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1 Emerging Topics > 1.2 DeFi > Flashcards

1.2 DeFi Flashcards

1
Q

DeFi stands for _____

A

Decentralised finance

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2
Q

DeFi is defined as a B-B FI built on PSCPs that are
1. o
2. p
3. t
4. i

A

DeFi is defined as a blockchain-based financial infrastructure built on public smart contract platforms that are
1 open
2 permissionless
3 transparent
4 interoperable

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3
Q

Rather than relying on centralized institutions and intermediaries like a traditional financial services model, DeFi is based on OP and DA

A

OP: open protocols
DA: decentralised applications

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4
Q

Roles traditionally filled by central clearing houses and custodians are assumed by ____

A

Smart contracts

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5
Q

Smart contracts, which are SA stored on a B and executed by a large set of V, are the backbone of all DeFi applications and protocols

A

Smart contracts, which are small applications stored on a blockchain and executed by a large set of validators, are the backbone of all DeFi applications and protocols

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6
Q

The backbone of all DeFi applications and protocols are ______

A

Smart contracts (small applications stored on a blockchain and executed by a large set of validators)

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7
Q

Why may smart contracts be deemed inefficient, but at the same time have advantage of security?

A

They facilitate the involvement of every participant

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8
Q

Smart contracts facilitate the involvement of every participant - so they are have disadvantage of being ___ but the advantage of _____

A

Inefficiency, but high security

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9
Q

Difference between a smart contract and a regular server based web app?

A

While a regular server-based web application does not allow the user to control the execution environment or see how the internal logic works, the contract code for a smart contract is stored on the underlying blockchain and is open to public scrutiny.

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10
Q

Transactions are processed by all network participants in (1), which (2)

A

1) parallel
2) helps to ensure the execution of a transaction is legitimate

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11
Q

What is beneficial about the flexibility of smart contracts ?

A

They can fill a custodial role by storing cryptoassets and determining how and when the assets can be released

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12
Q

Any execution which results in a state change to the blockchain will be subjected to (1) and will appear (2)

A

(1) the network’s consensus rules
(2) in the blockchain’s state tree

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13
Q

Smart contracts have composability in that they _______

A

They interact with and build on top of each other.

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14
Q

Which is the largest smart contract platform in terms of development activity, available applications, and market capitalization.

A

Ethereum

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15
Q

Ethereum is the largest smart contract platform in terms of (3)

A

1 development activity
2 available applications
3 market capitalization.

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16
Q

What are the five layers of the DeFi Stack? (SAPAA)

A

(from bottom layer up)
1 settlement
2 asset
3 protocol
4 application
5 aggregation

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17
Q

Although the public blockchain is used to track (1), other assets get added to the chain over time.
The process of adding new assets to the blockchain is called (2).
The token is defined as (3)

A
  1. the native protocol asset
  2. tokenisation
  3. the blockchain representation of the asset
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18
Q

Two benefits of tokenisation:

A
  1. assets are highly accessible
  2. assets are easily transferred amongst participants
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19
Q

Tokens are a critical part of the DeFi marketplace, as they can be (1) and (2)

A
  1. stored within smart contracts
  2. used in decentralized applications
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20
Q

The majority (90%) of tokens are issued through:

A

the ERC-20 token standard smart contract template on the Ethereum blockchain

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21
Q

What are stablecoins?

A

They are digital currency linked to an underlying asset like a national currency (fiat-backed) or precious metals (commodity-backed).

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22
Q

Issuer risk - is it present with native digital tokens / where is it present and why?

A

Native digital tokens do not present issuer risk, but it is a concern when new tokens are introduced and values are contingent on promises (such as dividends, interest payments, etc.) that may never be met by the issuer

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23
Q

What are the three backing models for ‘promise-based tokens’?

A

Off-chain collateral (underlying assets are stored outside of the blockchain, often with escrow services such as commercial banks)
On-chain collateral (assets are typically held in smart contracts and locked on the blockchain)
No collateral (promise is based on trust alone)

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24
Q

a. What is off-chain collateral (promise-based token)?
b. What are 4 examples
c. 1 benefit and 2 negatives, with what consequence

A

a. underlying assets are stored outside of the blockchain, often with escrow services such as commercial banks
b. examples: two USD-backed coins (USDT and USDC) both available on Ethereum blockchain as ERC-20 tokens, DGX (an ERC-20 stablecoin backed by gold) and WBTC (tokenised BTC on the Ethereum blockchain)
c. off-chain can help mitigate exchange rate risk, but also cerate external dependencies and counterparty risks so require frequent audits to track collateral availability

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25
Q

a. What is on-chain collateral (promise-based token)?
b. What is an example
c. 2 benefits and 1 negative

A

a. assets are typically held in smart contracts and locked on the blockchain
b. Dai stablecoin - primarily uses ETH as its on-chain collateral. It incorporates a stability fee which is the interest rate paid by an entity creating new Dai
c. benefits include claims secured by smart contracts and high levels of transparency, but disadvantage is that because the collateral is typically held in a native protocol asset, it will be vulnerable to price fluctuations

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26
Q

Negative of no collateral promise-based token?

A

Counterparty risk

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27
Q

Non-fungible tokens (NFTs) are tokens that represent (1) typically built on the (2) token standard. NFTs are either (3) which naturally expose the holder to counterparty risk. Because the tokens are non-fungible, individual asset ownership and precise identification of the asset are easily tracked.

A
  1. unique assets / collectibles
  2. ERC-721
  3. digitally native units of value with unique characteristics or digital representations of physical objects like art
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28
Q

Centralised exchanges - one benefit:
1. e
Issues:
1. dishonest…
2. single…
3. struggle

A

Benefit:
1. efficiency
Issues:
1. vulnerable to dishonest exchange operators
2. they are a single point of attack for hackers etc
3. due to rapid growth in transactions, exchanges may struggle t offer infrastructure and regulatory support needed

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29
Q

Decentralized exchanges are exchanges that facilitate transactions without ___________

A

the involvement of an intermediary

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30
Q

Main benefit of decentralized exchanges? Users maintain…

A

Users maintain full control of their assets until trades are executed through smart contracts, reducing counterparty credit risk.

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31
Q

What is a recent evolution of decentralized exchanges? (Incorporation of OEP which…). What is an advantage of this?

A

Incorporation of open exchange protocols, which provide asset exchange standards and allow exchanges built on the protocol to use features such as shared liquidity pools. The biggest advantage is that other DeFi protocols can use these marketplaces to liquidate and exchange tokens.

32
Q

Decentralized Order Book Exchanges differ in how (1) but they all (4). Order books may be (2) or (3).

A
  1. how order books are hosted
  2. they all settle transactions using smart contracts
  3. on-chain (fully decentralised, with smart contracts storing every order)
  4. off-chain (use blockchain as a settlement layer only, with relayers being the centralized third parties that host and update off-chain order books)
33
Q

Pro and con of on-chain decentralised order book exchange?

A

Pro is that they are fully decentralised, with smart contracts storing every order.
However, a blockchain transaction is required for every action, which makes it a slow and costly process (especially in volatile markets where order cancellations are a regular occurrence)

34
Q

What is a relayer (re. off-chain decentralised order book exchange)? They do not 1,2,3, they just 4.

A

Relayers are the centralized third parties that host and update off-chain order books.
1,2,3 - control funds, match orders, or execute orders
4 - they just provide ordered lists with quotes

35
Q

What is the primary protocol to use the off-chain decentralised order book exchange? What is the three step trade process?

A

0x
1. a maker will send an order to the relayer to include in the order book
2. a potential taker selects one of the orders by talking to the relayer
3. the taker submits the order to the smart contract, which executes the exchange of assets

36
Q

What is the name for a smart contract-liquidity pool that holds multiple cryptoassets in reserve and facilitates token deposits in one type along with token withdrawals of a different type

A

Constant Function Market Maker (CFMM)

37
Q

What is a Constant Function Market Maker? It is a SC LP that holds _____ and facilitates _____ along with _____. The exchange rate is based on the _______.

A

Smart contract-liquidity pool that holds multiple crypto assets in reserve and facilitates token deposits in one type along with token withdrawals of a different type. The exchange rate is based on the smart contract’s token reserve ratio.

38
Q

CFMM - what equation is used to represent the model? (increase / decrease results in what?)
What ultimately forces the liquidity pool price to converge with the current market price?
What would lead to a higher constant value?
4 examples of CFMM pool protocols.

A

The equation xy = k is used to represent the model, with k as a constant and x and y representing each smart contract’s token reserve. Any increase (or decrease) in x results in an opposite decrease (or increase) in y.
Arbitrage ultimately forces the liquidity pool price to converge with the current market price.
Pool share tokens may increase in value as additional funds accumulate in the pool, leading to a higher k.
Examples: Balancer, Bancor, Curve and UniSwap.

39
Q

Two benefits of P2P/OTC protocols (decentralised exchanges).

A
  1. Offers may be accepted by those involved in the negotiation
  2. Eliminates the risk of third parties frontrunning by seeing unconfirmed transactions
40
Q

What is the name for when participants use an automated process to find counterparties in the network interested in trading a cryptoasset pair and negotiate the exchange rate in a bilateral manner?

A

Peer-to-peer / OTC protocols

41
Q

In P2P protocols, participants use an automated process to (1) and negotiate the (2), with the trade executed using a smart contract on-chain.
Offers may be accepted, eliminates risk of front-running
Most prominent example is (3)
Peer discovery may also be done through (4)

A
  1. find counterparties in the network interested in trading a cryptoasset pair
  2. exchange rate in a bilateral manner
  3. AirSwap
  4. Off-chain indexers may also be used for peer discovery.
42
Q

What is AirSwap an example of?

A

Peer-to-Peer (P2P)(a.k.a. over-the-counter, OTC) Protocol

43
Q

Smart Contract-Based Reserve Aggregation. With this method, liquidity reserves are (1) that serves as the (2). Users send their trade requests to the smart contract, which then (3). To work well, there must be (4). A minimum number of liquidity providers or maximum prices may be put in place as a control mechanism. An example is : (5)

A
  1. consolidated within a smart contract
  2. hub for users and liquidity providers
  3. compares prices set by liquidity providers, accepts the best offer, and executes the trade
  4. a broad base of liquidity providers
  5. the Kyber Network
44
Q

Unlike traditional centralized markets, a decentralized lending platform allows for anonymity for…

A

both the borrower and the lender

45
Q

What are the two approaches to protect the lender in a decentralized lending transaction?
1. flash
2. collateral

A
  1. a single blockchain transaction can be used to ensure that the borrower receives the funds, uses the funds, and then repays them. this is called a flash loan. if the borrower doesn’t repay, the transaction and its results are nullified.
  2. loans may be secured by collateral locked in a smart contract and released only when debt is repaid.
46
Q

What are the three variations of loans that are secured by collateral locked in smart contract? CDP, PCDM, P2PCDM

A

1 collateralised debt positions
2 pooled collateralised debt markets
3 p2p collateralised debt markets

47
Q

What happens in a CDP (token, loan, ratio)?

A

A CDP is a loan that uses newly created tokens, which are issued when a user locks collateral (cryptoasset) into a smart contract. The number of tokens created is dependent on the target collateralisation ratio, the value of the collateral and the target price of the generated tokens.

48
Q

What is an example of a CDP (Maker, Dai)?

A

MakerDAO: a decentralized protocol used to issue Dai stablecoin
Dai stablecoin: pegged to the U.S. dollar
ETH: the Ethereum blockchain
MKR: the governance token for MakerDAO

The user will deposit ETH in a CDP smart contract. A contract function is called to create and withdraw a specific number of Dai to lock the collateral. The minimum collateralization ratio is 150%, such that for any $50 of ETH locked into the contract, the most Dai that can be created by the user is 33.33 (i.e., $50 / 33.33 = 1.5, or 150%). Outstanding Dai are subjected to a stability fee which is set by MKR token holders.

Closing the CDP involves the owner sending outstanding Dai (and accumulated interest) to the contract. Once the debt is repaid, the owner can withdraw the collateral. The smart contract will start to liquidate collateral if the borrower fails to repay the debt or if the collateral falls below the minimum ratio (150%, noted above). The total MKR supply decreases due to the interest payments and liquidation fees. MKR holders also assume the residual risk of ETH price shocks, which means they are inclined to help maintain a healthy system.

49
Q

MakerDAO system (CDP) is mostly ____ but still relies on _____ and has recently _____

A

MakerDAO system (CDP) is mostly decentralised but still relies on price oracles and has recently moved to a multi-collateral system allowing different types of crypto assets to be used as collateral

50
Q

Two types of collateralised debt markets?

A

Pooled loans and P2P matching

51
Q

What is different collateralised debt position (CDP) vs collateralised debt markets?

A

Rather than creating new tokens as in CDP, CDM involves borrowing already existing cryptoassets from others. Loans must be fully collateralized with collateral locked in a smart contract to protect the lender against counterparty risk. Lenders and borrowers may be matched using either P2P matching or pooled loans.

52
Q

What happens in P2P matching CDM?

A

The person providing the liquidity lends cryptoassets directly to specific borrowers, which allows for a mutually agreeable period and fixed interest rates.

53
Q

What happens in pooled CDM? Variable rate is dependent on what?

A

All borrower funds are lumped together in a single, smart contract-based lending pool and lenders earn variable interest immediately upon depositing their funds into the pool.
Variable rates are driven by the pool utilization rate, with lower rates when liquidity is readily available and higher rates when demand is greater and liquidity is harder to find

54
Q

What are the two types of derivative tokens?

A

Asset-based and event-based derivative tokens

55
Q

What is the centralised element of a derivative token?

A

Oracles (external price feeds) are needed to track the variables from which the tokens derive their value (e.g. price of underlying asset, outcome of event).

56
Q

What is an example of a derivative token platform where the total debt pool for participants changes in value based on the aggregate price of all outstanding synthetic assets?

A

Synthetix

57
Q

What is Synthetix? What is one advantage and one disadvantage?

A

It is a derivative token platform. One advantage is that it offers redemption independent of the issuer, but users bear the risk associated with their debt position being impacted by others’ asset allocations

58
Q

Inverse tokens where price is based on an inverse function of underlying asset performance offer ______

A

short exposure to crypto assets

59
Q

What are three things that an event-based derivative token must have?

A
  1. a known set of potential outcomes
  2. a resolution source
  3. a specified observation time
60
Q

What is the external/centralisation issue with event-based tokens?

A

Prices and market resolution are highly dependent on the resolution source, which; introduces external dependencies and the risk of unreliable or malicious reporters.

61
Q

What is an example of event-based derivative token platform? What does it use to minimise dependency on a single reporting source?

A

Augur. It uses a multi-step dispute process that minimizes the dependency on a single reporting source.

62
Q

On-chain funds serve as (1) as they provide investors with (2) without (3)

A

1) valuable diversification tool
2) a basket of crypto assets
3) without requiring an investor to hold individual tokens

63
Q

Why do on-chain funds not require a custodian?

A

Cryptoassets are contained within smart contracts where investors can observe their balances, withdraw, or liquidate them at any time

64
Q

Strategies that can be deployed with smart contracts include (1) using (2) and (3). Contracts can also be managed actively under (4).

A

1 trend trading
2 moving averages
3 semi-automatic rebalancing of portfolio weights
4 predefined strategies and specific fund rules

65
Q

What are issued from smart contracts (on chain AM) and serve as evidence of partial fund ownership/low for redemption?

A

Fund tokens

66
Q

What happens when someone closes out an investment in an on-chain fund?

A

Fund tokens are burnt, underlying assets are sold through a decentralised exchange and and investors are compensated with ETH equivalent of their ownership portion of the basket of assets

67
Q

What are 3 examples of on-chain fund protocols? What are they all dependent on?

A

Betoken, Enzyme Finance, and the Set Protocol. They are all dependent on price oracles and third-party protocols for the purposes of trading, lending

68
Q

What is Betoken?

A

On chain fund protocol. A single fund of funds managed by a community of asset managers. The greater the success of the individual fund manager, the greater their respective influence on collective resource allocation.

69
Q

What is Enzyme Finance?

A

On chain fund protocol. Uses smart contract-based rulesets, fund fee schedule parameters, and trading restriction parameters to keep fund managers aligned to fund strategies.

70
Q

What is Set Protocol?

A

On chain fund protocol. Can be used for active management but is primarily set up for semi-automatic portfolio rebalancing which is triggered by predefined timelocks and threshold values.

71
Q

In what way is UniSwap’s liquidity pool similar to an on-chain investment fund?

A

Its constant product model incentivizes semi-automatic portfolio rebalancing with investors earning passive income via trading fees.

72
Q

What are Yearn Vaults?

A

Collective investment pools that are designed to maximize asset yields and use collective action to allocate network fees proportionally amongst all participants

73
Q

What are the four main opportunities/benefits of DeFi?
1 T
2 E
3 C
4 A

A

1 Transparency - all transactions are publicly observable and smart contract code can be analyzed on-chain, which leads to far greater transparency than what any centralized operation can provide.

2 Efficiency - smart contracts are used in place of centralized institutions (serving as custodians, central counterparty clearing houses (CCPs), and escrow agents). Transactions via tokens can be settled atomically and very quickly, which increases financial transaction efficiency and decreases counterparty credit risk. Because trust requirements are lower, regulatory pressure and the need for third-party audits may be reduced as well.

3 Composability - shared settlement layers allow protocols and applications to interconnect, allowing integration and new possibilities

4 Accessibility - can be used by anybody, which facilitates a very open and accessible financial system

74
Q

Six risks of DeFi ecosystem?
1 OS
2 SCE
3 D
4 S
5 IA
6 ED

A
  1. operational security (admin keys, governance tokens)
  2. smart contract execution (security-usability trade-off i.e. transfer permissions for efficiency and coding errors may create opportunities for hackers)
  3. dependencies (interactions/dependencies trade off - problem with one SC impacting others, price shocks on ETH or problems with stablecoins)
  4. scalability (long confirmation times, growing transaction fees (gas prices) meaning less wealthy individuals may not be able to conduct trades in a timely or cost-efficient manner. Although some solutions such as base-layer sharding, state channels, zero knowledge (ZK) rollups, optimistic rollups, and moving to a centralized base layer may be possible, it remains a challenge for blockchains to keep up with growing demand.
  5. illicit activity - privacy both good and bad, debate over whether decentralised infrastructure should be regulated. Still using fiat on/off ramps connected to TradFi. Also a DeFi protocol may be marketed as decentralized to avoid regulation while in reality be under the control of a few individuals
  6. external data - If a smart contract relies on data not available on-chain, it must be coming from external data sources. External data sources represent “oracles” and can lead to contract executions that are highly centralized. Risk can be mitigated by relying on decentralized oracle networks.
75
Q

What are the operational security risks of Defi?
- Admin keys - mitigation (2)
- Governance tokens (3)

A

Specific individuals are given admin keys to upgrade smart contracts/perform emergency shutdowns, creating vulnerability if these keys are not secure or if these individuals have malicious intent.
To mitigate this risk, projects may used multisig (M-of-N keys to execute admin functions on the smart contracts) and timelocks (which specify the earliest time that a transaction can be confirmed).

Voting schemes where governance tokens grant owners voting rights on the future of the protocol and early adopter rewards may not do enough to minimize highly concentrated distributions of administrative power. They also create a risk in that a founder can unload all of their token holdings at one time, which could shock the project system. Yield farming may also result in centralization creep, where an established protocol can end up assuming a large portion of a new protocol’s governance tokens.

76
Q

Not a question - just good paragraph:

The potential to have a genuinely open and transparent financial ecosystem where any individual can access readily available data and verify all transactions makes DeFi a truly unique and attractive infrastructure. Smart contracts and a decentralized settlement layer have facilitated the creation of trustless financial transactions which can only exist via the underlying public blockchain. However, security and scalability issues (amongst other things) present myriad risks that must be considered. In addition, even though these are considered “decentralized,” there are still some dependencies that require elements of trust.

A

The potential to have a genuinely open and transparent financial ecosystem where any individual can access readily available data and verify all transactions makes DeFi a truly unique and attractive infrastructure. Smart contracts and a decentralized settlement layer have facilitated the creation of trustless financial transactions which can only exist via the underlying public blockchain. However, security and scalability issues (amongst other things) present myriad risks that must be considered. In addition, even though these are considered “decentralized,” there are still some dependencies that require elements of trust.

1 Emerging Topics (8 decks)

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