Decentralized Finance (DeFi) and Blockchain

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DeFi derivatives offer a way for investors to capitalize on cryptocurrency’s volatility. Image: Quoteinspector

Decentralized financial applications, popularly known as ‘DeFi’, are a new type of open financial applications deployed on publicly accessible, permissionless blockchains. A rapid surge in the popularity of these applications saw the total value of the assets locked in DeFi applications (TVL) grow from $675mn at the outset of 2020 to an excess of $40bn towards the end of the first quarter of 2021.

Permissionless Blockchain Technology and Decentralized Finance 

The commercial applications of smart contract technology have led scholars to examine its suitability for financial service activities like

  1. the settlement and clearing of ‘tokenized’ assets
  2. the execution and compilation of financial contracts 
  3. the complexities in supply chain logistics and beyond. 

A blockchain is a type of distributed database architecture in which a decentralized network of stakeholders maintains a singleton state machine. Transactions in the database represent state transitions disseminated amongst network participants in ‘blocks’ of data.The correct order of the blocks containing the chronological overview of transactions in the database is maintained with the use of cryptographic primitives, by which all stakeholders can manually verify the succession of blocks. 

A network consensus protocol defines the rules for what constitutes a legitimate transaction in the distributed database. In most cases, consensus protocols are rigorous game-theoretical mechanisms in which network participants are economically incentivized to promote network security through rewards and penalties for benevolent or malicious behavior. 

There are typically two types of blockchains:

  1. Permissionless blockchains, which are open environments accessible by all
  2. Permissioned blockchains, which are inaccessible to external parties not recognized by a system administrator.

Recent implementations of the technology introduce a virtual machine, the state of which is maintained by the nodes supporting the network. The virtual machine is a simple stack-based architecture, in which network participants can execute metered computations denominated in the native currency format.

Because all ‘nodes’ running the blockchain ‘client’ software must replicate the computations required for a program to run, computational expenditures are priced on the open market. This design choice is intended to mitigate excessive use of resources leading to network congestion or abuse.

Network participants pass instructions to the virtual machine in a higher-level programming language, the most recent generations of which is used to write programs, referred to as smart contracts. Because operations in the virtual machine are executed in a shared state, smart contracts are both transparent and stateful, meaning that any application deployed as a smart contract executes deterministically. This ensures that once a smart contract is deployed, it will execute exactly as instructed.

DeFi Agent Taxonomy

A ‘DeFi application’ is an arrangement of consumer-facing smart contracts, executing a pre-defined business logic within the transparent and deterministic computational environment afforded by a permissionless blockchain technology.

Blockchain technology is the core infrastructure layer (see Figure 1) storing transactions securely and providing game-theoretic consensus by issuing a native asset. As a basic financial function, standardized smart contracts are used to create base assets in the asset layer. These assets are used as the basis for more complex financial instruments in the application layer.

In the application layer, DeFi applications are deployed as sophisticated smart contracts and thus execute a given business logic deterministically. Contemporary DeFi applications provide a range of financial services within trading, lending, derivatives, asset management and insurance services. Aggregators source services from multiple applications, largely to provide the best rates across the ecosystem. Finally, user friendly front-ends combine the applications and build a service similar to today’s banking apps. In contrast to traditional banking services, in a blockchain-based technology stack, users interact directly with the application independent of any intermediary service provider.

Figure 1. DeFi applications on permisionless blockchain

The metered pricing of computational resources on permissionless blockchains means that DeFi applications are constrained by the computational resources they can use. Application designers seek to mitigate the need for the most expensive operations, such as storing extensive amounts of data or conducting sophisticated calculations, in the effort of reducing the level of complexity required to execute the service that their application provides. Because the resources required for interacting with a smart contract are paid by the user, DeFi application designers employ an innovative combination of algorithmic financial engineering and game theory to ensure that all stakeholders of their application are sufficiently compensated and incentivized.

In Table 1, we introduce a taxonomy for the different types of agents and their roles in contemporary DeFi applications. We highlight the incentives for participation and key risks associated with each role.

Owing to the original open-source ethos of blockchain technology, application designers are required to be transparent and build ‘open’ and accessible applications, in which users can take ownership and participate in decision-making processes, primarily concerning new features or changes to the applications. As a reaction to these demands, application designers often issue and distribute the so-called governance tokens.

Governance tokens are fungible units held by users, which allocate voting power in majority voting-schemes. Much like traditional equities, governance tokens trade on secondary markets which introduces the opportunity for capital formation for early stakeholders and application designers of successful applications. By distributing governance tokens, application designers seek to disseminate value to community members while retaining enough capital to scale development of the application by selling inventory over multiple years.

The generalized agent classification demonstrated in Table 1 is applicable to a wide area of DeFi applications providing peer-to-peer financial services on blockchain technology including, trading, lending, derivatives and asset management.

Popular DeFi Application Categories

The development principles presented above have been implemented in a number of live applications to date.

  1. Decentralized Exchanges and Automated Market Makers 
  2. Peer-to-Peer Lending and Algorithmic Money Markets
  3. Derivatives 
  4. Automated Asset Management

Identifying and Managing Risk in Decentralized Finance

Some of the risk factors which are likely to introduce new complexities for stakeholders involved with DeFi applications are – 

  1. Software Integrity and Security
  2. Transaction Costs and Network Congestion
  3. Participation in Decentralized Governance
  4. Application Interoperability and Systemic Risk

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