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How have the four basic financial elements evolved in DeFi?



Abstract: Most factors in market development boil down to four financial fundamentals: liquidity, leverage, risk, and arbitrage. This article outlines the evolution of DeFi through these four aspects. While it's still experimental, DeFi has matured considerably since I first wrote about it in June 2019. With the launch of v2 and v3 of the DeFi protocol, I took a fresh look at the industry and how it is developing. After working in finance for many years, I realized that most of what drives markets boils down to four fundamentals of finance: liquidity, leverage, risk, and arbitrage. This article outlines the evolution of DeFi through these four aspects. This article provides an overview of financial elements, or core building blocks of financial markets, as distinct from software or cryptographic elements. This article assumes some knowledge of finance, encryption, and DeFi, and the coverage of the protocol is not comprehensive. Fundamentals of Finance #1: Liquidity Almost everything boils down to liquidity, but we keep underestimating its importance. The higher the liquidity, the smaller the spread and the higher the market efficiency. Lower liquidity can exaggerate market movements and amplify sell-offs. It creates a flywheel on the way up, but a cliff on the way down. v1 DeFi is a liquidity vacuum that relies on proprietary capital. The term captive capital refers to underutilized capital locked in a protocol or inefficiently allocated in a protocol. It incurs an opportunity cost, as this capital could have earned a higher return inside or outside the protocol. The first DeFi protocols relied on proprietary capital. MakerDAO requires a minimum mortgage rate of 150%, the lending agreement has not yet adopted super liquid collateral (the second version of innovation led by Compound), and the distribution efficiency of Uniswap's liquidity on the price curve from -∞ to ∞ is very low. The opportunity cost of own capital expands with DeFi, and now V2 and V3 are fighting for greater capital efficiency. As Liquid Collateral Stablecoins play a huge role in DeFi. Fiat-backed stablecoins are problematic (centralization, regulation, potential competition from CBDC), crypto-collateralized stablecoins are the most viable option. However, V1s relied on overcollateralization to maintain their peg and were not able to scale. Purely algorithmic, uncollateralized stablecoins never quite worked out as expected, and the V2 attempt seems to have the same flaws (incentives work well above the peg, but not below). Many recent iterations of stablecoins (FEI , OHM, FLOAT, FRAX) take advantage of Protocol Controlled Value (PCV). This is a concept where the collateral backing a stablecoin cannot be redeemed by the user, but is owned by the protocol (the protocol decides whether/how to invest, which can be used to recovery peg, etc.), which is similar to a treasury or an insurance fund, but the difference is that PCV can be converted into liquidity immediately (AMM pool). Leaving aside the startup problem, FEI's PCV makes it the largest liquidity provider on Uniswap The "Beijing Blockchain Innovation and Development Action Plan" is issued and will initially build four "highlands": "Beijing Blockchain Innovation and Development Action Plan" is issued and will initially build four "highlands" "Plan" Said that it is necessary to strengthen organizational leadership, establish a blockchain work promotion group led by city leaders, and coordinate and solve major problems in blockchain technology and industrial development. Strengthen financial support, increase financial support at both urban and municipal levels, and insist on long-term The combination of short-term investment encourages innovative entities to actively participate in the construction of industrial bases, providing a strong guarantee for blockchain technology and industrial development. (Beijing Daily) [2020/6/30] Aave v2 also blurs the relationship between collateral and liquidity DeFi v1 figured out how to use liquidity as collateral (LP token Coin). The v2 and v3 protocols are figuring out how to convert collateral into liquidity. Unfortunately, liquidity alone does not bring stability. The real reason for the collapse of stablecoins is a crisis of trust under the nail. Solving captive capital It is not enough. A sound economic mechanism is needed to keep the stable currency near the peg for a long time, and the mechanism design is very difficult. The pure algorithmic stable currency (Basis Cash, Empty Set Dollar) has been struggling in the mechanism, and these The mechanism is precisely to require confidence in the future peg when the current peg fails. The so-called direct incentive mechanism, that is, punishing transactions that deviate from the peg and rewarding those that are biased to the peg, will eventually draw liquidity from the system when it is most needed Go¹⁰ heavy sell penalties mimic constrained liquidity, keeping more capital trapped, which is what we're trying to fix in the first place. Other models try to fix confidence first and improve capital efficiency over time , starting with fully mortgaged tokens, let the market dynamically adjust the mortgage rate. As confidence increases, capital efficiency will also increase. FRAX uses this model, but is currently backed by a stable currency backed by a basket of fiat currencies. Although the The mechanism appears to be working, but it is unclear how it will be maintained if it is fully collateralized by uncensorable assets. While the latest generation of stablecoins has focused on reducing collateral requirements, before capital efficiency, we Confidence in the peg needs to be addressed (effective mechanism design). Liquidity is a liability When it comes to liquidity, we have to talk about Uniswap, a mainstream AMM. Uniswap has been instrumental in the rise of yield farming and liquidity mining, which in turn has been instrumental in Uniswap's trajectory. After we learned that liquidity is not a moat (hardly), the focus shifted from acquiring liquidity to retaining it. Competing AMMs start to climb up, adding higher moat/margin services like lending (Kashi Lending), borrowing from traditional fintech: cheaply acquire users and upsell credit products. On the contrary, Uniswap fundamentally reconsidered the liquidity mechanism of AMM, and the result is that under special circumstances, V3 can improve capital efficiency by up to 4000 times. Financial Lawyer: Estonia's Financial Intelligence Unit has revoked the licenses of more than 500 companies for four reasons: According to a previous Bloomberg report, Madis Reimand, the head of Estonia's Financial Intelligence Unit, said regulators were concerned that these companies would take advantage of local qualifications and switch to other jurisdictions. As a result, the licenses of more than 500 companies have been revoked this year, accounting for one-third of the total. So far, the crackdown has mainly targeted companies that have failed to do business in Estonia within six months of obtaining a license. In his statement, Reimand stated that the idea is not to weaken the crypto industry, but to prevent the risks associated with money laundering. "If a virtual currency provider repeatedly violates the regulator's regulations, the FIU can revoke its authorization," he said in an interview. Financial technology lawyer Mykola Demchuk revealed that Estonia's move is related to the $220 billion money laundering scandal at the Danske Bank branch. hardly matter. He believes that there are four reasons that led the agency to take action: 1. Some licensed companies did not actually need to apply for a license due to unclear regulatory measures during the 2017-2018 period. 2. Some companies simply cannot start operations within 6 months as required by regulators. 3. Some companies failed to comply with anti-money laundering regulations and their licenses were revoked. 4. Some consultancies sell "off the shelf" companies that have acquired encryption licenses. Some of these companies failed to sell such companies within 6 months. As a result, Kim's FIU license was revoked. (Cointelegraph) [2020/6/19] While V1 AMMs 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 $10 million in the ETH/DAI pool, up to 25% of the liquidity pool may exist to buy ETH below $10 or above $5,000. ⁵ In this example, it is extremely unlikely that liquidity will be required at these levels. Maintaining this constant price curve results in low turnover (~20%), as $5 billion in locked capital translates to only $1 billion in transaction volume. ¹The even distribution of liquidity across the range also means that very little liquidity is concentrated in most of the trades in one currency pair. Curve recognized this early on, creating an AMM specifically for stablecoins, which are designed to trade within a narrow range. Uniswap v3 solves these problems and, in the process, moves closer to a limit order book, as LPs can now specify a price range within which to provide liquidity (i.e. ETH/USDC from $1800 to $2200). This change should cause nearly all transactions to occur within a few barrels of the market's mid-price, improving liquidity where it is most needed. More concentrated liquidity should also reduce inventory risk, which leads to wasted capital and exposure to assets that LPs do not want to hold. For example, if an LP posts $500 for an ETH/DAI pair, but believes the price of ETH will go up, then they have taken a risk (ETH opportunity cost) on an asset they don't want to own (DAI) and are holding $500 DAI is just for buying when ETH is down, which they think is unlikely. Uniswap v3's centralized liquidity provisions reduce this risk by enabling LPs to significantly increase their exposure to preferred assets. ¹³ Balancer v2 also attempts to reduce inventory risk by introducing asset managers, which allow LPs to lend out one side of a pair of assets when they are not being used as exchange liquidity. Yearn’s Stablecredit leverages a similar feature. Live | Wang Yanwei: There are four reasons why the development of blockchain invoices is relatively successful: Jinse Finance live report, January 4, 2020, "Blockchain Super Introduction - From Technology to "Application" lecture was held at CITIC Bookstore (Beijing Qihao Building Store). Beijing Lianan COO Wang Yanwei shared his views on blockchain invoices. He pointed out that blockchain invoices meet some characteristics. First, the tax system has a high degree of digitization, which is the basis for data on-chain; second, it benefits multiple parties and creates value; third, it does not change the main Fourth, step by step, loosely coupled with the main business, so Wang Yanwei believes that the development of blockchain invoice applications is relatively successful. [2020/1/4] The next generation of AMMs requires less capital, but will bring more liquidity. Liquidity Tradeoffs Hyper liquid collateral is a v1 concept that refers to the ability to tokenize locked capital (collateral or liquidity) to gain liquidity or gain leverage on that capital. Staking derivatives extend this concept to staking assets (assets that secure the proof-of-stake network) through staking tokens (stETH, rtokens), essentially allowing staking capital to be deployed elsewhere more efficiently. Proponents of staking derivatives argue that without them, the liquidity of network tokens would suffer as a significant portion of the outstanding supply would be circled. There are also concerns that validators will not be incentivized to stake (DeFi protocols) if/when they can earn higher returns on capital parked elsewhere. In theory, pegging derivatives can increase the pegging ratio of ETH from 15-30% to 80-100%, because it eliminates the extra cost of pegging¹⁴ compared to not pegging. Spot-on derivatives can also create new financial instruments. For example, cash flows "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 join DeFi. However, collateralized assets are different from collateral in that they are not just a promise to pay, but a security mechanism. I'd like to see more research on the associated security costs, but it's clear that design matters. Some designs, particularly those that enable collateralized derivatives to move across chains, allow for a shift in risk (from endogenous to exogenous), which may affect the underlying game theory that helps secure public networks. ¹¹ Instead, Proof of Liquidity converts staked capital into the liquidity of the underlying network token in a way that balances capital efficiency and network security, which should be the main priority. Voice | Huobi Yang Jinyan: Chinese companies need to be cautious about four legal issues through STO fundraising: Huobi Law Lin General Manager Yang Jinyan said in regards to STO’s Moments that Chinese companies are trying to raise funds overseas through STO (Security Token Offering) , It must be carried out strictly according to the law, otherwise it will easily constitute a violation of the law. There are four key legal issues that need to be treated carefully: 1. It should be conducted in strict accordance with the laws of the issuing country and the country where funds are raised. At present, the most mature STO model is in the United States, and the law on which STO is based in the United States is the exemption clause of the US Securities Law (Reg A/D/S). 2. China's securities law does not stipulate how to issue security tokens, but the act of directly financing Chinese investors in the name of STO in China is not allowed by law. 3. It is a legal minefield to raise money directly in China under the pretense of ICO through the name of STO, suspected of illegal fundraising. However, it is completely legal to strictly abide by the laws and regulations of the issuing country and the country where the fundraiser is located, and to raise funds overseas under the guidance of a lawyer. [2018/12/2] Fundamentals of Finance 2: Leverage Leverage magnifies gains (which is the pinnacle of capital efficiency), but it also greatly accelerates losses. It is easy to create leverage, but difficult to control it. We love it until we hate it. There have been countless TradFi markets that have crashed due to excessive and/or hidden leverage. In the past six months alone, we have seen the market impact of Archegos (highly leveraged) and Gamestop leveraged short squeezes (140% of Gamestop's float was shorted). In the cryptocurrency market, we recently saw $10 billion in liquidations in 24 hours, partly due to the cascading liquidations of leveraged long positions. This is a kind of stress test for the cryptocurrency market, and some DeFi protocols are under a lot of pressure. Leverage is easy in DeFi, controlling it is still hard. Creating Leverage Much of the frenetic activity in the DeFi summer of 2020 was driven by active-zce leverage strategies that relied on recursive yield farming and liquidity mining.


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