"Decentralized finance: On blockchain-and smart contract-based financial markets" Schär, F. Flashcards
Describe DeFi..
DeFi – alternative financial infrastructure built on top of the Ethereum blockchain
DeFi (and smart contracts) can create highly interoperable financial system with:
*Spectacular transparency
*Equal access rights
*Little need for custodians, central clearing houses or escrow services
Currently, DeFi is still niche and has some big inbuilt issues. Yet, some of the technologies are extremely promising, providing significant scope for improving the current financial system.
What are smart contracts? Their benefits?
Smart contracts – small applications stored on a blockchain and executed in parallel by a large set of validators
Regular server-based applications – cannot observe internal logic, user is not in control of execution environment (leads to risks)
Benefits:
● Provides security (executed as specified, anyone can verify results)
● No need for custodian (counterparty risks eliminated, bc certain conditions on both sides need to be satisfied to start the process)
● Composability when smart contracts are on one blockchain (easy to build new processes based on existing ones)
What are the layers of DeFi?
- Settlement Layer (blockchain & protocol asset)
- Asset Layer (all assets that are issued on top of the 1st layer)
- Protocol Layer (provides standards for specific use cases – derivatives, debt markets, decent. exchanges)
- Application Layer (creates user-oriented applications that connect to individual protocols; interactions of smart contracts)
- Aggregation Layer (aggregators create user-centric platforms that connect to several applications and protocols)
What is tokenization?
The process of adding new assets to a blockchain.
Tokenised assets are more efficient – much easier and faster to transfer.
Most prominent type – stablecoins.
Other types of tokens: NFTs, governance tokens, commodity-tracking assets etc.
Why and what collateral do tokens have?
Tokens can’t appear out of thin air, promise something and have value – they need to have some credibility and backing.
3 types of collateral:
● Off-chain – real-world assets
● On-chain – uses blockchain assets as collateral (most transparent)
● No collateral – lol
What is the difference between centralized and decentralized exchanges?
Centralized – transfer all assets on an exchange account, defeats whole purpose of crypto, but lower costs
Decentralized – opposite, control your own assets until trade is executed
What are the types of decentralized exchanges?
Decentralized Order Book Exchanges – Use smart contracts for trades. Use on-chain and off-chain collateral.
Constant Function Market Maker – Smart contract-liquidity pool, can trade one asset for another (like currency exchange).
Smart Contract-Based Reserve Aggregation - Aggregates information about liquidity providers to give the best deal to customer.
Peer-to-Peer Protocols - Two-party agreements to exchange pair of assets (normal contract).
What are the benefits of decentralized lending platforms?
Both lender and borrower can remain anonymous (does not create counterparty risk due to collateral or smart contracts).
What are the lending/borrowing options on decentralized lending platforms?
● Flash loans – borrower receives funds, uses them, and repays loan within the same blockchain transaction (if funds not returned, assets returned to lender)
● Collateralized Debt Positions – a user can create new tokens by locking cryptoassets in a smart contract; the user is then able to receive a stability fee – interest rate set by the community
● Collateralized Debt Markets – user can borrow existing cryptoassets from another user, while locking the collateral in a smart contract
What are decentralized derivatives?
Tokens that derive their value from an underlying asset’s performance, the outcome of an event, or the development of any other observable variable.
Require oracles – Complex systems that connect off-chain events to the on-chain world.
What are the 2 types of decentralized derivatives?
- Asset-Based Derivative Tokens – synthetic tokens that are tied to a wide variety of real-world assets (USD, gold)
- Event-Based Derivative Tokens – tokens that can be based on any objectively observable variable with a
*Known set of potential outcomes,
*Specified observation time,
*Resolution source
A complete set of sub-tokens consists of 1 sub-token for each potential outcome. Can be traded individually, price depends on probability of success.
What are the blockchain innovations in asset management?
● In contrast to traditional funds, on-chain variant does not require a custodian. Instead, the cryptoassets are locked up in a smart contract.
● Investors never lose control over their funds, can withdraw/liquidate, and can observe the smart contracts’ token balances any time.
● Smart contracts can be set up to follow a variety of simple strategies, including semi-automatic rebalancing of portfolio weights and trend trading.
● Can also select fund managers who will actively manage, but the smart contract ensures they follow the pre-defined strategy, act in investors’ best interest.
What are the opportunities in DeFi?
● Efficiency – DeFi relies on smart contracts, often eliminate the need for a third party in transactions. Additionally, token transfers are much faster than traditional ones.
● Transparency - DeFi applications are transparent. All transactions are publicly observable, and the smart contract code can be analysed on-chain.
● Accessibility - DeFi protocols can be used by anyone, the risk of discrimination is almost non-existent due to the pseudo-anonymity.
● Composability – DeFi protocols are like lego, one can stack something new on top forever, creating new processes.
What are the risks of DeFi?
● Smart Contract Execution – coding errors can de-stabilize the whole system and avg. user cannot recognize errors.
● Operational Security – many DeFi protocols and applications use admin keys that allow to change the contracts. If they are stored insecurely, can be stolen.
● Dependencies – if one block in a complex smart contract structure fails, everything built on top fails.
● External Data - the so-called oracles (data from outside) introduce dependencies and may, in
some cases, lead to heavily centralized contract execution.
● Illicit Activity - cryptoassets may be used by individuals who want to avoid monitoring.
● Scalability – blockchains face the ultimate trade-off between decentralization, security, and scalability.
