In my post The Core Tenents of DeFi, I discussed what DeFi is, why it is needed, and the problems in the current financial sector that DeFi platforms are trying to solve. As a continued discussion on DeFi, this article looks at the technology that exists within DeFi that applies the core tenents of blockchain with the core tenents of DeFi, creating a unique solution to global financial issues. The DeFi ecosystem can be separated into three distinct layers: exchanges, derivatives, and automated money markets.
Exchanges
For most people, the entry point into DeFi is through exchanges. An exchange operates as a platform to buy, sell, and trade crypto. While centralized crypto exchanges exist and are arguably a key part of DeFi, providing an easy on-ramp for new users and a secure way to buy crypto with FIAT currencies, these exchanges do not comply with the core tenets of blockchain. By definition, they are centralized, but they also lack transparency which has caused several exchanges to collapse due to the misappropriation and misuse of user deposits, with the most recent example being the collapse of FTX.
Additionally, these exchanges typically operate by creating custodial wallets for their users crypto. Custodial wallets lack security, as the exchange itself holds the private keys for the wallet, allowing them more access to user funds than the users themselves. For this reason, many DeFi experts promote transferring any crypto purchases off of exchanges and into non-custodial wallets such as hardware wallets or even browser-based wallets such as Metamask, where users do hold their private keys and are therefore fully in charge of their funds.
Decentralized exchanges, or DEXes, typically require the user to have a non-custodial wallet already created, as users connect to these exchanges through wallet addresses rather than email addresses. Funds are transferred directly between wallets and transactions must be approved by users before they are executed. This allows for greater transparency, as users can directly see which accounts each transaction interacts with and what each step of the transaction is doing. That being said, a core tenent of DeFi is that these transactions are automatic. So while users can verify these transactions, they do not need to do manual transfers or calculations to complete multiple transactions, allowing for a better user experience.
Automated Money Markets
In finance, a money market is defined as a market consisting of highly-liquid, short-term assets. They allow for the lending and borrowing of assets which, in the case of DeFi, is typically a cryptocurrency. In traditional finance, this borrowing and lending requires a certain level of trust and permission from both parties to participate in a transaction. A core part of DeFi, however, is that it operates automatically and without permissions needed. This allows for a lower bar to entry for participants in DeFi and prevents discriminatory practices that are present in traditional financial systems. In order to achieve this, DeFi has created Automated Money Markets (AMM), which allow for the lending and borrowing of assets through liquidity pools. Many DEXes are also AMMs.
The term “liquidity pool” hints at its role in automated money markets, again defined as a market with highly-liquid, short-term assets. Liquidity pools are what allow for easy, trustless, permissionless trading on DeFi platforms. In order to initiate a liquidity pool, two or more assets are stored together in equal market value. DAI and Tether, for example, which are both pegged to the U.S. dollar, could be stored in a 1:1 ratio. A liquidity pool can then be made consisting of 10,000 DAI and 10,000 Tether. If a user wishes to borrow 100 Tether, they can add 100 DAI to the liquidity pool and withdraw 100 Tether. The liquidity pool is now 10,100 DAI and 9,900 Tether. This creates a disparity in value between the two pools: the DAI in this liquidity pool is worth slightly less than its market value, while the Tether is now worth less, incentivising another user to contribute Tether in order to receive DAI at a favorable rate.
Derivatives
Another key technology in DeFi is the use of pegged tokens such as stablecoins and wrapped tokens. Stablecoins are ERC-20 tokens that are pegged, or dependent on, another real-world asset with a relatively stable value. DAI, for example, is a stable coin pegged to the U.S. dollar. Other stablecoins may be pegged to other FIAT currencies, precious metals, or other assets of value. Because of the volatility of cryptocurrencies and the cryptomarket, stablecoins, as their name suggests, provide stability to the ecosystem, allowing for more real-world applications of DeFi. Wrapped tokens, on the other hand, are not pegged to real-world assets but are, typically, pegged to native tokens on other chains, allowing for transactions between chains, increasing the interoperability of DeFi platforms.
To demonstrate both stablecoins and wrapped tokens, and their place in DeFi, consider Bitcoin. As a native token, Bitcoin is the underlying value asset of any transaction on the Bitcoin network. However, as we have seen over the years, the price of Bitcoin has been extremely volatile. In 2010, Laszlo Hanyecz purchased 2 pizzas from Papa John’s, valued at $12, for 10,000 bitcoin. This was the first real-world use of cryptocurrency in the real world. However, because of the volatility of Bitcoin’s value, that 10,000 bitcoin would be worth over $16,500 USD today– much more than the price of 2 pizzas. Stablecoins, on the other hand, are not nearly as volatile, making them much safer to both spend and accept in real-world transactions, gaining a much higher adoption rate, particularly for users skeptical of the value of cryptocurrencies in general. DAI, for example, pegged to the US dollar, fluctuates between 99 cents and $1.01.
Bitcoin’s wrapped token, WBTC, is pegged to the price of bitcoin. While this makes WBTC as volatile as bitcoin, it allows for easy interoperability between different blockchain networks. To make a purchase on the Ethereum network, a user can store their bitcoin in a smart contract that acts as a vault and receive WBTC on the ethereum network instead, allowing them to conduct transactions. Wrapped tokens, then, are key to allow seamless user experiences within DeFi by increasing interoperability between chains.
It is important to note, however, that derivatives can be pegged to almost any asset either on or off-chain, not just currencies or other crypto tokens. Because a key aspect of DeFi is providing liquidity, many innovations in DeFi have come from tokenizing new and unique assets whose value is somehow locked. The tokenization of art, for example, has allowed art owners and collectors to take out loans against the value of their art in smaller amounts, without the need to sell their art piece outright. Other large-value assets such as real estate have been similarly tokenized, as their value is locked due to its inability to break into smaller pieces. Shipping invoices have also been tokenized, with their value being time-locked to when their cargo will be received and paid for. This concept of time-locked value is key in hedging and perpetual trading as well, where value can either increase or decrease over time.
