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The DeFi Revolution — A Beginner’s Guide

Decentralized Finance (DeFi) is a financial revolution that’s rewriting the rules of economic engagement. Built atop the principles of Web3, DeFi is a decentralized, non-custodial financial system offering an array of services that run autonomously, without needing intermediaries like traditional banks or clearing institutions. This radical departure from convention is fuelled by the power of blockchain technology, enabling the development of advanced protocols for Staking, Borrowing/Lending, and Decentralized Exchanges (DEXs). The immense growth of the DeFi industry is undeniable, with a Total Value Locked (TVL) of $250 billion in recent years and a current standing of $64 billion. This staggering growth and increasing interest in DeFi has piqued the curiosity and enthusiasm of investors, entrepreneurs and academics alike. In this article, we explore the basics of DeFi in a beginner-friendly way, and delve into the exciting possibilities that the future holds for this technology. With an emphasis on non-custodial finance, we aim to shed light on how DeFi is challenging the status quo and redefining the financial landscape by putting control in the hands of the users.

Authors: Hannes Detlefsen

The traditional financial system (TradFi) as we know it to date is essentially based on two pillars: the custodial approach and the permissioned nature. The custodial approach means that clients entrust their assets to centralized entities that administer and manage them. The permissioned nature means that potential users have to disclose their identity and go through KYC processes in order to participate in the financial system. This requirement acts as a gatekeeping mechanism. The large number of intermediaries involved in different processes leads to inefficiencies, high costs and low transparency.

In recent years, a dynamic system of DeFi protocols has emerged, implementing a highly efficient open financial system on the blockchain. Decentralised Finance (DeFi) can be described as a decentralized financial system based on smart contracts implemented on a distributed ledger technology (DLT). These smart contracts execute transactions automatically, and the secure technological foundation prevents single points of failure. Unlike the traditional financial system, DeFi allows any user with internet access to set up a wallet, participate in the decentralized financial system and maintain control over their own assets. The DeFi ecosystem has experienced rapid growth, with the total value locked (TVL) in DeFi protocols reaching an all-time high of $250 billion in November 2021, up from $1 billion in the summer of 2020. However, due to macroeconomic conditions and crypto-specific developments, the TVL has since fallen to $64 billion.

Figure 1: TVL in DeFi (source:   https://defillama.com/)

This article explains the basic concepts of decentralized finance to provide beginners with an easy-to-understand overview of this dynamic sector. DeFi protocols provide a viable alternative to the traditional financial system, offering greater efficiency, lower costs and increased transparency. By cutting out intermediaries and enabling peer-to-peer transactions, DeFi has the potential to disrupt traditional finance and usher in a new era of financial inclusion.

Fabian Schär, a renowned expert in the field of decentralized finance, has divided the DeFi Stack into five layers.

Figure 2: Fabian Schär’s DeFi Stack (source:   researchgate.net)

The bottom layer is the settlement layer, which is the underlying blockchain. Ethereum is the most widely used blockchain for DeFi applications, but high transaction fees have also prompted alternative smart contract-enabled Layer-1s or Layer-2s to build substantial ecosystems.

The second layer is the asset layer, which describes the different assets that are traded in DeFi. These can be native protocol assets as well as ERC-20 or ERC-721 tokens. Other designs, such as security tokens based on the ERC-1400 standard, are also possible. The tokens can be created without major restrictions, as they are essentially entries in a decentralized registry.

The third layer is the protocol layer, which contains the smart contracts that execute business models in the form of code on the blockchain. Smart contracts are digital agreements that are executed automatically. They can be described as ‘if…then’ relationships, and are executed by all nodes in the network. Over time, fundamental business models have emerged in this context, which will be discussed in more detail later in this article.

The application layer specifies the protocols that result from the combination of smart contracts. These protocols allow access to the blockchain and interaction with different smart contracts via the front-end. Since the smart contracts are published on a public blockchain, anyone can interact with them and create new business models through composability. This is one of the reasons why DeFi has been developing at such a rapid pace.

The aggregation layer builds on the benefits of composability and combines many dApps into a single access point. It can be seen as an extension of the application layer, aimed at providing a good user experience and cost benefits. Composability allows different protocols to be brought together to create a seamless user experience. The Aggregation Layer is therefore an important part of the DeFi ecosystem, providing a user-friendly and cost-effective way to access DeFi protocols.

The following explains the fundamental elements of the DeFi ecosystem.

Staking

Within DeFi, staking at the protocol level has become increasingly important. This process is used in proof-of-stake platforms, where validators deposit a stake to bundle transactions into blocks and attach them to the blockchain through the consensus process. Validators are typically selected through a weighted lottery based on the amount of tokens they deposit. As a reward for their work, validators receive a transaction fee and possibly newly minted coins.

With the Ethereum mainnet’s shift from Proof-of-Work to Proof-of-Stake (the Merge), decentralized staking became a very interesting way for DeFi users to generate revenue. Decentralized staking pools allow users to pool their ETH and share in the rewards of staking on a pro-rata basis. Those decentralized protocols offer a high level of user-friendliness, freeing investors from complex processes such as setting up a node.

When users stake, they often receive a Liquid Staking Derivative (LSD), which represents their share of the staking pool and can be freely traded on DeFi. This derivative allows users to use their staked assets for other DeFi transactions without giving up the benefits of staking.

Figure 3: Staking in DeFi

Staking can also be used within protocols (dApps) implemented on a blockchain. In this area of application, staking is not about participating in the consensus process, but about the economic aspects sought by projects. For example, staking can tighten supply and have a positive effect on the price of the token, or it can be used as a form of collateral. Staking in this context is often not linked to value creation and should be considered in a differentiated way.

Lending/Borrowing

Smart contracts make it possible for unknown users of a blockchain to take out loans, to grant loans and to pay or receive fixed or variable interest rates in return. Due to the technical underpinnings of the blockchain, there is no need to involve intermediaries.

The decentralized lending/borrowing protocols live exclusively on the blockchain, which means that transactions and amounts lent can be viewed at any time in the public decentralized ledger. Any user can access these protocols, regardless of their identity, as the platform operates in a fully automated and transparent manner.

In traditional finance, it is possible to make unsecured or under-collateralized loans because the counterparty borrower goes through KYC processes and background checks to participate. With DeFi, however, users are pseudo-anonymous and there is usually no recourse to identity. Since unknown individuals would have no incentive to repay the money if the value of the collateral falls below the value of the loan, DeFi loans tend to be over-collateralized. The collateral is liquidated once it falls below a certain threshold.

Figure 4: Lending in DeFi

Loan-to-value (LTV) describes the required level of (over-)collateralisation, i.e. the maximum amount of tokens that can be lent against the collateral. The Liquidation Threshold (LT) describes a threshold value that determines the point in time at which liquidation takes place. If the value of the collateral falls below this threshold, the collateral is (partially) liquidated.

This is because the loan would then be under-collateralised and the borrower would have no incentive to repay the loan — also known as moral hazard.

Decentralized Exchanges

Traditional centralized exchanges, such as Coinbase and Binance, use order books that are managed off-chain. This is done for cost reasons, as creating and canceling orders on-chain would incur gas fees and blockchain-dependent block times could cause delays. The price is where the bid and ask meet, and market makers contribute to liquidity and ensure that there is a seller for every buyer. Market makers therefore aim to minimize slippage and spreads. Slippage is the difference between the expected and actual execution price of a transaction, while spread is the difference between the bid and offer price of a financial instrument.

On the other hand, decentralized exchanges work with liquidity pools. Users provide capital by depositing it in a smart contract in order to participate in the fees. A liquidity pool consists of two (or more) tokens locked in a smart contract and users interact with this pool to exchange one token for another. Through automated market makers (AMMs), liquidity pools enable liquid on-chain exchanges. AMMs are algorithms that take on the role of market makers in an order book model, but in this case, they algorithmically determine the price at which token swaps will be executed.

Figure 5: Automated Market Makers (AMMs)

Due to the design of the AMMs, liquidity providers are exposed to an impermanent loss (IL). This results from the volatility of asset prices within a liquidity pool. The impermanent loss is the difference between the value extracted from the liquidity pool at the time of payout and the value the liquidity provider would receive if it had only held the tokens.

The price within the liquidity pool is determined by the relative exchange ratio of the trading pair. However, the loss is only realized when the liquidity provider withdraws its liquidity from the liquidity pool. If the exchange ratio of the two or more assets is the same as at the time of the original payment, there is no permanent loss because the prices are in the same ratio.

Despite the permanent loss, it is worthwhile for liquidity providers to provide capital because the fees of the liquidity pool are usually shared proportionally between the liquidity providers. In addition, some protocols pay out governance tokens as an additional form of reward. If the rewards exceed the loss due to volatility, there is an incentive to provide capital.

It is important to stress that impermanent loss is not a flaw in the system, but a natural consequence of pricing in a liquidity pool. Nevertheless, users of the system should be aware of the risks before deciding to provide liquidity.

The classification of Maker (MKR) according to the ITC

The International Token Classification (ITC) is a multi-dimensional, expandable framework for the classification of tokens. In this example we will classify the ETH token according to the latest version of our ITC.

ITC classification of the ETH token
Figure 6: Figure 4: ITC ETH Tokenbase entry (source:   https://itin.itsa.global/979KJJQ27)

Economic Purpose (EEP): ETH is listed as a Settlement Token (EEP22TU01) due to its design.

Industry Type (EIN): The issuer of ETH is active in the field of Cloud Computing, Distributed Systems, and Decentralized Applications (EIN05DA03).

Technological Setup (TTS): ETH is a Blockchain-Native Token (TTS41BC).

Legal Clam (LLC): ETH does not entitle its holder to any legal claim or rights against the issuing organization, therefore, it is listed as a No-Claim Token (LLC31).

Issuer Type (LIT): The dimension “Issuer Type” provides information on the nature of the issuer of the token. The Issuer Type for ETH is a Distributed Ledger Protocol (LIT62DL).

Regulatory Framework (EU) (REU): The dimension “Regulatory Status EU” provides information of the potential classification of a token according to the European Commission’s proposal for a Regulation on Markets in Crypto Assets (MiCA, Regulation Proposal COM/2020/593 final). ETH qualifies as a Utility Token (REU52) according to the definition provided in Article 3 (5) of Regulation Proposal COM/2020/593 final.

Consensus Mechanism (TCM): The dimension describes the mechanism that is deployed to achieve consensus on the token’s distributed ledger. ETH transitioned from Proof-of-Work to Proof-of-Stake; therefore, it is listed as Proof-of-Stake (TCM71PS).

Type of Maximum Supply (EMS): The dimension describes the token’s type of maximum supply. Currently ETH is Inflationary (EMS82IF).

Primary Mode of Origination (EMO): The Dimension Type of Maximum Supply forms part of the Economic Dimensions Group and describes the token’s type of maximum supply. The ETH token is listed in the Tokenbase as Reward (EMO91).

Taxes (RTA): One common distinction can be drawn between crypto-assets: those crypto-assets that resemble ‘conventional’ assets, like securities, and which are merely recorded on DLT systems (Conventional Asset Tokens DTA71), and those assets and activities that raise new regulatory challenges such as virtual currencies (New Asset Tokens DTA 72; OECD 2020). ETH is listed in the Tokenbase as a New Asset Token (RTA72).

As it is often difficult for newcomers to identify trustworthy websites and find relevant information related to DeFi, below are some useful websites 🌍 that can help navigate this dynamic environment and deepen one’s knowledge:

Crypto Twitter:
Crypto Twitter refers to a specific niche on Twitter that mainly deals with the topics of blockchain and cryptocurrencies. For newcomers, it is recommended to first follow the established protocols and the founders and to gradually familiarise oneself with the topic. Due to the fact that most of the contributions come from anonymous users who share their knowledge in so-called threads, a general caution against potential misinformation is advised.

Link 🔗: https://twitter.com/

GeckoTerminal:
GeckoTerminal is CoinGecko’s dexscreening and price charting tool that provides real-time statistics and price analysis across multiple blockchains and decentralised exchanges. It provides real-time data on prices, market capitalisation and trading volumes for more than 10,000 digital assets. It also provides detailed market information for all major blockchains such as Ethereum, Arbitrum, Optimism and Polygon.

Link 🔗: https://www.geckoterminal.com/de

Dune Analytics:
Dune Analytics is a free blockchain analytics platform that provides access to a wide range of on-chain data. Customisable dashboards allow users to gain insights into the performance of digital assets, DeFi projects and other blockchain-based applications. As an open source platform, Dune Analytics also enables active collaboration and continuous improvement through community contributions.

Link 🔗: https://dune.com/home

Messari:
Messari is a reputable source of information and analysis in the crypto industry. Their data archive is used by various investors such as hedge funds, venture capital firms and private investors. Messari’s research reports are also widely read by crypto enthusiasts and professionals. Messari offers comprehensive data on over 1,000 cryptocurrencies in their database, including price, market capitalisation and trading volume.

Link 🔗: https://messari.io/

DeFiLlama:
DeFiLlama offers comprehensive data and analysis, including locked values, fees and price deviations. With handy tools such as a portfolio tracker and price charts, DeFiLlama is ideal for beginners and those interested. Free and accessible, it is a valuable resource for making informed decisions in the DeFi space.

Link 🔗: https://defillama.com/

The International Token Standardization Association (ITSA) e.V.

The International Token Standardization Association (ITSA) e.V. is a not-for-profit association of German law that aims at promoting the development and implementation of comprehensive market standards for the identification, classification, and analysis of DLT- and blockchain-based cryptographic tokens. As an independent industry membership body, ITSA unites over 100 international associated founding members from various interest groups. In order to increase transparency and safety on global token markets, ITSA currently develops and implements the International Token Identification Number (ITIN) as a market standard for the identification of cryptographic tokens, the International Token Classification (ITC) as a standard framework for the classification of cryptographic tokens according to their inherent characteristics. ITSA then adds the identified and classified token to the world’s largest register for tokens in our Tokenbase.

  • The International Token Identification Number (ITIN) is a 9-digit alphanumeric technical identifier for both fungible and non-fungible DLT-based tokens. Thanks to its underlying Uniform Token Locator (UTL), ITIN presents a unique and fork-resilient identification of tokens. The ITIN also allows for the connecting and matching of other media and data to the token, such as legal contracts or price data, and increases safety and operational transparency when handling these tokens.
  • The International Token Classification (ITC) is a multi-dimensional, expandable framework for the classification of tokens. Current dimensions include technological, economic, legal, and regulatory dimensions with multiple sub-dimensions. By mid-2021, there will be at least two new dimensions added, including a tax dimension. So far, our classification framework has been applied to 99% of the token market according to the market capitalization of classified tokens.
  • ITSA’s Tokenbase currently holds data on over 4000 tokens. Tokenbase is a holistic database for the analysis of tokens and combines our identification and classification data with market and blockchain data from external providers. Third-party data of several partners is already integrated, and API access is also in development.

Remarks

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Hannes Detlefsen is a Community Manager at the International Token Standardization Association (ITSA) e.V. and has been active in the blockchain field for several years. Currently he is studying Business Administration at the Christian-Albrechts University in Kiel. Besides his experience in the field of digital assets, his main focus is on decentralized finance. You can contact him via detlefsen@blockchain-sh.de and connect with him on LinkedIn.