Core Mechanisms of Defi
Find a quick summary of the Defi mechanisms available today.
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Below is a summary of Defi I made to quickly explain the structure of the ecosystem to a friend looking to better understand and invest in the space.
The Evolution and Mechanisms of DeFi
Defi is a huge space and it’s difficult to keep up with the various new technologies and protocols being built. Ultimately, most protocols use a few core smart contract mechanisms and continually remix them to build new types of products.
Find the core pillars of the space below.
Maker DAO (2017) was the first significant modern defi protocol, and continues to be highly relevant to the ecosystem. They pioneered the Collateral Debt Position (CDP) in order to create a “stable coin” called DAI. A CDP is a mechanism that secures the value generated by a protocol (in this case DAI) by staking another asset (initially ETH, but now other assets as well). Maker was also a “DAO” (decentralized autonomous organization) from inception and uses its own smart contract governance system to adjust parameters within the protocol, such as adding new collateral types, or increasing the “debt ceiling” for a certain collateral type.
The Uniswap (2018) decentralized exchange (DEX) was the second significant Defi protocol to emerge. It has a more elegant smart contract and tokenomic structure than Maker DAO. The purpose of Uniswap is to allows anyone to create a decentralized marketplace for digital assets. It uses a smart contract that acts as an “automated market maker” or AMM. This AMM sets the price of an asset based on the ratio between another asset. The people adding liquidity to this pool are “Liquidity Providers” (LPs). LPs are extremely important in decentralized markets for assets that are yet to be listed on centralized exchanges (ie. Coinbase, Binance, etc). Their trades incur a certain amount of slippage (price differential) in a trade, which is determined by the volume traded and the depth of the pool. If a pool is shallow, a higher amount of slippage occurs. Another concept to familiarize with in DEX-world is impermanent loss (IL). IL negatively affects LPs and is worse for more volatile assets. For example, if I hold an ETH/DAI LP position and ETH moves 100%, people will be continually selling their DAI for ETH from the pool to balance the market. This results in a significant loss of exposure to ETH.
Synthetix (2020) was the first major protocol that developed the idea of “Liquidity Mining” (LM). As noted above, liquidity is extremely important for Defi apps. Total Value Locked (TVL) is the most significant statistic a Defi protocol boasts to show their value (see Defi Pulse). Synthetix is a protocol that creates derivative assets on-chain that represent the price of an off-chain asset (ie. sTSLA). The protocol still incentivizes participation via LM activities that give the “stakers” a reward in network token for participating in the protocol. This type of yield spurred the creation of “Yield Farming”, and often resulted in pools that offered 1000% APY for a very short amount of time. LM is a technique still used regularly with a large number of variations and twists such as token vesting and bonding.
Yearn Finance (2020) drove the explosion of Defi summer in 2020. Yearn would not exist without the adoption of liquidity mining. The point of Yearn was to allow for a “vault” to optimize yield opportunity for specific asset types. This system allowed users to collectively aggregate millions of dollars of value to automatically deposit into the latest yield farm activity. Additionally, Yearn (YFI) developed the idea of a “Fair Launch”. Today, Fair Launches reward the largest initial liquidity providers with a larger token reward, as they stake a larger portion of the pool.
The most recent Defi pattern to develop (outside of governance mechanisms) is the Olympus Pro (2021) bonding system to create a “Protocol Owned Liquidity” scheme. There’s also Convex Finance (2021), which works to support the most efficient DEX in the world (Curve (2020), a stable coin-based DEX that optimizes for reduced IL).
Lastly, there are insurance protocols, options and derivatives, index protocols, and undercollateralized lending solutions available on the market today, but the above projects cover the important mechanisms at work in the ecosystem.
PS: This is a great new article diving into the meat and evolution of Liquidity Mining and Protocol Treasury Development.