What will DeFi bring to the financial industry?

What will be the shape of finance with smart contracts? How should smart contracts, such as Libra or central bank digital currencies, be designed if they are attached to smart contracts in the future?

What will DeFi bring to the financial industry?

As the imaginary boundary of combining blockchain technology and finance continues to expand, the emergence of decentralized finance (“DeFi”) may bring some insights.

“DeFi has made its debut in 2019, and 2019 can be defined as the first year of DeFi, with a twofold increase in the value of lockups throughout the year, and the momentum continued in 2020, with the overall lockup volume now exceeding $2 billion.” Xu Kun, chief strategy officer of OKEx, told Punch News.

According to the latest data from blockchain data indexing company The Graph, Defi’s monthly query count surpassed 1 billion in June. In previous months, the daily query volume on The Graph’s hosting service was at 20 to 30 million queries, but in June, it reached 40 to 60 million daily queries.

DappReview, an information and analytics platform for blockchain-based decentralized applications (Dapps), reports that total Ether DeFi transactions grew 403% in the second quarter of 2020 compared to the same period last year, and multiple Ether DeFi projects saw their market capitalization more than double in value in the second quarter.

So, what exactly is Defi? What is the difference with traditional finance? What will it bring to traditional finance?

What is DeFi?
The full name of DeFi is Decentralized Finance, also known as Open Finance, and almost all DeFi projects are currently conducted on the blockchain of Ether.

Ether is a global open source platform for decentralized applications. On Ether, it is possible to manage digital assets and run programs by writing code without geographical restrictions. The cryptocurrency it produces is called Ether (ETH).

According to Xu Kun, DeFi is a series of financial applications based on an open decentralized platform, and the whole business process is an interactive action on the chain.

She said that DeFi is more open and inclusive than traditional finance: first, DeFi does not need to rely on any centralized entity to provide credit intermediation or endorsement; second, there are no access restrictions, i.e., any person connected to the network can enter; third, no third party can stop any transaction or reverse any transaction.

However, Zou Chuanwei, chief economist of Wanxiang Blockchain and PlatOn, told Punch News that DeFi and traditional finance are two different tracks and cannot be compared. DeFi has nothing to do with the real economy, nor with legal tender, but more mainly with the cryptocurrency sector.

He gave the example of a bitcoin miner, for example, producing bitcoins, needing to buy a miner with fiat currency or pay for electricity to hire someone, usually mining out bitcoins to sell, but in a better market situation may not want to sell, the miner can then make an over-collateralization based on bitcoins in an application like Compound, lending out stablecoins for RMB to meet his payment needs. A so-called stablecoin is a cryptocurrency that is pegged to another asset (e.g., gold, U.S. dollars, another cryptocurrency, etc.).

“Although both may use some methods of financial engineering product design, which also involve financial risks and can also use the risk analysis methods of traditional finance, the scenarios, objects and goals of the service are completely different, so it is a completely different concept than traditional finance.” Zou Chuanwei said.

Some people believe that DeFi based on distributed ledger technology not only solves the problem of capital gains being earned by intermediaries in traditional finance, on the other hand, it also eliminates the credit barriers between countries.

In this regard, Zou Chuanwei said that credit borrowing is very common in traditional finance, and there is a risk pricing mechanism based on credit. DeFi based on smart contracts does have no intermediary, but there are two sides, and the anonymity makes it de-crediting, so it needs over-collateralization, and uses over-collateralization to achieve lending and reduce risk. This leads to reduced cryptocurrency liquidity and ties up cryptocurrency resources at a high cost.

“In terms of the efficiency of this resource allocation, it is hard to say it is an advanced way of allocating financial resources.” Zou Chuanwei said.

“Open finance” is not “open finance”
Although DeFi is also known as “open finance,” Zou Chuanwei believes it needs to be distinguished from the concept of “open finance” from a traditional financial perspective.

He pointed out that in the mainstream financial industry, the concept of “open banking” is now a very important trend, but some people have also extended the term “open banking” to “open finance But some people also extend “open banking” to “open finance”, which is actually linked to the management of personal data of bank customers and open user data. Now it also extends to the export of technical capabilities mastered by open banks, as well as the opening of banking scenarios.

“This kind of is also from the mainstream financial field inside, from the open bank API (Application Programming Interface, Application Programming Interface) extended another concept of open finance, you can see the essence is still not quite the same.” , said Zou Chuanwei, “I am more optimistic about this open mechanism in the traditional financial sector, because it has a very deep such evolutionary logic inside, and the scene itself is much bigger.”

The current direction of DeFi applications
According to Chuanwei Zou, DeFi is similar to Lego building blocks, taking some basic financial modules and having different smart contracts to implement them. Then by calling each other between these smart contracts, some financial functions are put together, “with someone providing a lending like Compound, someone providing a decentralized exchange, and someone providing a mechanism to monitor collateral adequacy.”

Take MakerDAO, an automated mortgage platform among lending platforms, for example. Founded in 2014, MakerDAO pledges users’ digital assets through smart contracts and then lends them the same amount of stablecoin Dai. and it uses a dual-coin model, producing stablecoin Dai, the form in which users eventually borrow assets, on the one hand, and also providing equity tokens and managed tokens MKR, which is used to pay interest when redeeming the collateralized cryptocurrency.

Zou Chuanwei said Dai is a debt contract at the collateralized debt position level. A uniform over-collateralization rate requirement applies to all collateralized debt positions. If the market value of the collateral falls, the issuer needs to replenish the collateral or return a portion of Dai to maintain the collateralization rate. If the collateralization rate falls below the liquidation rate, it triggers the liquidation of the collateralized debt position, similar to the unwinding mechanism in equity pledge financing. If the collateral disposition is not sufficient to cover the debt shortfall, then MKR will issue additional issues and go through an auction to obtain Dai, which is equivalent to having the MKR holder as the final loss taker.

Similar to lending in traditional finance, lending in the cryptocurrency space suffers from a maturity mismatch between the “lender’s desire for a shorter repayment period” and the “borrower’s desire for a longer borrowing period”. In traditional finance, maturity mismatch is regulated by banks, but it is difficult to be solved by algorithms in cryptocurrency.

According to Zou Chuanwei, there are two ideas to solve the problem. The first is to move towards a peer-to-peer lending model that matches the maturity of deposited coins and borrowed coins, such as the early ETHLend, but this will limit the scale of lending activities and make it costly to match depositors and borrowers. The second is to dynamically manage the duration of depositing and borrowing coins through algorithms. But the effect remains to be seen.

Compound is a decentralized lending platform, where depositors can transfer their Tokens to the Compound smart contract (deposit) and transfer the deposited Tokens from the Compound smart contract back to their own address at a future time (withdrawal). Borrowers can use the deposited Tokens as collateral to borrow coins from Compound. The Token borrowed by the borrower can be different in quantity and type from the Token deposited by the borrower, provided that the over-collateralization requirement is met. If the coin borrower does not have enough collateral, the Compound protocol will force the liquidation of the collateral.

According to Zou Chuanwei, the risk of the Compound platform is also evident because based on the overcollateralization, the price of collateral is very volatile and if there is a sharp drop, there may be insufficient collateral. According to the agreement there are two ways to deal with it, one is to replenish the collateral and the second is that the smart contract will liquidate the collateral. Therefore, once the price drops sharply, whether it is additional collateral or the disposal of collateral, it will be traded on the blockchain of Ether, and there will be transaction congestion, and it will be difficult to clear the market asset risk.

Xu Kun, on the other hand, mentioned Uniswap, a decentralized exchange (DEX) that provides an automated market-making mechanism.

She said Uniswap is now the leading DEX, with a trading volume share of nearly 40%. It automates market making, replacing manual quotes with established algorithms, thus removing centralized aggregation and clearing and “eliminating” market makers from trading.

According to Xu Kun, Uniswap’s market making method is to simply deposit two specified assets and the system derives the asset price through a constant product model. That is, the balance between the two inventories is guaranteed for a certain amount of total capital. If there is an imbalance, the price is adjusted.

However, she also points out that this feature of Uniswap is suitable for smaller traders, especially for small traders who do not want to set limit orders. It is not friendly to large orders, and with its limited trading depth, prices can easily change drastically.

Problems with Defi and lessons learned
With the frenzied capital chase, Defi needs to be treated with cold thinking.

Xu Kun believes that at present, DeFi is still in its infancy and faces three major challenges: first is code vulnerability, programmable finance represents the power of technology, but the vulnerability after code stacking is always unavoidable; second is systemic risk, whether it is traditional finance or programmable finance, one must think about systemic risk, such as whether the DeFi ecology can carry it when facing extreme market fluctuations; third is asset on the chain, the complexity and uncertainty of asset on the chain is a very big challenge for the whole DeFi industry and requires first movers to make an attempt.

DeFi applications face the risk of hacking. According to media reports, in February-March 2020 alone, there were six security incidents in the DeFi space, with losses of more than $1.5 million.

Zou Chuanwei said DeFi actually has more security issues, including the security of fundamentally smart contracts, the fluctuating value of collateral that is highly dependent on overcollateralization, and the efficiency of risk clearance.

He added that DeFi has liquidity risk, can’t solve the maturity mismatch problem through algorithms, and uses building blocks without unified planning and no way for different modules to communicate with each other.

He said, “Assuming there is a link that is not designed properly, some loopholes will actually magnify the effect of this risk.”

However, Chuanwei Zou also believes that DeFi may have some insights for mainstream finance.

“What is the shape of finance with smart contracts? In the future, for example, like Libra or the central bank’s digital currency, if smart contracts are attached to it in the future, how should it be designed? Maybe we can find some reference from DeFi.” Zou Chuanwei said.

Posted by:CoinYuppie,Reprinted with attribution to:https://coinyuppie.com/what-will-defi-bring-to-the-financial-industry/
Coinyuppie is an open information publishing platform, all information provided is not related to the views and positions of coinyuppie, and does not constitute any investment and financial advice. Users are expected to carefully screen and prevent risks.

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