CAIA L2 - 1.1 - Decentralized Finance: On Blockchain- and Smart Contract-Based Financial Markets Flashcards
Define
Decentralized Finance
(DeFi)
1.1 - Decentralized Finance
Blockchain-based financial infrastructure built on public smart contract platforms
that are open, permissionless, transparent, and interoperable
Is based on open protocols and Decentralized Applications (DApps)
1.1 - Decentralized Finance
Define
Smart contracts
1.1 - Decentralized Finance
small applications stored on a blockchain
and executed by a large set of validators
(are the backbone of all DeFi applications and protocols)
Dica:
Sm = Small
a = application
1.1 - Decentralized Finance
Define
5 layers of DeFi
(Decentralized Finance)
1.1 - Decentralized Finance
SAPAA
- Settlement
The blochain + native protocol asset
Ex: Ethereum Blockchain - Asset
Native protocol asset and “tokens”
ETH, fungible and non-fungible tokens - Protocol
Smart contracts designed for specific use
Exchanges, lending, derivatives, asset management - Application
User-oriented apps for individual protocols
Web-browser front-end - Aggregation
Platforms connecting several apps and protocols
Simultaneos use of exchanges and lending
1.1 - Decentralized Finance
List
Advantages and Disadvantages
of smart contracts
1.1 - Decentralized Finance
Advantages:
* Security
* Transparency
Dica: primeira e última letra de smart
Disadvantages:
* Inefficiency (involvement of every participant)
Dica: lembrar de smarti => i = inefficiency
1.1 - Decentralized Finance
Define
Token
and
(Asset) Tokenization
1.1 - Decentralized Finance
Token:
Blockchain representation of the asset (added to blockchain)
Highly accessible and easily transferred amongst participants
Can be stored within smart contracts and used in myriad decentralized applications
‘–
Tokenization:
Process
of adding new assets to the blockchain
1.1 - Decentralized Finance
Define
Stablecoin
1.1 - Decentralized Finance
Digital currency linked to
* underlying asset like a national currency (fiat-backed)
* precious metals (commodity-backed).
Usage: Asset of low volatility for financial contracts
1.1 - Decentralized Finance
Discuss
Risk that
new tokens / stablecoins
have
(and native digital tokens doesn’t)
1.1 - Decentralized Finance
Risk of a issuer of a new token
do not pay the promises (eg dividend, interest)
Collateral can be used to mitigate risk:
-
Off-chain collateral
(underlying assets are stored outside of the blockchain)
=> mitigate exchange rate risk, but creates external dependencies + counterparty risk -
On-chain collateral
(Assets are typically held in smart contracts and locked on the blockchain. Example: Dai stablecoin) -
No collateral
(promise is based on trust alone)
1.1 - Decentralized Finance
Contrast
Centralized and
Decentralized exchanges
(advantages and disadvantages)
+ Examples of Decentralized exchange protocols
1.1 - Decentralized Finance
Centralized exchanges
* Adv - Relatively efficient
* Disadv - Vulnerability - Traders lose access to asset (more vulnerable to attacks)
Decentralized exchanges
* Adv - No intermediary / Less counterparty credit risk / other DeFi protocols can use to exchange tokens
Examples of Decentralized exchange protocols:
* Decentralized order book exchanges
Settle transactions using smart contracts; on-chain (blockchain transaction is required for every action, which makes it a slow and costly process) and off-chain order book;
* constant function market maker (CFMM)
smart contract-liquidity pool. have multiple cryptoassets in reserve. 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
* P2P protocols
participants use automated process to find counterparties - bilateral manner. Trade is executed using a smart contract on-chain
* smart contract-based reserve aggregation
liquidity reserves are consolidated within a smart contract that serves as the hub for users and liquidity providers
1.1 - Decentralized Finance
Contrast
Collateralized Debt Positions
(CDP)
and
Collateralized Debt Markets
(CDM)
(in Decentralized Lending platforms)
1.1 - Decentralized Finance
- Loans in DeFi are permissionless (doesn’t rely on trusted relationships)
- Can be “flash loans” and collateralized:
Collateralized Debt Positions (CDP):
* Loans that use newly created tokens
* Can have collateral - by locking cryptoassets into a smart contract
* Ex: Collateralization ratio of 150% (150/100) => 150 locked for creation of 100
Collateralized Debt Markets (CDM):
* Loans from existing cryptoassets
* Must be fully collateralized (in smart contract)
* Lenders and borrowers matched by
1. P2P matching (direct matching)
2. Pooled loans ( borrower funds are lumped together / Lender earn variable rate - depends on demand)
1.1 - Decentralized Finance
Contrast
Asset-Based
Derivative Tokens
and
Event-Based
Derivative Tokens
1.1 - Decentralized Finance
Asset-Based Derivative Tokens
Token
whose price comes from
stocks, commodities, cryptoassets, etc.
‘—
Event-Based Derivative Tokens
Token
whose price comes from
any observable variable not related to the performance of an asset.
Need:
1. Set of outcomes
2. Resolution source
3. Specified time
=> introduces external dependencies
1.1 - Decentralized Finance
Discuss
DeFi Ecosystem
4 Opportunities and
6 Risks
1.1 - Decentralized Finance
Opportunities => TECA
* Transparency - transactions are publicly observable
* Efficiency - Transactions via tokens can be settled very quickly,
* Composability - DeFi protocols and applications can interconnect
* Accessibility - DeFi protocols can be used by anybody
Risks => “SE DISE”
* Security - if keyholders do not sufficiently secure their admin keys
* (Coding) Errors - opportunities for hackers to drain funds
* Dependency - A problem with one smart contract may negatively impact multiple applications across the DeFi system
* Illicit Activities
* Scalability
* External Data Dependency
1.1 - Decentralized Finance
