Understand the evolution of DeFi's four major financial primitives: liquidity, leverage, risk and arbitrage

The development of DeFi is advancing by leaps and bounds, and various innovations based on composability emerge in an endless stream, but there are still traces and reasons behind it. The venture partner of the investment institution Playground wrote on the Medium blog that liquidity, leverage, risk and arbitrage are the main factors driving the development of the DeFi market, and elaborated on how the DeFi protocol evolves from their perspective. While DeFi is still experimental, it has matured considerably since I first wrote about it in June 2019. With the release of V2 and V3 of the DeFi protocol, I re-examined the industry and how it is developing. After working in finance for many years, I realized that most of the factors affecting the DeFi market can be boiled down to four basic financial elements: liquidity, leverage, risk, and arbitrage. This article outlines the evolution of the DeFi market logic through these lenses. This paper provides an overview of financial primitives, the core building blocks of financial markets, which are distinct from software or cryptographic primitives. This article assumes that you have some understanding of finance, encryption, and DeFi, so the introduction to the protocol is not comprehensive. Almost everything boils down to liquidity, but we consistently underestimate the importance of liquidity. Higher liquidity leads to less slippage and higher market efficiency. Lower liquidity exaggerates market moves and amplifies the sell-off. It creates a flywheel effect on the way up and a cliff on the way down. V1 DeFi protocols rely on a liquidity vacuum of constrained capital. The term restricted capital refers to underutilized, inefficiently allocated capital locked in an agreement. This incurs an opportunity cost, as that capital could have earned a higher return either inside or outside the protocol. V1 DeFi protocols rely on captive capital: MakerDAO requires a minimum collateralization ratio of 150%, lending protocols have yet to accept hyperliquid collateral (V2 innovation led by Compound), and Uniswap’s liquidity is distributed inefficiently across all price curves. The opportunity cost of constrained capital expands along with DeFi, and now V2 and V3 are striving to achieve higher capital efficiency. As Liquid Collateral Stablecoins play a huge role in DeFi. Fiat-backed stablecoins have many problems, such as centralization, regulation, potential competition from CBDC, and crypto-collateralized stablecoins are the most viable option. However, V1 DeFi relies on over-collateralization to maintain its peg to the US dollar, so it cannot scale up. Financial technology company Revolut will continue to recruit employees to promote cryptocurrency business: August 5 news, financial technology company Revolut plans to increase the number of employees in its cryptocurrency business in Europe, the United Kingdom and the United States by 20% in the next six months, Revolut Currently hiring for 13 cryptocurrency-related roles, including compliance and financial crime prevention, as well as software engineers and professionals with cryptocurrency experience in the legal field. Revolut has hired 43 cryptocurrency business employees so far in 2022. (Bloomberg) [2022/8/5 12:03:57] Many of the latest stablecoin iterations (FEI, OHM, FLOAT, FRAX) utilize Protocol Control Value (PCV). This is a concept where the collateral backing a stablecoin cannot be redeemed by users, but is owned by the protocol (the protocol decides if/how it is invested, it can be used to restore the peg, etc.). This is similar to a treasury or an insurance fund, but the difference is that PCV can be instantly converted into liquidity (AMM pool). Issues aside, FEI’s PCV makes it the largest Liquidity Provider (LP) on Uniswap. AAVE V2 similarly blurs the line between collateral and liquidity, allowing borrowers to repay debt with existing collateral. Proof of Liquidity creates a similar dynamic for staking derivatives, described in more detail below. DeFi V1 addresses how to use liquidity as collateral (LP tokens). The V2 and V3 protocols are working on how to convert collateral into liquidity. Unfortunately, liquidity alone does not bring stability. The real reason for the collapse of the stable currency system is the crisis of confidence under the pegged exchange rate system. Addressing constrained capital is not enough. Over time, sound economic mechanisms are needed to keep stablecoins near their pegs, and mechanism design is difficult. Purely algorithmic stabilization mechanisms (Basis Cash, Empty Set Dollar) have been struggling, and these mechanisms require users to maintain confidence in the future peg mechanism. The so-called direct incentives, that is, penalize transactions that deviate from the pegged exchange rate, and reward transactions that anchor the exchange rate, and ultimately draw liquidity from the system when it is most needed. Severe sell penalties mimic constrained liquidity and keep more capital in check, which is what we tried to address in the first place. Other models try to address the confidence issue first and increase capital efficiency over time, starting with fully collateralized tokens and letting the market dynamically adjust the collateralization ratio. As confidence increases, so does capital efficiency. "Time" magazine hopes to convert all future subscriptions into NFT: Golden Finance reported that Keith Grossman, president of "Time" magazine, said that he hopes to migrate all future subscriptions to TIMEPieces NFT, thus giving holders exclusive subscription rights and personal Data Ownership. TIMEPieces NFT includes a total of four series, all NFTs are works of art inspired by Time magazine pictures. [2022/7/19 2:23:40] FRAX uses this model, but is currently backed by a basket of fiat-backed stablecoins. While this mechanism appears to be working, it is unclear how it will hold up if it is fully backed by non-custodial assets. While the latest generation of stablecoins is focused on reducing collateral requirements, we need to address the issue of confidence in the peg mechanism before we can improve capital efficiency. Liquidity as Liabilities When it comes to liquidity, we have to talk about the dominant Uniswap. Uniswap has been instrumental in the rise of liquidity mining, which in turn has been instrumental in Uniswap’s trajectory. After we learned the hard way that liquidity is not a moat, the focus shifted from acquiring liquidity to retaining it. Competitors started to move forward, adding higher moat/margin services, such as Kashi Lending, borrowing from traditional fintech practices: acquire users cheaply, and upsell credit products. Instead, Uniswap fundamentally rethought the liquidity mechanism of asset management, resulting in v3 that improves capital efficiency by up to 4000 times in special cases. While AMM V1s are a 0-to-1 innovation, they are also inefficient because they need to provide liquidity for prices that may never be reached. For example, if ETH is in the $200 range and there is $10m in the ETH/DAI pool, the liquidity pool could be as high as 25% buying ETH at under $10 or above $5k. In this example, there is little chance that liquidity will be needed at these levels. Maintaining this constant price curve results in lower volume (~20%), as $5 billion in locked capital equates to only $1 billion in volume. The even distribution of liquidity across the spectrum also means that very little liquidity is concentrated where it is most traded. Curve recognized this early on, creating an AMM specifically for stablecoins that trade in a narrow range. Discord is adding text chat function to the voice chat room: On June 1, Discord announced on its social networking site that it will add text chat function to the voice chat room of the platform, so that users can share links or text materials in the voice chat room , so as to avoid unnecessary channel jumping. The feature will roll out to all Discord servers globally on June 15th. [2022/6/2 3:57:14] Uniswap v3 solves these problems, and in the process gets closer to limit orders, because LPs can now specify the price range for providing liquidity (ie ETH/USDC from $1800 to $2200). The change should cause nearly all trading to occur in the range around the mid-price, improving liquidity where it is most needed. More concentrated liquidity also reduces asset risk. For example, if an LP bids $500 for an ETH/DAI pair, but is convinced that the ETH price will rise, they are taking on exposure to an asset they don't want to own (DAI) (ETH opportunity cost). The centralized liquidity of Uniswap v3 reduces this risk by allowing LPs to substantially increase their exposure to preferred assets. Balancer V2 also attempts to reduce inventory risk by introducing an asset manager, which allows LPs to lend assets on one side of a trading pair without using them as trading liquidity. Yearn’s Stablecredit uses a similar feature. Next-generation asset management systems require less capital, but bring more liquidity. Liquidity Trading Hyperliquid collateral is a V1 concept that refers to the ability to tokenize a locked asset (collateral or liquidity) in order to obtain liquidity or gain leverage on that asset. Pledged derivatives extend this concept to pledged assets (assets that secure a proof-of-stake network) through pledged tokens (stETH, rtokens), essentially allowing users to deploy pledged assets elsewhere more efficiently. Proponents of staking derivatives argue that without them, staking token liquidity would suffer. There are also concerns that validators will not be incentivized to stake tokens if they can earn higher returns from DeFi protocols. Theoretically, staking derivatives can increase the stake ratio of ETH from 15–30% to 80–100%, because it eliminates the extra cost of staking compared to not staking. Pledged derivatives also allow for the creation of new financial instruments. For example, cash flow "guaranteed" by proof-of-stake rewards can make products look similar to interest-bearing bonds (Terra's bAssets, Blockswap). These tools can be used to generate sustainable, stable, and relatively high yields (such as Anchor Protocol), which may allow more mainstream users to support DeFi. Bitcoin fell below $34,000 for the first time since July last year: BTC fell below $34,000 and is now reported at $33,990.94, with an intraday drop of 3.66%. The market fluctuates greatly, so please do a good job in risk control. [2022/1/24 9:09:41] Compared with collateral, pledged assets are unique in that they are not just a payment commitment, but a security mechanism. Some designs, particularly those that enable pledged derivatives to move across chains, allow for the transformation of risk (from endogenous to exogenous), which may affect the underlying game theory that helps secure public networks. In contrast, Proof-of-Liquidity converts pledged tokens into the liquidity of the underlying network tokens, in a manner that balances capital efficiency and network security, which should be the main priority. Leverage magnifies gains (which is the end result of capital efficiency), but it also magnifies losses. It is easy to build leverage, but difficult to control it. We love leverage until we hate it. Traditional financial markets have crashed countless times due to excessive or implicit leverage. In the past six months alone, we have seen the market impact of Archegos' high leverage and Gametop's short leverage (140% of Gametop's float was shorted). In the cryptocurrency market, we have seen $10 billion liquidated in the last 24 hours, partly due to the serial liquidation of leveraged longs. This is a sort of stress test for the crypto market, with some DeFi protocols under considerable stress. Creating Leverage In the DeFi summer of 2020, the crazy activities were largely driven by the active-zce leverage strategy of liquidity mining. While that activity has subsided since then, we're starting to see new leverage mechanisms emerge. Element’s yield token is one example. When a user deposits collateral through Element, two tokens are generated: the main token and the revenue token. Assuming that a user deposits 10 ETH at an annual interest rate of 20%, the user can sell its main token at a discount, and at a fixed interest rate of 10%, the user will receive 9 ETH, and at the same time can maintain it through the income token. Exposure to interest over time on all 10 ETH. After that, the remaining 9 ETHs establish a new position and repeat the operation to achieve a leverage ratio of up to 6.5 times. The ability to earn interest on full principal and be able to earn the net present value of the loan is unique compared to earlier loan agreements. While there are protocols out there that aim to enable undercollateralized lending in DeFi, it's mostly conceptual. Although CREAM V2 strives to enable protocol-to-protocol unsecured lending through Iron Bank, it only works with whitelisted partners, with parameters determined directly by the CREAM team, highlighting current limitations. Maker plans to launch the cross-chain bridge Wormhole next year and will deploy MCD on L2: On November 11, the core engineering department of the Maker protocol announced that it will launch a cross-chain bridge Maker Wormhole for the US dollar stablecoin DAI to connect Ethereum and other second-tier networks , will start with Arbitrum and Optimism, and also plans to deploy MCD (Multi-Collateral DAI) on the second-tier network. Maker Wormhole is a generalized version of the "quick cash withdrawal" scheme proposed by Maker before, and this scheme is completely trustless. Maker expects that the fast withdrawal function will be launched in the first quarter of next year, while Wormhole is planned to be released in the second quarter of next year, and will consider expanding to more second-tier networks in the future. [2021/11/11 6:47:08] Instead, Alchemix approaches the problem from a completely different angle, enabling borrowers to benefit from overcollateralization. For example, a user who deposits 1000 DAI can access 500 alUSD. Put 1000 DAI in the Yearn vault to earn yield, which can be used to repay the loan over time. Another option is to buy $500 first and then invest the unspent $500, which will obviously yield less than the $1000 gain ($280 gain, assuming 25% APR for two years, is $280 less)..

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