Editor's Note: This article comes fromEditor's Note: This article comes from(ID: We_R_HOT), author: Dai Shichao, published with authorization.

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01. Smart contract lands in finance, DeFi achieves Ethereum

A DeFi product is essentially a smart contract or a group of smart contracts.

Smart contracts were first proposed by Dr. Nick Szabo in the 1990s. In the doctoral dissertation, the first use case of smart contracts is financial contracts.

However, due to the lack of a trusted execution environment in the 1990s, smart contracts have not been applied to the actual industry.

On January 3, 2009, after the birth of Bitcoin, people discovered that the underlying technology of Bitcoin, the blockchain, was inherently able to provide a trusted execution environment for smart contracts.

"Bitcoin leads the blockchain, Ethereum revives smart contracts."

At the beginning, everyone used smart contracts to carry various ideals, trying to move all assets and models to the blockchain, write a project with contracts, and launch 1C0. In the second half of 2018, when the 1C0 boom finally receded, the In the bear market, everyone finally understands that smart contracts are not a panacea, and are not suitable for DApps in all fields.

It was also during the 18-year bear market that Wall Street and Silicon Valley elites discovered that smart contracts are naturally suitable for the financial sector. Several representative DeFi projects raised funds against the trend during the winter of 2018-spring of 2019, and the seed of smart contracts really found its own soil.

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(October 2018-2019)

In addition to decentralized exchanges, financial products such as lending, margin trading, prediction markets, contracts for difference, etc., have all begun to be constructed using smart contracts.

Due to the rise of DeFi in Ethereum, Ethereum also seems to have found a new self-positioning: from the world computer to the global economic settlement layer.

What is the economic settlement layer on the global chain? It is a financial system that requires no access, no trust, anti-regulation, and global free flow of assets on the chain.

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• (Ethereum’s new official website: Ethereum is a global open-source decentralized platform. On Ethereum, everyone can run programmable electronic value and open access to the world.)

• programmed digital value: programmable electronic value, that is, assets on the chain

• code controls: code control, that is, the trustless feature of DeFi

accessible anywhere in the world: global open access, that is, DeFi does not require permission (permissionless) features

How did this position change?

Because the Ethereum virtual machine EVM is expensive and slow, it cannot provide the high performance of the world computer. So what is suitable for such an expensive and slow setup?

--finance.

• The low-frequency and large-amount transactions of finance itself can prevent the current shortcomings of Ethereum from being an obstacle.
  

• Low frequency: 30-40 tps for Ethereum is enough

Large amount: you don't mind the gas cost of transferring money on Ethereum

And what is the biggest demand of finance for the public chain?

--Safety.

Therefore, we say that at the current stage of Ethereum, the most suitable type of DApp for development is DeFi, a financial decentralized application.

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02. Use DeFi to build building blocks, combination, fork and evolution

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Source: The Block

Source: The Block

So, is there a new latitude to sort out the relationship between defi products?

We might as well only divide DeFi products into two categories: [transaction] and [asset]. Then focus on how they can "interoperate" and what new combinations can be spliced ​​together?

[Trading items]: buy&sell, swap, lend&borrow, margin trading, etc.

Buying and selling (buy&sell), exchange (swap):

When an exchange does not host user funds, we can call this exchange a decentralized exchange. The design of decentralized exchanges is divided into three classic models:

1) Order book mode: such as DDEX, IDEX, Binance DEXThe order book shows the willingness of buyers and sellers to "buy" and "sell". This exchange is suitable for highly liquid markets. According to whether the matching and settlement are carried out on the chain or off the chain, that is, different exchanges have different choices for security and efficiency, and there are more detailed classifications. See these two articles for details:、DEXThe tens of billions of dollars in the DeFi market needs another one

classic design model

2) Capital pool model: such as Bancor, Uniswap

Also called Automatic Market Making (AMM: Automatic Market Making) mode. This type of exchange does not have an order book, but brings together liquidity into a pool, that is, stores all tokens in smart contracts, and makes markets based on deterministic algorithms. That is to predefine a formula to quote to users in real time. Different exchanges may adopt different market-making algorithms.

The exchange of the capital pool model is suitable for providing a market for long-tail tokens. However, usually the slippage is high and the best price cannot be provided.

3) Dutch auction model: such as Duntchx agreement, FairDEX

A Dutch auction is a reduced price auction. Algorand’s token sale made the concept known in the cryptosphere. But in fact, the Dutch auction method is widely used in flowers, fruits, seafood and other items (such as Dutch tulips). Simply put, the exchange keeps lowering the quotation until all tokens are sold out, and each buyer closes at the same closing price. To tokens, the number of tokens is determined by their order size.

Dutch auctions are suitable for price discovery in low-liquidity markets, and auctions often take hours. A classic use case is to auction NFT non-fungible tokens on Decentraland and CryptoKitties.

Borrowing (lend&borrow):

1) p2p matching model: such as Dharma

The platform matches counterparties for borrowers and lenders. Dharma's loan period is up to 90 days, and the loan interest is fixed. Funds are locked in while the borrower is lending and only starts earning interest once they are matched with a lender.

2) Capital pool model: such as Compound

Also known as Automated Market Making (AMM) mode. The pool of funds acts as a counterparty to borrowers and lenders. The interest rate is quoted by an algorithm and fluctuates in real time with the demand and supply of tokens in the pool.

Compound does not set a fixed loan term, deposit and withdraw at any time, and repay the loan at any time.

3) Stable currency model: such as MakerDao

Mortgage of ETH on its platform (currently supports mortgage of multiple assets) can create Dai. Dai is a USD-pegged stablecoin issued by MakerDAO. The mortgage rate remains above 150%. Interest is determined by MKR holders through voting.

【Asset Items】: native assets on the chain, traditional assets on the chain, etc.

Native assets on the chain: generally stable coins, a basket of tokens and index products. Such as WBTC, NUSD, USDx, SET Protocol, and NFT non-homogeneous tokens such as encrypted cats.

Off-chain assets on-chain: UMA Protocol issues certificates for assets such as stocks, oil, and gold, and circulates them on-chain.

The above trading and asset products are the two building blocks of defi. So how can these building blocks be combined?

【Transaction + Portfolio】

The most classic form is decentralized exchange + stable currency.

Stablecoins provide DEX with stablecoins as a liquid market for based tokens, and DEXs provide arbitrage and liquidation mechanisms for stablecoins.

The former brings liquidity to DEX. For example, the Weth-Dai trading pair is usually the most liquid trading market on Ddex; the latter is the key link to make stablecoins "stable".

【Asset+Asset Portfolio】

For example, a set protocol provides a basket of token combinations.

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(The above three types are investment portfolios of wbtc+weth, weth+dai, and wbtc+dai)

Another emerging example, the meta-stablecoin or stablecoin index, is a combination of stablecoins + stablecoins. Representative projects include USDx and NUSD.

Both package USDC, TUSD, PAX, and DAI into a basket of stable coins to obtain lower risk of price fluctuations. The difference is the ratio of constituent coins and the specific currency exchange and arbitrage mechanism.

【Trade+Trade Combination】

Decentralized margin trading is: a combination of lending + trading.

The meaning of the so-called margin trading is to mortgage loans and trade with loan funds, which is what we often call "leverage".

dYdX is a decentralized margin transaction, which combines lending products with DEX products in one stop.

(trade.dydx.exchange)

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[In addition to combination, you can also fork]

Above, we are talking about the 1+1>2 DeFi product portfolio type. Of course, not every pair of products can cooperate and win-win. Where there are interests, there will be conflicts, and where there are conflicts, there will be forks.

When the protocol layer cannot fully meet the needs of the application layer, and when the protocol layer does not provide enough incentives for developers, forks can often strip away the old consensus, gather a new consensus, and open up a more pragmatic path.

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03. The ultimate form of DeFi, who can spell Optimus Prime?

From the perspective of the combination of assets and transactions, what will the ultimate form of defi look like?

[The Dilemma of DeFi Assets]

For the asset side, what the community needs are more high-quality assets. However, whether it is the assets on the original chain or the traditional assets on the chain, there are currently difficulties.

1) Assets on the original chain require cross-chain infrastructure. The practice of WBTC has proved that it is currently difficult for high-quality on-chain assets other than Ethereum, such as Bitcoin, to access the Ethereum ecosystem.

2) On-chain assets off-chain require a strong reliance on decentralized oracles. At present, decentralized oracle machines (such as ChainLink and Dos Network) have just emerged and have not yet entered the stage of market application. The project party often chooses to build a centralized oracle machine by itself. As a small company, it has not yet accumulated credibility and chooses a centralized solution. As a result, it is difficult to win the trust of the community.

This is also one of the reasons why UMA Protocol's stock token has not been successfully promoted and is undergoing a strategic transformation.

[Evolution of DeFi trading side]

Because of the early development of DEX, after the development and practice of several generations of exchanges from EtherDelta to 0x to Hydro, the current infrastructure and liquidity experience of decentralized exchanges are relatively complete.

This is the latest product direction Hydro is developing.

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(Product Design Schematic)

Why do margin trading?

1) The source of funds for leveraged trading is lending, and the lending market is the largest market for DeFi

defi pulse.co

2) Lending product users and exchange users: large users overlap by nearly 40%

data from AIeth.io

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This shows that the purpose of user lending is to increase leverage. The ultimate destination of borrowing liquidity is the exchange.

Why do decentralized margin trading?

1) Decentralization requirements: don't liquidate your position. Centralized margin trading lacks financial security.

2) Liquidity requirements: dYdX provides decentralized margin trading, but based on the 0x protocol, it lacks spot liquidity.

Hydro's margin trading products, with the help of the off-chain order book solution of the Hybrid trading model, can provide the same liquidity as the Huobi spot market.

Why is margin trading the most advanced form of DeFi at present?

1) Demand: Leverage can be used to enter, and interest can be earned when withdrawing, one-stop to meet demand

In the bull market stud open leverage, in the bear market save money to earn interest.

2) Technology: The contract complexity of margin trading products is one of the highest among DeFi products currently.

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04 On the DeFi map, define your own positioning

The new positioning of Hydro Protocol is Market Layer, a layer 2 that focuses on the trading market, provides a variety of trading venues for various financial assets, and provides multi-chain liquidity for various markets.

Above, what we are talking about is only based on the analysis and judgment before Ethereum 2.0, what is the most promising business that can be realized with the most advanced technology at this stage.

While waiting for Ethereum 2.0 (an optimistic estimate is 3 years later), it is not ruled out that we will explore new needs and gameplay on the new generation of public chain and cross-chain infrastructure.

Generally speaking, we are still in the early stage of DeFi, which replicates traditional financial assets and gameplay on the chain.

The next stage of development of DeFi will have two key words: 1. Financial innovation 2. Compliance

The two trends will occur in different circles.

Financial innovation: It will happen in the "grassroots" group of geek entrepreneurs, based on the characteristics of the blockchain and smart contracts, to carry out financial innovation and create new asset categories and trading markets.

Compliance: It will be traditional financial and Internet giants and even national entities that will enter the "cryptocurrency war" in a dimension-reduction and strike-like manner, with political and commercial interests involved, and form a cryptocurrency economy under the regulatory framework.

Under the current situation, what we have to do and what we can do is to stick to our positions, keep an open mind, and embrace the trend.