Part 1: Once upon a time there was Decentralized Finance (DeFi)…

Published on March 16, 2022

 

An article by Bert Staufenbiel (DeFiBert) & Liane Walker-Meininger

 

...are you already familiar with this story and is there a happy ending?

Our Story

We have in common that we both work for the same financial institution but in different departments. Unfortunately, with the Covid-induced home office, co-workers hardly meet by chance anymore. It is all the more gratifying that we have met again through the DeFi Talents and DLT Talents program offered by the Frankfurt School Blockchain Center. As part of our final assignments we would like to share some of our learnings over the 18-week mentoring program by publishing this multi-part, co-authored article on our joint Medium publication ‘Journey to the crypto space — Our experience and learnings with DLT, DeFi, Token economy, DAOs, crypto investments…’.

Outline of DeFi’s story

Part 1 (current publication)

1. Description

2. Beginning

3. Foundation of DeFi

Part 2 (upcoming publication)

4. Historical highlights

5. Is there a happy ending?

1. Description

Decentralized Finance (DeFi) describes financial services built upon the decentralized foundations of blockchain technology. In 2015, Ethereum launched its blockchain-based smart contract platform, laying the groundwork for the larger space. Interest has increased dramatically, as new DeFi services are evolving to reinvent key elements of financial services and billions of dollars of digital assets are pledged to Decentralized Finance capital, all of which provide the opportunity for DeFi to continue its narrative.

2. Beginning

Our once upon a time started in August 2018 when the term DeFi is allegedly mentioned for the first time. Ethereum’s entrepreneurs and developers were trying to find a name for open financial applications built on the corresponding blockchain.

Source: https://twitter.com/injeyeo/status/1157001562457174016

Decentralized Finance stands for a range of financial applications based on permissionless distributed ledger systems which operate on a global, borderless scale.

The vision is to be decentralized and censorship-free by taking out intermediaries and eventually establishing an alternative financial system. To accomplish this, the underlying contract execution is fully automated in a trusted environment.

You may now be wondering why an alternative financial system is important. The current financial system has several seemingly entrenched drawbacks. Inequality is one of the downsides leading to the reality that a lot of people have little access to financial services and 1.7 billion of our population have no access at all. The fact that the lack of financial inclusion and poverty are highly correlated means that no access to the financial system comes at a cost, keeping this part of the population in poverty. Further weaknesses lie in the centralization and intermediation of the current system, which partly led to the global recession in 2008. The current set of rules in reference to payments and remittances leads to missed business and economic growth opportunities.

3. Foundation of DeFi

To truly understand the story of Decentralized Finance we need to briefly take a look behind the curtain and dive into its foundation, meaning what are the current building blocks of the infrastructure and what truly defines DeFi.

3.1 Classification

The main characteristics of Decentralized Finance are:

Non-custodial: With DeFi it is important to understand that the responsibility for your assets lies with you. Private keys, a set of passwords, grant the owner access to the digital asset world through a wallet. In a sense, your wallet is your window to your crypto world. This has the advantage that no other person can access, change, transact or lock assets in one’s wallet. At the same time, the drawback is that no other party can be made liable or help you regain access to your assets in the event of losing your set of passwords.

Open, self-governed and community-driven: Decentralized finance protocols are in general open-source so that other software developers can review the underlying code. Therefore the developers and the community are vital factors of any DeFi project. Creating network effects is essential to reach adoption. Usually, at the beginning of a Decentralized Finance project, the distribution of control is rather centralized towards the developer team. This usually changes over time by granting governance tokens to contributors and early adopters to allow for the community’s participation in decision-making.

Composable: One of the most exciting features of DeFi is its architecture. Several sources in the market quote it as the ‘Lego of Finance’. Building on top of existing layers of architecture has advantages over creating new systems. One of these benefits is constantly growing innovative speed in the Decentralized Finance space. This translates into brand new and previously unimaginable products within the current financial system alongside the replication of existing financial products and services. Examples are micropayments and small-scale insurances.

However, most DeFi projects cannot achieve full decentralization. Some degree of centralization is likely to prevail. As previously stated, especially at the early stages of a decentralized project, a concentration towards the developer team can determine the speed at which problems are fixed.

Another point hindering decentralization is the fact that the crypto space — in which Decentralized Finance can be seen as a subset — is a closed environment to the extent that central intermediaries such as central exchanges are required to manage Fiat currency conversion. Additionally, oracles are needed to receive information from outside of the DLT/blockchain system. Both points are explained in the next section.

The Bank for International Settlements even argues that decentralization is an illusion.

Centralisation allows firms to deal with this “contract incompleteness” (Coase (1937) and Grossman and Hart (1986)). In DeFi, the equivalent concept is “algorithm incompleteness”, whereby it is impossible to write code spelling out what actions to take in all contingencies.¹

— Sirio Aramonte | Wenqian Huang | Andreas Schrimpf

Therefore some even consider using the term ‘Open Finance’ more adequate than ‘Decentralized Finance’.

3.2 Building Blocks

To understand the fascination and possibilities of Decentralized Finance we will look at the architectural layers starting with an illustrative overview and then move on to the individual description of each layer including auxiliary services.

3.2.1 DeFi Stack

Source: Own illustration, inspired by Schaer², Deshmukh | Warren | Werbach³

DeFi is ‘architected’ from different layers, where each layer serves a distinct function. Through layering, highly composable infrastructure is created that allows everyone to build on it, enhance it, or utilize other parts of the stack. This structure is built upon a highly interoperable protocol stack. On top of the settlement layer, DeFi protocols are implemented as a set of smart contracts that act upon certain conditions. In addition to standardizing specific use cases, these protocols also provide open standards for access by any DeFi application or user. Top-layer aggregators connect to a variety of applications and protocols, allowing users to connect to several protocols simultaneously and accomplish tasks that would otherwise be difficult.

Please stay tuned for real-world examples that we will provide in part 2 of this article under ‘historical highlights’.

Let’s dive into each layer.

Settlement layer

The blockchain and its native protocol asset e.g. Ether can be referred to as the base layer. Substituting for the execution and settlement layer of traditional finance, asset ownership information is stored and compliantly amended within the underlying blockchain.

Distributed ledgers, or more specifically blockchains, are the underlying technology. Several technologies converge to blockchain technology. Cryptography, consensus mechanisms, and the type of network distribution are the most noteworthy. The information is stored in interlinked blocks in a tamper-proof manner, hence blockchain. Despite Bitcoin being the most popular blockchain, it is not suitable for Decentralized Finance applications, thus most DeFi applications are operated on the Ethereum network. Many alternative chains are starting to challenge Ethereum. At the time of writing this article, Ethereum has a stake of 61.72% of the $130.22 billion total value looked over all Decentralized Finance protocols⁴. Total value locked is the total amount of assets locked in DeFi smart contracts at a particular time and measures the activity of Decentralized Finance. The catch is that double-counting of assets over various protocols can lead to inaccuracies around ‘20% of value locked in smart contracts of DeFi applications’⁵.

Asset layer

Tokens are issued on top of the settlement layer and compose the asset layer. There can be tokens for any kind of service or product in the crypto space such as native protocol tokens like Ether. Also worth mentioning are stablecoins.

So-called stablecoins are based on blockchain protocols that have the principle of price stability inherently encoded and, thus, fulfill the function of a reserve currency. The introduction of stablecoins set the foundation of the functioning decentralized financial system, as they enable participants to engage with each other without the underlying risk of price volatility.⁶

— Benedikt Eikmanns | Prof. Dr. Isabell Welpe | Prof. Dr. Philipp Sandner

Typically, stablecoins can be identified by their underlying collateral.

Fiat-backed stablecoins: These stablecoins bring off-chain Fiat currencies into the blockchain system or rather the on-chain world. The collateral held in Fiat currencies is in custody with central issuers or financial institutions and proportional to the stablecoins in circulation.

Asset-backed stablecoins: In contrast to Fiat collateral the crypto collateral backing process occurs on-chain and employs smart contracts instead of central issuers. To protect against price fluctuations of the cryptocurrency, over-collateralization of the underlying asset is necessary.

Algorithmic stablecoins: Resembling the most decentralized version of stablecoins, price stability is achieved through algorithms and smart contracts. These manage the circulation of stablecoins when the price of the tracked Fiat currency fluctuates.

Tokens are managed by wallets, a kind of keychain holding the owner’s private keys, allowing to store, exchange, send and receive digital assets. As a necessary auxiliary service that is not part of the asset layer, wallets come in different forms. Non-custodial wallets grant full control over your private keys or a set of passwords, whereas with custodial wallets a service provider takes on this responsibility.

Protocol layer

In the protocol layer, implemented sets of self-executing programs resemble standards for decentralized exchanges and asset management, among others. Known as smart contracts, these programs execute program code in a predefined manner without a third party’s interference. In Decentralized Finance smart contracts are open for review and audit by any user. This openness, however, also makes them subject to exploitation.

The main protocols in a blockchain system are among other things:

Exchanges: Central exchanges (CEX) mainly operate outside of the blockchain (off-chain) with the help of human interaction. Also, it is standard procedure to offset a certain amount of transactions that will never be submitted to the blockchain, i.e. recorded on the settlement layer. Furthermore, CEXs offer customers custodial services which make this form of exchange vulnerable to attacks. In contrast, non-custodial Decentralized exchanges (DEX) only operate on the blockchain (on-chain) by using automated market-making that requires no human interference.

Credit: Resembles the credit in traditional financial markets. Since the borrower’s creditworthiness is unknown, current protocols mostly use over-collateralization to compensate for the missing information. Once a certain threshold is breached, the collateral will be liquidated and the position is closed. The main incentive to use these protocols is to utilize cryptocurrencies without selling the holdings or receiving interest on an otherwise non-interest-bearing asset.

Derivatives: Assets outside the blockchain can be ‘mirrored’ into the blockchain without holding the original asset. These positions can also be leveraged or inversely represent the underlying assets. Examples are stocks, futures and options.

Insurance: Can be given (premium receiving) or received (premium paying) to protect against smart contract errors. Claim payouts are voted by an assessor or automated if parametric insurance is in place.

Asset management: Portfolios with crypto assets aim to follow investment strategies to gain interest as well as price appreciation and to achieve diversification. Some DeFi services offer platforms for users to pick and publish their portfolio inviting other investments.

Application layer

The application layer facilitates the creation of user-specific applications by connecting to the individual protocols. In most cases, the smart contract interactions are abstracted using a web browser-based interface, making the protocols more accessible. Whereas apps in this layer can be seen as the user’s interaction surface (front-end). The back-end that interacts with these apps is a set of smart contracts on the protocol layer (Decentralized applications or Dapps).

Aggregation layer

In the aggregation layer, platforms utilize the application layer in offering a broader service of gaining access to several applications and protocols simultaneously. The platforms created by aggregators usually provide tools to compare and rate services. In connecting to several protocols and combining the relevant information, the best prices (demand side) or highest yields (supply side) can be provided for collateral.

3.2.2 Further building blocks

Data resources, the already mentioned wallet software, and the interfaces used to manage assets interacting with DeFi services can be categorized as necessary auxiliary services.

Oracles: Play a vital role in the execution of smart contracts because they bring external information resources like stock prices into the DeFi system. However, this bears the risk of centralization. To overcome single-source risk, some protocols do not rely on one single oracle and can average the retrieved data.

Storage: Capacity is limited in blockchain systems, thus storing large amounts of information and data needs to be addressed. Consequently, data is ‘outsourced’ by transferring data into a system outside of the blockchain. Only the hashes, i.e. digital signatures, are recorded on the blockchain to verify that this particular data was used to trigger the smart contracts.

Exchange (Fiat to crypto): Fiat currencies, such as USD or EUR, are not native assets in blockchains. To utilize cryptocurrencies you need to “mine” or “mint” coins, which involves recording and legitimating transactions on the blockchain. Another alternative is to on- and off-ramp Fiat currency over exchanges that carry out Know Your Customer (KYC) or Anti-Money Laundering (AML) checks. However, the tokens inside the blockchain system are not the central bank-issued USD or EUR because these are represented by stable coins.

4. Historical highlights

Please stay tuned for the historical highlights and fascinating projects in the story of Decentralized Finance. You will also learn if this story has a happy ending in Part 2, which will be published in the next few days.

The story of DeFi is to be continued …

[1]: Sirio Aramonte, Wenqian Huang, Andreas Schrimpf. (published: December 2021). ‘DeFi risks and the decentralisation illusion

[2]: Cf. Fabian Schaer. (published: February 5, 2021). ‘Decentralized Finance: In Blockchain- and Smart Contract-based Financial

[3]: Cf. Sumedha Deshmukh, Sheila Warren, Kevin Werbach. (published: June 8, 2021). ‘Decentralized Finance (DeFi) Policy-Maker, Toolkit

[4]: DefiLlama. (accessed: February 4 2022, 21:36h). ‘Total Value Locked All Chains

[5]: OECD. (published: 2022). ‘Why Decentralised Finance (DeFi) Matters and the Policy Implications

[6]: Benedikt Eikmanns, Prof. Dr. Isabell Welpe, Prof. Dr. Philipp Sandner. (published: February 4, 2022). ‘Decentralized Finance Will Change Your Understanding Of Financial Systems

 

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