How to understand DeFi? (Part 2): Decentralized Exchange and Insurance

In "How to Understand DeFi (Part 1)" last week, we introduced what DeFi, decentralized stablecoins, and decentralized lending are. Today’s article will continue to introduce you to decentralized exchanges, decentralized derivatives and decentralized insurance in DeFi.

The decentralized exchange DEX (Decentralized Exchange) aims to solve the inherent problems of the centralized exchange CEX (Centralized Exchange), such as centralized custody of assets, geographical restrictions, and asset selection.

During the 1c0 period in 2017, EtherDelta was the most popular DEX, where users could freely exchange ERC-20 tokens, but the on-chain order book model it adopted, the cumbersome process of placing orders and low performance made the user experience not good. Before 2020, the trading volume on all DEXs is less than 1% of CEX.

In 2020, DEX ushered in an explosion. The total transaction volume increased by 115 times in this year, reaching 19.2 billion US dollars. The single-day transaction volume of Uniswap, the king of DEX, even once beat Coinbase. Among them, the AMM automatic market maker adopted by Uniswap The mechanism is indispensable.

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To understand the term automatic market maker, you must first understand what a market maker is.

This is an order book that we often see when trading on a centralized exchange. On the left is the quotation for selling orders, and on the right is the quotation for buying orders. An institution that provides liquidity to a tradable asset, such as BTC, quotes the buying price and selling price at the same time, and makes a profit from the bid-ask price difference is a market maker.

Through continuous two-way quotations, market makers maintain the liquidity of assets, so they are also called liquidity providers. On Uniswap, people who deposit tokens into the liquidity pool and provide asset liquidity are also called liquidity providers. The difference is that these people do not need to manually perform two-way quotations.

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There are two types of tokens in each liquidity pool on Uniswap. When a pool is established, the first person to deposit tokens in it is the one who sets the initial price for the token exchange in this pool. Then other people will deposit tokens into the pool one after another, and all those who deposit tokens into Uniswap can be called liquidity providers LP (Liquidity Provider).

After these people deposit tokens, they will get the corresponding LP token as a certificate, and the handling fee paid by other users for transactions on Uniswap will be distributed to LP as a reward. When you trade on Uniswap, instead of matching individual buy and sell orders, Uniswap determines the price based on the proportion of assets in the pool.

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The unique feature of Uniswap is that it greatly reduces the threshold for market makers. Anyone can become a market maker, deposit assets into the pool to provide liquidity and earn fees from it.

However, the birth of Uniswap was actually an accident. Its founder, Hayden Adams, got his first job out of college as a mechanical engineer at Siemens. When he was fired one day, Hayden was very upset and told his good friend Karl Floersch that he had been fired. Karl was working on Casper FFG at the Ethereum Foundation at the time.

Hayden: I got fired :(

Karl: Great! Congratulations, this is a blessing in life for you. Mechanical engineering is already a sunset industry, Ethereum is the future, you are still young, your new mission is to write smart contracts!

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Hayden: But I don't know how to write code~

Karl: It’s okay if you don’t understand, writing code is very simple. And now no one really understands smart contracts, Ethereum and the like.

Hayden: Alright~

In this way, Hayden was persuaded by Karl to learn the code and Ethereum with a try mentality, and began to apply what he had learned based on the concept of an automatic market maker proposed by Vitalik in 2016-developing Uniswap.

Decentralized Derivatives

Derivatives are a key component of any mature financial system. Derivatives, as the name suggests, are commodities derived from an asset, be it a stock, bond, commodity, interest rate, currency or crypto asset. Common derivatives are forward contracts, futures, options and swaps.

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There are two types of usage scenarios for derivatives: hedging risk and speculative trading

For example, there is a farmer who is diligently growing wheat. The price of wheat fluctuates throughout the year. The price of wheat, like all commodities, is affected by supply and demand, and when the harvest arrives, the price of wheat may fall. To hedge against falling wheat prices, farmers can buy put options.

If the price of wheat does fall as the farmer expects, then this option can bring income to the farmer and hedge the loss caused by the drop in wheat price. If the price of wheat rises, the option will cause a loss to the farmer, but the loss due to the option is also offset because the higher wheat price allows the farmer to earn more.

So whether wheat prices rise or fall when the harvest comes, farmers can hedge some of their risk. When this real-life scenario is moved to the blockchain, the liquidity provider can also short or long the tokens in his liquidity pool in order to hedge impermanent losses.

Financial derivatives represented in digital form are known as synthetic assets. We covered synthetic assets in detail. To put it simply, synthetic assets are financial instruments that simulate the value of another asset through tokens. For example, USDT and Dai are synthetic assets that simulate US dollars, and wBTC and imBTC are synthetic assets that simulate BTC.

In the field of encryption, when we mention synthetic assets, the first thing that comes to mind is Synthetix. Synthetix is a protocol for generating synthetic assets on Ethereum, which applies the derivatives model of the traditional market to fiat currencies, indices, commodities and digital assets. Through Synthetix, users do not need to register or go through a third-party centralized platform to directly enter the market, purchase and trade various synthetic assets, regardless of nationality, region and time.

The derivatives market in traditional industries is worth a trillion dollars, dwarfing the bond and stock markets, not to mention the crypto market, which has just reached a total market capitalization of $2 trillion. However, as the digital economy matures, many people are looking forward to the future of the encrypted asset derivatives market. Compared with traditional derivatives, the value of encrypted asset derivatives lies in improving the liquidity of low-liquidity assets and enriching investment options by combining various assets.

In daily life, we transfer unpredictable risks by purchasing accident insurance, medical insurance, etc. When using various DeFi products in the blockchain and encountering unexpected events, how should we transfer risks?

Most smart contracts will undergo code audits before being officially deployed to the main network, and developers who find code loopholes will be rewarded through bug bounty and other methods, thereby improving contract security. But even so, no one can guarantee that a smart contract is absolutely secure, and the possibility of hacking always exists.

Nexus Mutual is an insurance company in the blockchain world, and its first product is smart contract insurance. Uniswap, Curve, Synthetix, Compound, MakerDAO, etc. are all covered by it. In addition, Nexus Mutual has just launched custodian insurance recently. If a user hosts assets on a centralized exchange, he can also obtain Nexus Mutual protection if his assets are lost due to hacker attacks.

On Valentine’s Day in 2020, a security check of the DeFi loan agreement bZx was not successfully initiated. Hackers used this vulnerability to carry out a flash loan attack on bZx. Investors who purchased the corresponding insurance services through Nexus Mutual before the attack were compensated.

When the risks of smart contracts are transferred to insurance companies, the entire DeFi ecosystem is more complete, and it can be used with less fear for the public.

Bitcoin allows anyone in the world to transfer money anytime, anywhere, without time and geographical restrictions. However, a financial system with only a single asset is not sound. In addition to transfer and hedging, users also need financial products with richer functions, which is one of the values ​​of DeFi.

The risk and complexity of smart contract interaction limit the growth of the number of DeFi users, and the thousands of handling fees make many users daunting. However, as more capital and developers enter DeFi, as more traditional financial institutions People in the world are aware of DeFi, and these problems will be supported by resources to the greatest extent. Now that many solutions have been proposed and put into practice, the threshold and security are only a matter of time. We look forward to seeing the exponential growth of DeFi users.

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Ethereum