transfer resources across time and space . Resources in terms of time and space is never evenly distributed resources need to be regulated in two dimensions, in order to maximize efficient use of resources. For example, Zhang San has spare money that cannot be spent, and Li Si has projects but lacks money. Through the financial system, Zhang San can lend money to Li Si (cross-space transfer). In the future, after the Li Si project obtains the income, part of the income will be transferred to Zhang San (transfer over time).
4. Manage risk . The allocation of resources by the financial system is carried out in an uncertain environment. Any financial activity, whether it is centralized or decentralized, is essentially based on operating risks to obtain income.
5. Provide information . The financial system has an important price discovery function for funds and risks. The information provided by the financial system is of great significance to the resource allocation of the whole society.
6. Solve the incentive problem . A large amount of value in the whole society is traded and circulated through the financial system, and the resulting economic incentives promote the formation of social division of labor and market order.

Mainstream financial institutions generally perform multiple financial functions simultaneously. For example, banks mainly perform functions such as payment and settlement, gathering resources, transferring resources across time and space, and managing risks.

Bodie and Merton believes that the financial function is more stable than financial institutions, financial institutions will depend on the form of financial functions they perform. For example, the organizational structure and business forms of banks 100 years ago were very different from today, but the financial functions performed by banks have not changed much.

The division of financial functions by Bodie and Merton also applies to DeFi (Table 1):

Therefore, the understanding of DeFi, it is best to proceed from the financial function. DeFi is constructed according to financial function modules, and has good assemblability. Multiple DeFi projects can be assembled together to achieve complex and diverse financial functions, which can be close to mainstream banks, securities, and insurance. But even the DeFi portfolio is very different from these mainstream financial institutions.

Discrete Time Finance

Finance is the continuous-time financial mainstream. For example, global foreign exchange transactions occur 24*7, and Yu’ebao is generating interest income every day. The time units used in mainstream finance are generally hours, days, weeks, months, quarters, and years.

DeFi is a discrete-time financial. Any financial activity has cycles and frequencies. The frequency of DeFi depends on the update frequency of the public chain distributed ledger. The extension of time in the public chain is reflected in the continuous generation of blocks, and the unit of time is the block generation time. A well-time block chain consensus decision algorithm running in a distributed network of authentication nodes, despite the statistical average, but prior to see a random variable.

Discrete time and TPS limitations have a comprehensive and profound impact on DeFi:

1. Effect DeFi activity efficiency, the amount of activity of natural subject DeFi well chain physical properties. For example, when there is congestion on the chain, transactions such as on-chain auctions and on-chain collateral disposal may not be processed in time.
2. Influence outside the chain within the chain synchronization and information arbitrage efficiency. This will be explained in detail later when discussing oracles and arbitrage.
3. The impact of price discovery and risk clearing efficiency. For example, with the exception of long-tail crypto assets, most of the price discovery of crypto assets is done on centralized exchanges. DEX follows the pricing of centralized exchanges, not the other way around. As another example, when the market panic mood, the public chain easily jam some help clearing market risk transactions may not be treated miners, or to pay higher fees or charges Gas miners will be processed. This will not only reduce the risk of market trends clearing and re-balancing of efficiency, will reduce market participants confidence in the orderly operation of the market, to further enlarge the market panic.

What kind of analytical methods should discrete-time finance adopt? Continuous time finance because you can use calculus and other mathematical tools, easier to analyze than the discrete time finance. This article proposes the following analysis methods for DeFi:

Discrete time finance = approximation of continuous time finance + the influence of public chain TPS and time lag

In other words, when analyzing DeFi, the core financial issues should be extracted first, and after a clear analysis in continuous time, the impact of public chain TPS and time lag should be considered. For example, the analysis of arbitrage mechanism of automatic machine maker and prophecy, you can follow this methodology.

In discrete-time finance, the time value of money still applies. For example, after 1 year of staking , 1 unit of encrypted asset will receive a total of 1.5 units including principal and interest. Then, 1 unit of encrypted assets today is equivalent to 1.5 units of encrypted assets 1 year later. This is the time value of money. The analysis of the cost of capital and investment income in DeFi is essentially analyzing the time value of money.

Although the block before time hindsight is a random variable, but a block of time for the unit of time, you can put the interest of mainstream financial theory introduced DeFi. Present value, future value, discount factor, simple interest, compound interest and no-arbitrage pricing of basic concepts and tools applicable to DeFi, and shows a strong value in a lot of problems.

Yu’ebao can query investment income in real time, but DeFi cannot do this due to the limitation of public chain performance. In many DeFi applications, in theory, every new block is accompanied by interest. However, if these newly generated interest are paid through on-chain transactions as soon as possible, it may consume higher gas fees and may also cause on-chain congestion. Therefore, very often it needs to be properly stretched interest payment period. For example, first accumulate interest instead of transferring it to the relevant address through on-chain transactions, and then pay the interest income in one lump sum after a period of time (for example, when you withdraw from Staking). In this type of problem, it is more necessary to introduce an accurate method of calculating interest.

Interest theory has important applications in staking and DeFi liquidity management. For example, PoS mineral pool while providing Staking income to investors also need to provide liquidity. Especially in Ethereum 2.0, the staking lockup period on the beacon chain is very long. When investors participate in beacon chain staking, if they have liquidity needs, can they transfer their staking shares? This question is a good application of interest theory.

Trustless environment

No matter what role DeFi participants assume, they are essentially public address within the chain. Within the chain is a public trust to the environment, the address is essentially anonymous, neither the identity nor credibility. This is the key difference between DeFi and mainstream finance. The participants in mainstream finance are individuals and institutions. When individuals or businesses applying for loans to banks, the banks will assess their willingness and ability to repay; when bond financing companies, credit rating agencies will assess the level; when companies raise equity funds, investors will assess the earnings outlook. The above evaluation work happens all the time in mainstream finance, but it does not exist in DeFi.

The trustless environment is the foundation of DeFi’s openness and permissionlessness. But to trust environment because the address itself can not be the subject of credit, mortgages and over-fulfillment by Staking financial contracts. For example, assume that address into a 1 encryption unit assets in the future would like to address b, to protect the enforceability of this commitment, addresses a need to provide more than one unit of encryption assets as collateral. How to understand over-collateralization and staking?

1. Over-collateralization and staking are important channels for public chains to capture value from DeFi. Without this mechanism, the price interaction between the public chain and DeFi may be out of touch.
2. Over-collateralisation locked liquidity, liquidity risk is equivalent to the address of the credit risk into collateral. In DeFi and mainstream finance, risks will not disappear out of thin air. Many times, they just change a form.
3. Because over-collateralisation, DeFi lending risk pricing efficiency is very low. This is reflected in the DeFi lending rate does not include a risk premium for the borrower and has nothing to do with the borrower’s creditworthiness. In fact, in a trustless environment, the credit of an address cannot be defined or measured. It can also be said that DeFi loans are essentially mortgage loans, not credit loans.
4. In MakerDAO , over-collateralization guarantees that Dai (essentially CDP liabilities) from different collateralized debt warehouses (CDP) have the same value connotation. No matter who initiates the CDP, and no matter what kind of collateral the CDP adopts, as long as the over-collateralization rules are followed, Dai is equivalent to each other.
5. Staking is a commitment mechanism stakeholders. This has been fully reflected in the PoS consensus algorithm to solve the Nothing at stake problem.

Financial activities cannot do without trust. Trust can reduce the uncertainty about the future and is essential for reducing the transaction costs of financial activities. This is true for both mainstream finance and DeFi. We say that to block chain of trust, in essence, human and institutional trust will trust into algorithms and intelligence contracts, but the essence is still trust. Introducing trust in a trustless environment helps to further reduce DeFi transaction costs. There are three approaches to introduce trust in DeFi in.

1. Address and identity and reputation associated with the chain, such as Gitcoin Grants use GitHub account to deal with multiple identities attacks and conspiracy to attack. The controllable anonymity of the central bank’s digital currency is essentially to associate an anonymous address with a real identity through KYC.
2. Repeated game can inhibit opportunistic behavior well chain, the chain is formed in the credibility, such ChainLink node. Repeated games make the long-term losses of opportunistic behavior exceed the short-term gains, so that anonymous addresses can also comply with the rules evolved from the game.
3. “Invisible Hand” -the behavior of maximizing profit driven by arbitrage and economic incentives . This is the basic logic of mechanism design. We don’t need to know the values ​​of DeFi participants, such as whether they keep their promises, as long as they are rational economic people, we can infer their behavior characteristics through economic analysis. Conversely, through arbitrage and economic incentive design, DeFi participants can show the behavior characteristics we expect. This point will be discussed in detail later.

Oracles and information

There are two consensus mechanisms inside and outside the public chain. The first is a PoW, and PoS and other consensus algorithm, is a consensus within the chain of information within the native to the chain. The second is the oracle, the chain within the chain consensus outside information. The oracle is the basis for information synchronization and arbitrage within and outside the chain. Regardless of the consensus mechanism, it means entropy reduction (that is, elimination of confusion), and energy input (or cost consumption) is required. The goal of oracle design is to minimize the ratio of error to cost.

There are many design schemes for oracles, but they can be roughly divided into two categories.

The first oracle based on the reputation and vote to ChainLink represented. This type of oracle relies on multiple bidders to select the average or median of multiple quotations as the oracle quotation to control the error of individual quotations. This type of oracle also eliminates inefficient and malicious bidders through reputation mechanisms and repeated games.

The second category oracle based trading and arbitrage, arbitrage mechanisms converge to let oracle quoted market price. The use of arbitrage mechanisms by this type of oracle will be discussed in detail later.

Communication from the engineering point of view, no matter what form it takes, on DeFi oracle essentially a sampling process with errors and delays. The oracle samples the continuous signal outside the chain at discrete time points, and then reads the discrete signal into the public chain (Figure 1).

Figure 1: Oracle as a sampling process

The error of the oracle relative to the original continuous signal consists of two parts (Figure 2). First, the error of the signal source . Various oracle schemes essentially reduce this error as much as possible. Second, the fluctuation of the original signal will be amplified by the sampling interval and the time it takes to reach a consensus. Both of these parameters are largely affected by the performance of the public chain.

Figure 2: Error decomposition of the oracle

fluidity

Liquidity is the core issue in DeFi. The application and management of liquidity is reflected in many aspects of DeFi. For example, it has been previously discussed, the excess risk of mortgage credit will be converted to address liquidity risk collateral.

Liquidity reflects the possibility of selling assets within a reasonable time at a reasonable price. Under the same conditions, the longer the time is extended, the more likely it is to sell assets at a reasonable price. But on many occasions, it is impossible to sell assets unhurriedly. In this way, the level of liquidity will have a great impact on the interests of investors.

Liquidity is a complex economic phenomenon, which is affected by many factors. For example, chain mobility within the transaction limit by the well-strand of TPS. Liquidity is the product of interaction between buyers and sellers. The higher the confidence of both parties, the greater the liquidity.

Liquidity is a special public goods. For most commodities, rising demand will stimulate supply by pushing up prices. But because of liquidity related to the confidence of buyers and sellers, the supply may be at least where they are most needed.

For investors, liquidity is a commitment and insurance mechanism. Liquidity provides investors with confidence in whether the transaction can be completed and at what price.

There are two main types of commitment mechanisms related to liquidity. The first category is based on the reputation of commitment, such as market makers in the order book. Based on their reputation and strength, this type of market maker promises to provide transaction convenience for both buyers and sellers, and profit through the bid-ask spread. The second category is the commitment algorithm, such as auto makers. Automated market makers provide buyers and sellers with the convenience of algorithmic transactions through the liquidity pool, but they will bear the impermanent losses caused by arbitrage and face challenges in business sustainability.

Obviously, under the same conditions, to provide liquidity to DeFi products more attractive to investors. For example, the PoS mining pool discussed above provides investors with examples of liquidity shares and transfer mechanisms.

Liquidity can be unbounded or bounded. The liquidity of a centralized exchange is unbounded. The liquidity of automatic market makers is bounded. For example, regardless of how investors trade with Uniswap, if you do not consider the impact of transaction fees, liquidity pools should always meet the constant product condition.

PoS mining pools provide investors with a share of liquidity, which is also bounded liquidity. Regardless of how the transfer of the share of the total amount of liquidity share liquidity among investors, who together hold the same – the liquidity of the share transfer does not constitute a redemption PoS mineral pool. This is similar to the secondary market trading of stocks that will not affect the number of shares issued by listed companies. As Keynes pointed out, there is no investment liquidity for society as a whole.

There liquidity combined effect. For multiple liquidity pools, their combined liquidity will exceed the sum of their respective liquidity. This is the same as the risk diversification effect, which is the basic law of finance-the risk of the asset portfolio is less than the sum of the risks of all parts.

arbitrage

Arbitrage is not a bad thing. Arbitrage is derived from the basic needs of human nature. When conditions permit, anyone wants to take advantage of others, but does not want others to take advantage of themselves. This is human nature.

There are many driving factors for financial development, such as regulation and technology, but the fundamental driving force is arbitrage. Any financial markets and products just launched to the time, because the pricing mechanism is not perfect, there will always be an arbitrage opportunity will attract arbitrageurs. Driven by arbitrageurs, the pricing mechanism was corrected, and the financial market and products tended to improve. With such a cycle, financial development can continue to move forward.

Arbitrage the price convergence, but convergence will take time and cost. For example, for any oracle based on trading and arbitrage (such as Uniswap), by solving an optimization problem, it can be proved that there is a no-arbitrage condition under which no new transactions will occur. And this no-arbitrage conditions are equivalent to the limited scope of the oracle quoted market price of the deviation.

The economic intuition here is very easy to understand. Once the oracle quotation deviates from the market price, it means an arbitrage opportunity, but the arbitrageur needs to pay the cost to execute the arbitrage strategy. Therefore, arbitrageurs will carefully weigh the benefits and costs when arbitrage, such as oracle quoted market price of the magnitude of deviation is large enough, will execute arbitrage strategies (This is essentially the optimal point problem right line American option). The execution of the arbitrage strategy will correct the deviation of the oracle quotation from the market price until the arbitrage strategy is no longer economically attractive, and so on.

It can also be proved that the lower the DeFi transaction cost , the higher the arbitrage efficiency , and the smaller the oracle quotation deviation (that is, reducing the error of the oracle at the source of information).

No-arbitrage pricing + interest theory is the basic tool of DeFi asset pricing. Arbitrage will form the benchmark interest rate curve in DeFi. For example, for PoS-type encrypted assets, the staking yield will constitute the “anchor” of DeFi lending rates.

Arbitrage is a universally applicable mechanism design. Minimum arbitrage assumptions about human nature. Arbitrage only requires people to be rational, to seek advantages and avoid disadvantages, and to maximize their own interests, without knowing whether they are good or bad. In the decentralized environment of DeFi, the incentive and coordination role of arbitrage is more important. For example, MakerDAO collateral liquidation is based on arbitrage design.

Arbitrage mechanism works on the premise that there is an active arbitrage community, so community motivation is very important. For example, for an oracle based on trading and arbitrage, if there is only one arbitrageur, then he will wait until the oracle quotes deviate from the market price by a large margin before executing the arbitrage strategy. If there are multiple arbitrageurs, each arbitrageur will consider the possibility of other arbitrageurs executing arbitrage strategies ahead of them. The competition among arbitrageurs will advance the execution time of the arbitrage strategy, thereby reducing the deviation of the oracle quotation from the market price.

No matter what form it takes arbitrage, arbitrage is essentially a zero-sum game, re-distribution of benefits, income of A that is B’s loss. For example, in the automatic market maker, the return loss Arbitrageur fluidity corresponds impermanent providers.

Some auto makers to introduce machines offer predictions, in essence, is to limit arbitrage space, reducing the impermanence loss of liquidity providers. Obviously, in any arbitrage mechanism, if one party continues to lose money, the arbitrage game cannot continue, and there will always be a day when it stops.

excitation

Incentives should be designed so DeFi become infinite game, rather than the limited game. Community self-organization and self-upgrading are the keys to the evolution of DeFi. Community members should be able to get their own benefits from DeFi. In other words, in the design of the DeFi incentive mechanism, one cannot expect a certain type of participant to always act as a “live Leifeng” role.

As mentioned earlier, in automatic market makers, the profit of the arbitrageur corresponds to the impermanent loss of the liquidity provider. To compensate for the loss of liquidity providers and market makers automatically charge transaction fees to investors, fee income and transfer payments to liquidity providers. However, due to the limited transaction volume in the chain and the low fee standard, the ” fee income <impermanence loss ” of liquidity providers is a common problem. Liquidity providers are equivalent to providing liquidity as a public product at their own expense.

Some auto makers introducing governance tokens as additional compensation to liquidity providers, in order to alleviate the problem of unsustainable commercial liquidity providers face. But the value capture ability of governance tokens is weak. For example, the valuation of the company stock, in general, estimates the company’s future earnings and dividends, then the estimated future cash flows stock holder, and then get the discount to the current stock valuations. If the investor’s equity ratio does not reach the threshold of 33% or 50% , the value of the voting rights corresponding to the stock will generally not be considered. Therefore, the effectiveness of the automatic market maker’s governance token remains to be further observed. The future direction should improve the charging method and governance token design in automatic market makers.

The above problems are common in the blockchain field. For example, if the block reward is not considered, or the block reward drops to a very low level, can the transaction fees received by PoW miners make up for the mining cost? For another example, can the user pay for the price of the oracle machine to make up for the cost of the oracle machine? These issues involve the provision and financing of public goods under decentralized environment in nature. To solve these problems, we must refer to the economic theory of public goods.

Risk and interconnection

DeFi is the core business risks, including market risk, liquidity risk, technology risk and credit risk. Market risk comes from fluctuations in the price of encrypted assets. In DeFi, the widespread application of over-collateralization and staking converts the credit risk of the address into the liquidity risk of the collateral, so the credit risk is not as prominent as in mainstream finance (the bank and corporate bond markets are mainly credit risk). DeFi technical risk than is necessary to highlight the financial mainstream much more likely to come from vulnerability intelligence contracts may limit public chain from the TPS.

DeFi various activities are essentially take risks in order to maximize revenue through. Risks can be transferred, shared, hedged, converted and dispersed, but they will never disappear.

DeFi project to build modules for the finance function, has assembled sex. DeFi projects are interconnected and combined through channels such as information, funds, and risks. This helps to develop the DeFi ecosystem ” from point to area “, but it tends to lack an overall plan and accumulate risks. In particular, the more fundamental projects in the DeFi ecosystem, even though they have a “moat” status, the more likely it is to introduce a single point of failure risk.

Many researchers sort out the DeFi ecosystem according to different business types, but it is even more necessary to draw an overall ” risk map ” for the DeFi ecosystem. In the future, DeFi project in front of the line, in addition to doing smart contract other than the audit, should do the audit of the financial risk.