DeFi 101: DEXs, Yield Farming, Liquidity Provisioning and More. | by Dimitrios Gourtzilidis
stablecoins were created as a solution to the volatility issue that crypto had from the start. They are said to be stable because they are pegged to other assets like US Dollars, Gold, Euros, etc. The most notable projects are Tether (USDT), USD Coin (USDC) and Dai (DAI).
For more information on stablecoins, see “The most interesting stablecoins on the market”.
After stablecoins, we need to define what a wallet is. metamaskprobably the most popular browser extension wallet for the Ethereum blockchain, creates wallets by providing the user with the seed phrase and public address, and can access dapps and manage digital tokens.
non-custodial Wallets provide users with both private and public keys, and also give them responsibility for safekeeping and safekeeping.
wallets for storage only provide the public keys to their user and the private keys are stored and secured by a third party who bears their responsibility.
A specialized application called “Oracle” is required for external data to be able to enter a blockchain. The most notable project on the Ethereum blockchain is Chainlink.
The first thing dapps need is a blockchain to run on. Ethereum was the first blockchain to offer dapps a place to run on. This would be called “settlement layer‘ on a DeFi stack.
The image is from https://coincript.com/
On top of a blockchain, on which “asset layer‘, we find the various tokens that exist on the blockchain. Ethereum provides a template for any other project to create additional tokens on it via its ERC-20 protocol.
The third layer is called “protocol layer“. Protocols like Maker, AAVE, and Compound can be found there.
Applications like Uniswap can be found on the “application layer”, which is on the fourth layer of the stack and contains DEXs like Uniswap etc.
Last but not least theaggregation layer‘ is the last layer of the stack.
One of the first DeFi pioneers was MakerDAO. It was founded in 2015 and published its first white paper in 2017. MakerDAO uses Ether as collateral to produce the stablecoin DAI, which is soft-pegged to the US dollar.
total locked (TVL) is an indicator that communicates the value locked in a log and together with their market capitalization gives us a rough estimate of their success. One detail we cannot verify using these two indicators is which tokens generate the TVL value. DeFi Pulse graciously includes this information on their site (https://www.defipulse.com/).
loan value (LTV) indicates the percentage amount of collateral issued as a loan. A higher LTV means a higher probability that collateral cannot cover the outstanding loans. Popular collaterals are Ether, Tether and Dai.
The image is from https://www.defipulse.com/
lending platforms utilize pools from which borrowers can then borrow, where each token is stored. In return, one receives tokens, “a-Token” in the case of AAVE and “c-Token” in the case of Compound, as receipts that can later be used to redeem the original loan. An important note here is this the loan is always less than the collateral (overcollateralized).
In extreme cases, if the securities are not sufficient, liquidation occur. Tokens are converted until the negative balance is zero, including any liquidation fees.
If the price of the security falls significantly, additional funds may need to be added to the loan log.
GHOST‘s “a-Tokens” are equal to their original token deposit amount (1 aETH = 1 ETH) but receive interest up front in the form of the original token in a user designated wallet.
Other notable protocols are: Maker, Compound, Alchemix
yield farming
The fundamental basis of borrowing is that money lent earns interest for the lender. Yield farming is the process by which lenders move their funds into various interest-generating protocols in order to maximize their earnings.
The picture is from https://blog.yearn.finance/
The ROI of each log is measured in “Annualized percentage return” (APY), and this measurement was used for their comparison. The higher the return, the better the investment. APY also accounts for the compounding of interest. On the contrary, the “Annualized percentage” (APR) Not.
year finances was the first yield aggregating protocol to automate the yield farming process.
Decentralized exchanges act as what we would now call a legacy exchange system, with the difference that all processes are handled by a smart contract instead of a central authority.
The “Liquidity based” DEXs use pools representing different pairs of crypto tokens deposited by different users who, as described above, earn interest on their deposits. When a DEX user wants to exchange one token for another, they put one token in the pool and receive the other in exchange.
If no trading pair is available between two tokens, a “Automated Market Maker” (AMM) like Uniswap will perform the transaction between different pools until the conversion is facilitated.
The transactions are calculated by calculating the “Constant product/price formula“. Pools with high reserves in one token and lower reserves in the other token increase their fees to incentivize users to bring the balance back to normal. In recent years, other methods have also been developed to replace this process.
the Constant product/price formula
The image is from https://cryptologos.cc/
Order book based DEXs like Loopring, match exchange requests via both DEXs and CEXs, and accept external data via Oracle systems like Chainlink.
A key difference between the two types of DEXs is that liquidity-based DEXs do not use oracles and therefore They don’t take into account the price of each token.
Other notable projects here are: 1inch, PancakeSwap, and Balancer
Provision of Liquidity
Liquidity Mining/Provisioning is used to incentivize token holders to put their funds into a specific DeFi project, thereby improving available liquidity.
Since a pool represents a crypto pair, the liquidity provider must provide both tokens to the pool based on their current price.
The rewards earned come from trading fees when other users trade the provided tokens and are proportional to the percentage of total liquidity. For example, if someone has provided 10% of a pool’s liquidity, he or she is eligible to receive the 10% of the rewards.
Temporary Loss (IL) is simply the opportunity cost of providing liquidity to a pool versus holding it in a wallet.
If a pool is provided with a token pair at a certain ratio, but after two days, for example, its ratio has doubled, then the initial liquidity provider has lost, as the payout would be at a different level.
By synthesis, issuance of synthetic assets is possible, representing the price of another asset at a 1 to 1 ratio from Sydney, Australia. For example, “sNIKKEI” follows the price of the famous Japanese index through a secured crypto debt way. Another interesting feature of the Synthetix protocol is that it allows for the creation of inverse synthetic assets like “iBTC” that track the inverted price of BTC. These assets are called “synthesizers”.
Synths derive their price from oracles like Chainlink and can be traded on the Synthetix exchange or any other DEX.
The image is from https://synthetix.io/
Synthetix also offers some index synths as a basket of crypto tokens. The tokens included in the index were selected through Twitter member polls.
Synthetix’s SNX tokens are ERC-20 tokens built on the Ethereum blockchain that were used as collateral for the synthetic assets. As the SNX token is highly volatile, a higher percentage of collateral is required.
Other notable projects here are DyDx (Margin/Leveraged Trading). DyDx enables margin trading by automatically borrowing funds from lenders on the platform.
One of the most popular insurance protocols out there is “Nexus Mutual“. It is based on the Ethereum blockchain and aims to cover losses due to smart contract failures and exchange hacks (deposit protection).
The image is from https://nexusmutual.io/
As the name suggests, Nexus Mutual is a mutual owned by its policyholders who go through a KYC process and receive NXM tokens to represent their rights. Its profits are retained in the mutual insurance company, stored in decentralized pools or distributed as dividends to its policyholders.
The possible payouts are decided by vote by the community members.
Since nothing is perfect, DeFi is also far from it. Smart contracts are software programs that, like any other software application, can have bugs that can corrupt them or be hacked.
Still, it can be very lucrative for a portfolio leveraging everything the DeFi space has to offer.
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