Reading 1.2

Question 1

What is DeFi? Main 3 elements?

Answer 1

Decentralized Finance - blockchain based financial infrastructure

1) open
2) permission-less
3) interoperable

Question 2

What is a public blockchain?

Answer 2

Database that allows participants to establish a SHARED UNCHANGABLE LEDGER (record of ownership)

Anyone is free to join and participate in the core activities of the blockchain network.

Anyone can read, write, or audit the ongoing activities on a public blockchain network

Question 3

KEY Benefit of smart contracts

Answer 3

Security: anyone can independently verify the resulting changes

Question 4

Which 2 issues do smart contracts mitigate?

Answer 4

1) users cant observe application’s internal logic (DApps)

2) users cant control the execution environment

Question 5

Ethereum is Largest smart contract platform in terms of:

Answer 5

1) market cap
2) applications
3) development activity

Question 6

DeFi market size: 2017 vs 2021

Answer 6

2017:
1m smart contracts and 0.1m Ether

2021:
10b smart contracts and 100m Ether

Question 7

Defi stack:

Answer 7

1) settlement layer - settling the transactions (must ensure that state changes adhere to the rules)

2) asset layer - all assets issued on top of settlement layer and tokens

3) protocol layer - provide a specific set of rules and code that developers use to create smart contracts

4) application layer - user interface

5) aggregation layer - dashboard for execution of DeFi transaction

Question 8

What is a token?

Answer 8

Representation of an asset that was tokenized on a blockchain

Question 9

What is TOKENIZATION

Answer 9

Converting a unit of value (eg painting) into tokens that can be transferred on the blockchain

Question 10

Key Risk of TOKENIZATION

Answer 10

Issuer risk

value of a promise-based token
(e.g., with a promise of interest payments, dividends, or delivery of a good or service) depends on the claim’s credibility.

If an issuer is unwilling or unable to deliver, the token may become worthless or trade at a significant discount.

Stablecoins are also exposed to issuer risk; native digital tokens ( e.g., BTC and ETH) are not

Question 11

3 backing models for PROMISE BASED TOKENS:

Answer 11

1) no collateral - promise trust base

2) off chain collateral - collateral stored with an escrow service (need to be aware of counterparty risk and external dependencies)

3) on chain collateral - requires OVER-COLLATERALIZATION to offset the price fluctuations

Question 12

What is Dai?

How much did it grow from early 2020 to mid 2020?

Why?

Answer 12

1) Dai stable coin pegged to USD

2) 100m to 500m

3) because since 2017 it did not fluctuate more than by 5c from 0.95 to 1.05$

Question 13

Off Chain Collateralized stable coins

Answer 13

1) USDT and USDC (USD backed)
2) DGX - backed by gold
3) WBTC - tokenized version of bitcoin

Question 14

What is a DAO

Answer 14

Decentralized Autonomous Organization

Question 15

What is the Governance Token?

Answer 15

1) VOTING TOOL: token that acts as a tool for DAO governance (voting) through smart contracts

2) Traded on exchanges

Question 16

What is a NFT? Usually built on what standard?

Answer 16

1) Non Fungible Token

2) like a digital certificate of uniqueness

3) ERC-721

Question 17

Advantages and Disadvantages of centralized crypto exchanges?

Answer 17

Advantage: Relatively Organized

Disadvantage:
1) Need to deposit assets with the exchange
2) They are the single point of attack

Question 18

Advantage of decentralized crypto exchanges?

Answer 18

Advantage:
Assets are not deposited until trade is complete (done through a smart contract => excludes counterparty credit risk)

Question 19

Atomic swap

Answer 19

Smart contract that automatically executes specific actions once predetermined rules are met

Question 20

Decentralized order books exchanges

Answer 20

Use Smart contracts for transaction settlement and host their order books either on chain or off chain

Question 21

Order book

Answer 21

List of buy and sell orders for a specific token

Question 22

Pros & cons of on chain ORDER BOOKS

Answer 22

pro: decentralized, stored within the existing infrastructure of the block chain

Con: every action requires a blockchain transaction => slow, costly process. Even more costly in volatile markets because of frequent cancelations

Question 23

1) how does off chain ORDER BOOKS work
2) Dominant protocol that uses this approach

Answer 23

1) Centralized third party is used for order books. Blockchain used for settlement.

Maker (trade initiator) sends order to relayer and taker (transaction full-filler) selects the order

2) 0x

Question 24

What is CFMM and how can one use an arbitrage opportunity?

Answer 24

1) Constant Function Market Maker
- Liquidity pool that holds 2 cryptoassets
- Constant Product Model - to withdraw one token the proportional amount of the other token should be deposited

2) because the contract based liquidity pools do not rely on external price feeds (oracles) when market price of an asset changes one can trade the liquidity pool until the price is aligned with the market price

Question 25

What is a Liquidity pool

Answer 25

1) Digital pile of cryptocurrency locked in a smart contract used for increasing liquidity for trading

The cryptoassets are provided by liquidity providers

Question 26

popular liquidity pool protocols

Answer 26

UniSwap, Balancer, Curver and Bancor

Question 27

The earliest implementation of liquidity pool concept was proposed by

Answer 27

1) Hertzog and Benartzi (2017).

2) Adams (2018) simplified the model;

3) Zhang, Chen, and Park (2018) provided a proof of the concept;

4) Martinelli and Mushegian (2019) generalized the concept for cases with more than two tokens and dynamic token weights;

5) Egorov (2019) optimized the idea for stablecoin swaps.

Question 28

Smart contract based reserve aggregation:
1) mechanism
2) who sets the price
3) most prominent implementation of concept

Answer 28

1) Serves as a gateway between users and liquidity providers: user sends a trade request to the smart contract and it finds the best price and atomic settlement is made

2) The price is set by the liquidity providers

3) Kyber Network (Luu and Velner, 2017)

Question 29

Possible issues with Smart contract based reserve aggregation and solutions to the issues

Answer 29

1) Limited competition can result in monopolistic pricing

2) centralized control mechanisms: max price, min number of liquidity providers, background checks

Question 30

Peer to peer (P2P) protocols = OTC protocols
1) how they work
2) uniqueness
3) most popular implementation

Answer 30

1) Parties are connected directly, without 3rd parties => participants query the market who wants to trade a given pair of crypto-assets and then negotiate directly

2) third party cant front run someone, only parties involved in the negotiation can accept the trade

3) Airswap (Oved & Mosites, 2017)

Question 31

DeFi lending platforms
1) how they work
2) types of loans

Answer 31

1) Borrowers and lenders are not required to identify themselves. The loans are permission-less. Everyone can borrow or lend

2) Flash loans and Fully secured loans

Question 32

Flash loans:
1) definition
2) how they work

Answer 32

1) Repaid automatically and on chain

2) the borrower receives, uses and repays the funds within the same blockchain transaction.

If the borrower doesn’t repay (i.e. meet a certain requirements) the loan is cancelled = loan is returned to the lender

Question 33

Mempool definition

Answer 33

Memory pool - waiting room for transactions that have not yet been included in the blockchain

Question 34

Fully secured loans:
1) how they work
2) types

Answer 34

1) loans secured with collateral that is locked via a smart contract and only released when the debt is repaid

2) 3 types:
- Collateralized debt positions
- Pooled Collateralized debt markets
- P2P collateralized debt markets

Question 35

Collateralized debt positions (CDPs)
1) how they work

Answer 35

New tokens are issued, backed by collateral

To create the token, the user must lock cryptoassets in a smart contract

Then the user can borrow based on the collateralization ratio

Question 36

Residual risk

Answer 36

Risk not accounted for

Question 37

Collateralized debt markets
1) how it works
2) how are lender and borrowers matched
3) Popular protocols

Answer 37

1) existing tokens are lent (to borrow ETH someone else has to lend ETH)

2) P2P matching - lending party only earns interest after a specific agreement with a specific party is made

Pooled Loans - the interest rate is set by the availability of liquidity (more liquidity - smaller interest rate).

3) Aave, Compound, dYdX

Question 38

P2P matching and Pooled Loans advantages:

Answer 38

1) P2P:
- loans have fixed interest rate
- parties agree on the period of the loan repayment

2) Pooled:
- lenders earn interest from the point of depositing funds in the pool
- can undergo maturity transformation (short term deposits transferred into long term loans)
- can undergo size transformation (small amounts gathered from savers and transforming them into large amounts needed by borrowers)

Question 39

Decentralized Derivatives
1) how works
2) 2 types of derivative tokens

Answer 39

1) Tokens whose value depend on an external requirement

Usually need oracles for tracking

2) Asset and Event based

Question 40

Asset based derivative tockens

Answer 40

Extend CDPs => locked collateral is used to issue synthetic tokens that track prices of various assets

Question 41

Inverse token

Answer 41

Asset based derivative token that providers users with short exposure and price is determined by the inverse of the underlying assets’ performance

Question 42

Event based derivative tokens
1) how they work
2) most popular implementation

Answer 42

1) The price is a function of any observable variable thats not asset performance

Can be based on observable variable with known potential outcomes, specific timeframe and resolution source.

2) Augur

Question 43

On chain funds
1) definition
2) how they work

Answer 43

1) Like traditional investment funds - allow users to invest in a basket of cryptoassets

2) do not require a custodian because assets are locked up in a smart contract, users can withdraw/liquidate them at any time

Either not managed (semi automatic trading) or actively managed (in this case the limitations of trading are stipulated in the smart-contract)

When investing into a on chain fund - a token is issued (# according to the % owner) and then when the investor exists - the position is sold and token is burned

Question 44

Popular examples of on chain fund protocols:

Answer 44

• Set protocol - can build invest funds
• Enzyme Finance (Melon) - can build invest funds, mostly designed for semiautomatic
• Betoken - meritocratic fund of funds
• Yearn Vaults - collective invest pools (actively managed and complex)

Question 45

4 opportunities of DeFi ecosystem

Answer 45

1) Efficiency & Speed - reduce counterparty credit risk & efficiency of transactions (smart contracts)

2) Transparency

3) Accessibility - any one can use the protocols

4) Composability - ability to build new protocols from existing protocols

Question 46

6 risks of DeFi ecosystem

Answer 46

1) Smart Contract Execution - only as secure as the smart contract protocol

2) Operational Security - governance tokens and admin keys (ability to change protocols) are often concentrated and result in exposure to malicious actions

3) Dependencies - issues with one of the protocols/contracts can result in multiple protocols and contracts being exposed

4) external data need exposure

5) illicit (illegal) activity

6) Scalability

Question 47

Yield farming

Answer 47

Liquidity farming - lending crypto assets in order to generate rewards in the form of additional cryptocurrency

Question 48

2 areas of attention for regulators in relation to DeFi

Answer 48

1) Fiat on ramps and off ramps - to verify the origin of funds when crypto is bought with fiat money and when crypto is sold for fiat money

2) Decentralization theater - to distinguish between truly decentralized protocols and not

Question 49

Possible solutions to scalability issue

Answer 49

1) Sharding - level 1 scaling solution - spreading computation across P2P network

2) Rollups - Level 2 scaling solution - transactions posted on main chain and computation is off chain

• ZK roll up - zero knowledge - verifiers confirm they have the same info without disclosing the info (validity proof - only accepted if cryptographically confirmed)
• Optimistic rolls ups - transaction is only denied if a valid claim of fraud is reported