The most widely used application of blockchain technology is the generation of digital currencies, which requires the development of financial markets to support their transactions. However, the current state of these financial markets prevents their fair and open use.

Additionally, the infrastructure supporting blockchain-based marketplaces is vulnerable to counterparty risk, censorship, lack of transparency, and manipulation because it is fundamentally centralized. Current infrastructure deficiencies erode trust and hinder adoption.

Just as the Internet leaves room for the generation of new information infrastructure, blockchain technology must also take into account the generation of new financial infrastructure and the development of new markets.DeFi emerged to make the infrastructure of new and existing blockchain-based markets as decentralized as the underlying technology.

1. Dream DeFi

In a properly functioning decentralized financial system, internet connectivity, not geography or situation, would be the only prerequisite for using financial services. Less centralization by institutions that control and own financial market infrastructure will increase transparency, reduce costs, and reduce opportunities for censorship and/or manipulation. The global "unbanked" (individuals and businesses) will have access to financial services.

DeFi will not only advance the market of existing illiquid financial products, but also take into account the creation of new financial products and markets that do not yet exist.Being able to arbitrage, borrow, hedge and access liquidity more efficiently will prompt more institutions to embrace this change without limiting these products and markets to what they can only use.

2. Realistic DeFi

Although DeFi is called "open finance" and is sometimes touted as the way to "bank the unbanked," the truth of the matter is that these products are not aimed at retail investors at large, let alone the "unbanked" worldwide. Account".Technology is generally not a major factor limiting access to financial services. Often, identity and/or government regulation is.

On the individual investor side, it is also unreasonable to think that the average retail investor would understand the risk profile of the simplest DeFi product, and I have yet to hear a convincing argument as to why the average retail investor would need to use novelty financial products. Derivatives. The lack of better design in UX/UI creates a further barrier for personal use.

The product market that is suitable for most institutional investors is not very clear now. Most DeFi projects are not very suitable for high-frequency trading because they are limited in terms of speed. They are also not suitable for trading with large positions, and traditional financial institutions will not even consider trading with unknown counterparties. At this point, institutional investors are reluctant to engage in these transactions as long as they can trust at least one side of the market in which they operate.

As a result, product market fit is currently limited to a subset of heavy users who have a good understanding of the poor UX/UI design of crypto networks and various blockchain-based assets. In order to accelerate user adoption, DeFi interfaces must not outweigh the expected benefits of ownership, access (Editor's note: unrestricted access) and transparency when compared to centralized offerings.

The education of developers and the lack of development tools are also limiting the growth of the industry. Tools and services need to be further developed and a best-in-class technical architecture built so that users don't have to interact with the ecosystem moving towards decentralization. Developers, regulators, lawyers, investors, professional traders, and individual users must work together to overcome these existential challenges.

Therefore, the transition to a decentralized financial system is more likely to be an incremental change rather than a revolutionary makeover. That doesn’t diminish DeFi’s potential to reshape how markets work and how the world at large interacts and transacts.

Although the development of DeFi has the potential to provide more meaningful results than centralized products, there are many practical challenges that the DeFi industry needs to overcome first.The current level of user usage may be the biggest obstacle to the development of the industry, and new risks mixed between different protocols may pose the biggest threat to its sustainability.secondary title

1. Identity and reputation

The first step in initiating a financial transaction often requires identifying the parties to the transaction. but,The central problem with DeFi is that one's ability to use financial services should not depend on every aspect of identity. This is problematic because breaching KYC/AML/OFAC regulations can lead not only to hefty fines, but also to criminal charges.

If a DeFi relayer (a party hosting an order book on a DeFi protocol) facilitates a transaction between unknown parties that are proven to be in violation of these regulations, the consequences could be severe. Additionally, without a way to enforce identity, proposals around decentralized governance for most projects quickly turn into plutocracies.

Although far from a complete solution, several projects are investigating how to achieve KYC without introducing centralization. For example, relayers on 0x may choose to implement permissioned liquidity pools to ensure that only whitelisted Ethereum addresses that meet certain requirements, such as those imposed by AML (anti-money laundering) and KYC policies, are used.

Still, this approach does not ensure identity to allow one to know if a counterparty is trustworthy without excluding those outside the traditional financial system and introducing centralization. Some have released Ethereum Improvement Proposals (EIPs) to integrate KYC/AML compliance into ERC-20 tokens.

In many cases, though, these proposals still require service providers to collaborate off-chain through consortiums to review each other’s KYC policies, and it’s unclear whether these proposals will fully meet regulatory requirements.

Building a reputation in a blockchain network is clearly a challenge. This is a strong industry focus, as the range of possible products expands when there is reputation on-chain. There are currently two main approaches to attempting to build a reputation in these networks:

• Allowing everyone to start on an equal playing field under the assumption that network participants are well behaved. Participants who prove untrustworthy are subsequently penalized. The underwriters of the Dharma network fall into this category, and they have gradually built a reputation through their accuracy and on-chain records of their behavior.

• Migrate existing credit data to the blockchain network through the oracle machine. This is hardly an improvement over the traditional financial system in terms of fair usage considerations.

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2. Capital inefficiency

The overcollateralization required by DeFi projects is capital inefficient. MakerDAO requires users to deposit 1.5 times the price of ETH to establish a collateralized debt position (Collateralized Debt Position) that supports Dai. Even so, most choose to keep their loan-to-mortgage price ratio at 300% to avoid double-digit liquidation penalties. Likewise, Compound requires a 2x collateralization ratio, which the company says will decrease over time.

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3. Oracle

The failure of on-chain oracles (the mechanisms that discover and submit real data to smart contracts) is a huge problem for these systems,Liquidation happens automatically if the collateral falls below the system-specified "loan-to-price" ratio. Different DeFi projects implement oracles in different ways, but many of them are using MakerDAO’s oracles.

MakerDAO's oracle is currently designed to support a single collateral Dai (only ETH can be used for collateral), but will be redesigned to support multiple collateral Dai (using different cryptocurrency mortgage pools) (Editor's note: multi-currency Mortgage is about to be realized).

MakerDAO's oracle fetches data from 16 different sources for its oracle input sources. These sources consist of Ethereum addresses voted by MKR token holders, which are then submitted to the smart contract.

This oracle selects the median of all 16 submitted data points. The system allows a tolerance of 51% because it excludes outliers that malicious actors might submit. Importantly, MakerDAO also uses an oracle security module, where the second layer of the protocol can activate emergency shutdowns.

If the system has reason to believe that the oracle may have been compromised, this shutdown freezes the system in the last known "safe state". In the event of an emergency shutdown, users can exchange Dai for ETH at a ratio equivalent to $1:1 Dai, based on the finalized "safe state" of the ledger.

The single-collateral Dai oracle is updated every time the price of ETH moves +/- 1%, but the multi-collateral Dai oracle is updated hourly. This allows 16 oracle inputs to be visible an hour before they are activated, increasing transparency.

Still, such a long lag may not be appropriate given the volatility of cryptocurrency prices. The company's argument that such delays can be compensated through risk models is questionable.

Compound’s oracle takes a different approach, aggregating prices from a set of exchanges and calculating an average price, which is then continuously published on-chain. The data is updated every time the base price fluctuates +/- 0.1%, but the data is updated on-chain every 15 to 30 seconds, which is limited by the processing speed of Ethereum.

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4. Network: Platform, Liquidity, Scale

Most of the current DeFi solutions are built on Ethereum, so the adoption of DeFi is closely related to the scalability and usability of the Ethereum network. The scalability debate is well known (and addressed below), while usability remains a challenge, as mainstream users still struggle to interact with Web 3.0.

While the constitutive nature of an Ethereum-based protocol creates even greater switching costs, it also introduces network risk. As more projects build on top of Ethereum, it may also become more difficult to upgrade the base layer protocol in a backwards compatible way.

The power of DeFi is that it can create new markets. However, decentralized markets suffer from the same liquidity problems that all new markets have: adoption requires a certain amount to bring liquidity, but adoption is driven by liquidity.

While DeFi can create new markets and make them accessible to new participants, this does not automatically create liquid markets for these products.

This is a problem because illiquid assets tend to trade at a lower price than liquid assets. The lack of arbitrage opportunities creates ineffective pricing as it remains difficult to quickly and smoothly transfer money between cryptocurrency markets.

Alex Evans of Placeholder VC divided the current DeFi network models into three categories:

• Those networks that require users to find counterparties. Such as Augur, 0x, Dharma

• Networks that pool assets from “order makers” and provide them to “takers” for a fee. Such as Compound, Uniswap

• Those networks whose parameters are set through governance, which allows users to transact directly with smart contracts. Such as MakerDAO

Each model has implications for liquidity. The lack of a requirement to find a specific counterparty appears to be a design strength of top protocols. These protocols also tend to offer fewer choices in terms of products/use cases, which pools demand to better drive liquidity.

Alex Evans also believes that automated and consistent processes (MakerDAO) facilitate liquidity better than customized and changing processes (Augur). This appears to be one of the driving factors behind UMA and Dharma, two networks that decided to set stricter parameters on their products (compared to a completely open system where individual users set all parameters).

“Markets that have built deep liquidity in a handful of significant markets, at least initially, appear to have a head start in user adoption over markets that are trying to build multi-asset infrastructure.” - Alex Evans

Assuming these markets find a way to drive the necessary liquidity on their own, the blockchain infrastructure is not yet scalable enough to handle the scale of a centralized exchange. Regarding the limited scale of the current DeFi network, Arjun Balaji, an investor at Paradigm, predicted that the cumulative trading volume on 0x in December 2019 would not be equal to the trading volume of Coinbase in one day.

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5. The business model is still unclear

Although there are many options, the commercialization method of most DeFi projects is not clearly defined, focusing on "incentives for clear protocols as a whole". But at some point, if these projects are to continue, they need to have a source of income.

dYdX highlights three main commercialization models for DeFi projects:

• Add value through the project's native token. Such as MakerDAO (MKR)

• Generate income through fees. Such as Compound

• Monetize with user-facing apps. Such as dYdX, Dharma, etc.

In most cases, the commercialization model of the project's native token will bring inconvenience to users. For other projects it may not work either. For example, this model is less likely to work in networks where the ownership/voting ratio is determined by the participants.

Nadav Hollander of Dharma pointed out that the fee model implemented at the protocol layer could be easily forked. However, Compound is not opposed to using an AUM model similar to traditional finance to allow the system to generate continuous interest.

The latter seems to be the dominant model. Dharma, dYdX, and other projects found that they needed to develop full-stack products (e.g., Expo on dYdX), because they found that developers were unwilling to invest the necessary time to continue advancing these new protocols.

Although the 0x model is often touted as a role model, part of the success of 0x is that there is already a ready-made market for decentralized exchanges. 0x’s protocol opened up to existing markets, whereas these new DeFi protocols had to create new markets from scratch.

To circumvent many of the challenges of creating a two-sided market from scratch, it is likely that new DeFi protocols will develop and commercialize full-stack services, at least in the near term.

It's important to remember that creating a marketplace is a service business, and that's not likely to change. No matter which party creates the market, it also has to provide services for both supply and demand.Markets cannot be created out of thin air, not even through the smartest protocols. They always require a team/company to support the ecosystem by providing services that allow the market to grow.

Therefore, designing businesses with "minimum viable decentralization" may be a more efficient way to launch products and address early governance, although this may not be favored by companies that prioritize decentralization.

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6. New risks brought by cross-protocol

Cryptocurrencies and blockchain-based markets have fundamentally different characteristics than traditional markets.DeFi protocols benefit from compositionality that leads to faster innovation, but also leads to a greater degree of interdependence. It is therefore reasonable to assume that the risk profile of these products, especially in combined form, is not yet fully understood.

Although each project claims to have developed its own risk model, the complexity of analyzing new risks across these interdependent protocols is significant.

Many of these projects leverage concepts that led to the 2008 financial crisis, but more importantly, they do so in new and untested ways. For example, the 2008 financial crisis included rehypothecation of collateral, fractional ownership of structured products, and risk pooling.

DeFi takes these concepts and applies them to extremely volatile and difficult-to-value assets in relatively illiquid markets that lack safeguards. The combination of all these factors, plus the complexity of agreeing on the idea of ​​inter-protocol collateral rehypothecation, creates a whole new risk profile with little precedent.

In this case, it's worth considering what market failure looks like. MakerDAO is an experimental network upon which the success of many other projects rests.

It is important to remember that CDPs and other DeFi products are not insured in the event of market failure, and it is unlikely that a third party will step in to fund small crypto startups. Investors, users, and token holders will be responsible for recapitalizing this highly interdependent DeFi system.

Systemic effects can be troubling. Dai is usually bought and sold in pairs with ETH on 0x Relayers. It is typically stored on Compound and then lent out to hedge funds for risky trades. dYdX also relies on MakerDAO, which relies more heavily on Dharma (borrowing Dai) and the 0x protocol (facilitating Dai transactions) for liquidity.

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7. Supervision

The main concern with regulation of the industry does not appear to be that the current regulation is too restrictive, but rather that this concern is related to the ambiguity of how existing regulations apply to blockchain networks and cryptocurrencies. Many startups in this industry don't know how to determine whether they should launch because the regulatory environment they operate in is so unclear. The cost of this uncertainty is high.

In fact, the regulatory burden is so high that some startups have determined they don’t have enough capital to launch in a fully compliant manner, and the recent deterioration in the fundraising environment has made this even more difficult.

3. From dream to reality

Projects in this industry are acutely aware of the above issues and are actively working to address them. For example, Dharma now pays gas fees for users to make the user experience better, and MakerDAO is planning to abstract the process of converting Dai to MKR when redeeming MCD.

These networks are gradually removing the requirement to hold native tokens, opting to replace them with more widely used cryptocurrencies such as Dai or ETH. This is a very important move as it removes past barriers to widespread adoption of DeFi.

New innovations and projects are also frequently entering the industry that can provide solutions to many deficiencies of current projects. For example, the Arwen protocol is perfect for HFT because only escrow opening and closing are published on-chain, while the rest of the protocol operates like a layer 2 channel, which allows transactions to proceed much faster.

Such transactions are also only visible to the counterparty and the exchange. Since no single transaction is executed on-chain, miners do not see transactions ahead of time, which eliminates most of the up-front problems faced by DEXs. This protocol can also solve other important pain points, such as allowing small fractional staking (which dYdX is actively working on), trustless fiat currency exchange (through integration with banks), and fast transfer of tokens between exchanges, so that it can be realized efficiently. arbitrage.

From 2017 to 2018, the main focus of the DeFi industry was to establish the scalability and liquidity of DEX. Solutions to this are rapidly developing. In 2018-2019 the focus shifted to borrowing.

The composability of DeFi products should allow the entire ecosystem to move forward at a faster pace, and possibly achieve more mainstream adoption in 2019 as users are brought into the ecosystem through multiple protocols (transactions, lending, derivatives) , these protocols require users to trade in cryptocurrencies.

Disclaimer: This article is the author's independent opinion, and does not represent the position of the Blockchain Institute (public account), nor does it constitute any investment opinion or suggestion.

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Translation: Chuan, special author of Blockchain Research Institute.

Disclaimer: This article is the author's independent opinion, and does not represent the position of the Blockchain Institute (public account), nor does it constitute any investment opinion or suggestion.

Source: https://medium.com/coinmonks/defi-what-it-is-and-isnt-part-1-f7d7e7afee16