Decentralized finance, an opportunity, or a threat for traditional institutions? (1/2)

This work is part of my thesis, submitted in 2022. Thoughts and opinions are my own.

Part 1 will focus on the executive summary, introductions and setting the scene on Blockchain technology and the DeFi Space.

Part 2 will focus more on the TradFi – DeFi relationship, here is the link : Link

This paper examines the birth and growth of blockchain technologies and focuses more specifically on Decentralized Finance (DeFi) and its opportunities within traditional finance (TradFi). The emulation of existing traditional financial services on public and open infrastructure in a decentralized way has enabled frenetic innovation and the apparition of new business models and financial mechanisms. The vertiginous rise of the DeFi space, in terms of size, offering and hype has sparked fear, anxiety but also curiosity and interest from regulators and traditional financial players. Some banks are looking from the side lines, some are dipping their toes in this new unregulated space, full of unknowns and opportunities.

Incorporating evidence from interviews, personal investigations, and constant scanning of the latest development in terms of regulation and use cases, we argue that despite their differences, traditional finance (TradFi) and decentralized finance (DeFI) are not necessarily opposed and might find synergies and ways to collaborate to generate value that will benefit both worlds.

We start by establishing a taxonomy of the decentralized ecosystem, presenting its unique characteristics, range of products, state of regulation and technological maturity. We then continue by stating some of the key challenges that banks are facing today and how DeFi could be a lever to address those. In our final section we conduct an analysis of the frictions between both worlds, list few real-life use cases where DeFi and TradFi are interacting today and list opportunities. We conclude by detailing the value creation and value capture mechanisms for banks that would be willing to explore DeFi.

Our final thesis is that DeFi protocols are paving the way for a new paradigm around open finance, where banks would become platforms, offering a gateway to products where customers, empowered with generic personal accounts (like web3 wallets) will be able to connect and pick and choose the right offerings.

Keywords: DeFi, TradFi, Blockchain, Protocols, Banks, Banking as a platform, Regulation

Yesterday’s banking giants are struggling to adapt and to tackle a fast-paced innovation, inhibited by their strong technical legacy dependencies and decades, if not centuries, of established monopoly and knowledge asymmetry with their customers. In today’s age of customization, universal access to knowledge and facilitated benchmarking, the end-customer is for the first time in the driving seat, being able to easily compare and choose the most practical, cheap, and efficient solution rather than a brand or a family bank. 

Consequently, the touch points between the client and the banks have become rare, indirect, and impersonal, this is particularly pertinent for local and smaller banks as they are accustomed to nurture physical proximity with their client base through brick-and-mortar agencies. 

The client has become proactive in his choices, he will choose the service with the most fit to his needs from any supplier, accepting to interact with a wide variety of partners (Wise, Revolut, VIAC, …) instead of solely with his bank teller. To retain him, banks will have to eventually propose a perfect user experience embedded with transparency, immediacy, and simplicity. 

Those evolving needs are becoming extremely specific which empowers aggressive, agile, and specialized fintech’s to access and capture entire segments of the client base and serve them with nearly custom-made solutions. As the pressure is increasing, traditional banks will be forced to innovate at an accelerated pace, whether it is by building new custom-made solutions in-house leveraging agile and modern software development processes or by partnering with specialized suppliers and embedding their products into the bank’s offerings, essentially transforming the bank into a platform.

Thus, we believe that eventually banks will have to open their infrastructure and their product catalog to the outside. Enabling the customers to access the products in an as-a-service model. In this futuristic outlook, customers would operate a generic account, or wallet, and would be able to plug natively into any financial institutions to pick and choose the right product, at the right price and at the right time in a flexible manner.

One model that could be a source of inspiration for this banking-as-a-platform operating model is the decentralized finance space and the underlying blockchain technology. Indeed, the blockchain technology offers natively an open ledger and an open interoperable infrastructure that allows peer to peer transactions and services. Banks, the protocols and the customers would be able to transact between each other on this neutral infrastructure in a seamless manner. Wallets, smart contracts, and the wide panel of innovation in terms of products offered by DeFi offers an alternative to how banking is done today. For years banks have been looking with doubt on the DeFi ecosystem, the latter has grown and today some banks are starting to see how to leverage and potentially integrate DeFi offerings. Of course, this does not come without challenges, today the DeFi space is widely unregulated and immature, but therefore it is also a fertile ground for innovation where ideas blossom and eventually succeed or fail, effectively serving as a testing ground on what finance could look like in the future. Progressively both worlds, decentralized finance and traditional banking gravitate towards each other. Both are trying to tie up with its counterpart and find ways how both could entangle into a symbiotic relationship. This paper will present both sides of this coin and present exploration ideas on how each could benefit from the other and how banking and DeFi are already finding common use cases.

A blockchain is essentially a distributed database where bits of data, usually transactions, are being stored in blocks. A new block is produced at fixed intervals and added on the existing chain of blocks, linked to the previous block by a hashing mechanism. The blockchain is immutable and append only, it is in essence an extremely inefficient but robust database, the economist qualifies it as “the trust machine” (the economist, 2015)[i].

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[i] The Economist (2015). The trust machine – How the technology behind bitcoin could change the world. Link

The size of each block being finite, the number of transactions stored in each is also hard-capped. The number of transactions contained in a block and the frequency at which a new block is added on the blockchain permit to quantify the speed of the blockchain, represented by the TPS metric (transactions per second).

Some of the key characteristics of blockchain networks are:

Decentralization: In opposition to the traditional financial system where the ledger is maintained by a central entity, in blockchain networks the ledger is kept by all nodes on the network. Essentially each node replicates and maintains the common ledger and stores a local copy of the data base and verifies the new transactions that are being broadcasted on the network. The easier it is to run a node, the more the network is decentralized as the barriers to entry are lower.

Openness: blockchains can be public and open or closed and permissioned, we will concentrate on public blockchains as we consider that those are the most interesting. In public blockchains everyone is welcomed to participate, the creation of a wallet is free and does not require any KYC, approval, or the possession of a passport. According to McKinsey, “2.5 billion adults, just over half of the world’s adult population, do not use formal financial services to save or borrow” (McKinsey, 2009)[i], but thanks to the democratization of smart phones in recent years a large part of this population can now connect at least sporadically to the internet. With a smartphone the unbanked could access blockchain networks and transact on those without any boundaries.

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[i] McKinsey (2009). Half the world is unbanked, Alberto Chaia, Aparna Dalal, Tony Goland, Maria Jose Gonzalez, Jonathan Morduch, Robert Schiff. Link

The processing of transactions is handled without intermediaries but rather by incentivized actors on the network. Depending on the consensus mechanism used, those actors can be miners (proof-of-work) or validators (proof-of-stake), other less popular models also exist.

The bitcoin white paper was released on the 31st of October 2008 by an unknown person (or group of people) called Satoshi Nakamoto. The abstract describes bitcoin as “A purely peer-to-peer version of electronic cash” that “would allow online payments to be sent directly from one party to another without going through a financial institution” (Satoshi Nakamoto, 2008)[i].

The Bitcoin network solves the fundamental challenges involved in a peer-to-peer payment system. It contains a distributed global and public ledger, which records all the confirmed transactions. Anyone can access this ledger and view the history of transactions and broadcast new transactions (send or receive bitcoins). The transactions are digitally signed by the account (wallet) broadcasting a transaction. This digital signature involving a private key (only known by the sender of the transaction) and a public key (publicly known) ensures that the wallet owner rightfully sends the transaction. Once a transaction is broadcasted to the network and signed by the wallet, a network of full nodes will confirm that the signature is valid, and that the sender has enough bitcoins to honor the transaction (preventing over-spend). Finally, the validated transactions are picked up by miners and added to a block. Miners are then in a race to solve a mathematical puzzle to be allowed to add this new block to the existing chain of blocks. The miner who solves the puzzle first and wins the right to do so is rewarded with new bitcoins (created out of thin air) and the transactions’ transaction fees included in the block.

Effectively the bitcoin blockchain went live on the 03rd of January 2009, Satoshi himself mining the very first block. It is interesting to note that this first block (called the genesis block) contained a custom message “The Times 03/Jan/2009 Chancellor on brink of second bailout for banks.” It was Satoshi himself that included the headline of the times newspaper from that day, a message targeted at banks and the traditional financial sector.

In essence today, bitcoin is still used as a medium to transfer digital value from address A to address B as it was envisioned in 2009, not much has changed since the launch besides two main upgrades. The first one, SegWit (segregated witness), was implemented in 2017 and improved the scalability of the network and the transaction malleability. The second, Taproot, was activated in 2021 and improved the privacy and lowered transaction fees.

Andreas M. Antonopoulos describes bitcoin in the following way: “At the end of the day, bitcoin is programmable money. When you have programmable money, the possibilities are truly endless. We can take many of the basic concepts of the current system that depend on legal contracts, and we can convert these into algorithmic contracts, into mathematical transactions that can be enforced on the bitcoin network. As I’ve said, there is no third party, there is no counterparty. If I choose to send value from one part of the network to another, it is peer-to-peer with no one in between. If I invent a new form of money, I can deploy it to the entire world and invite others to come and join me. Bitcoin is not just money for the internet. Yes, it’s perfect money for the internet. It’s instant, it’s safe, it’s free. Yes, it is money for the internet, but it’s so much more. Bitcoin is the internet of money. Currency is only the first application. If you grasp that, you can look beyond the price, you can look beyond the volatility, you can look beyond the fad. At its core, bitcoin is a revolutionary technology that will change the world forever. “(Andreas M. Antonopoulos, The Internet of Money)[ii]

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[i] Bitcoin: A Peer-to-peer electronic cash system (2008), Satoshi Nakamoto. Link

[ii] The Internet of Money (2016). Andreas M. Antonopoulos. Link

Ethereum is an alternative layer 1 blockchain, launched in 2015 by Vitalik Buterin. It is described in the white paper as “a next generation smart contract and decentralized application platform”.  “The intent of Ethereum is to merge together and improve upon the concepts of scripting, altcoins and on-chain meta-protocols, and allow developers to create arbitrary consensus-based applications that have the scalability, standardization, feature-completeness, ease of development and interoperability offered by these different paradigms all at the same time. Ethereum does this by building what is essentially the ultimate abstract foundational layer: a blockchain with a built-in Turing-complete programming language, allowing anyone to write smart contracts and decentralized applications where they can create their own arbitrary rules for ownership, transaction formats and state transition functions.” (Vitalik Buterin, 2014)[i].

Its consensus mechanism was also proof-of-work like bitcoin but has recently transitioned to the proof-of-stake mechanism, in September 2022. While Bitcoin is a pure peer-to-peer digital cash exchange protocol, Ethereum praises itself as being the internet computer, embedding programmability into the blockchain. Blocks in bitcoin contain transactions, which are in essence instructions to pass tokens from one address to another. Ethereum in turn permit to not only embed transactions into the blocks but also deploy smart contracts and calls to functions within deployed smart contracts. In other terms Ethereum permits to deploy mini-programs, or dapps (decentralized applications) on a blockchain and then enables the users to interact with those, while ensuring decentralization and security. This is a revolution as it is the first time that anyone, without any consideration on who the person is, can deploy code in a decentralized manner while being sure that users will be able to use it. In today’s world a great portion of the applications are deployed and operated using centralized platforms such as AWS, Azure or GCP, it is estimated that 60% of global workloads are running on a cloud infrastructure in 2022 (Nick Galov, 2022)[ii]. Having a decentralized and public alternative, which cannot be censored, is important and represents one of the foundations of decentralized finance. An open infrastructure that can embed programmability into a blockchain and as such fuel the use cases of tomorrow. We believe that while bitcoin was a pioneer and a precursor it is Ethereum that enabled the apparition of decentralized finance through smart contracts.

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[i] Ethereum: A Next Generation Smart Contract and Decentralized Application Platform (2014). Vitalik Buterin. Link

[ii] Web Tribunal (2022). 25 Must-know cloud computing statistics in 2022. Nick Galov. Link

Smart contracts are pieces of code deployed on a blockchain, but in all fairness, the name is not well chosen are those are in fact neither smart nor contracts, they are merely immutable (cannot be changed once deployed) and deterministic (with the same input, you will always get the same output) computer programs that run in an isolated fashion on decentralized networks. Those are also self-executing as nobody needs to monitor them and as the blockchain is running 7/7 and 24/24, those are basically always available. Running on a decentralized blockchain, Smart contracts enable trusted transactions and agreements to be carried out among disparate, anonymous parties without the need for a central authority, legal system, or external enforcement mechanism. Those are the backbone of the decentralized economy.

Bitcoin was created to exchange value, in the form of tokens, from an address A to an address B in a fully decentralized manner, Ethereum was created to embed code into a blockchain and make it programmable. The two protocols achieved their initial missions and are offering what they promised, what they failed to consider though is the scalability of their infrastructure. The number of blockchain users was very low at its inception, from 2011 to 2013 only less than a million users were transacting on blockchains, but the number of users has skyrocketed since them and today an estimated 80 million users of unique blockchain wallets are existing, coupled with more than 300 million people owning some cryptocurrency. This represents a huge bump in volume, traffic, and results in network congestion. As users are competing for block space to include their transactions, fees are exploding, and it might take more and more time to get transactions processed.

This phenomenon is linked to what is called “the blockchain trilemma”, a term coined by Vitalik Buterin (Ethereum) that represents the difficulty for a blockchain to offer at the same time:

• High decentralization: the ability for the chain to run via a trustless network of nodes with low barriers of entry, ideally a retail laptop should be able to run a node
• High security: the ability for the chain resist attacks composed of malicious nodes
• High scalability: the ability for the chain to run high numbers of transactions

Bitcoin and Ethereum are rather high on the decentralization and security aspects but low on scalability, making them great settlement infrastructure but with rather low transaction throughput. Therefore, new blockchains have made their appearance to palliate this shortcoming and offer retail-friendly, low-cost, and high TPS (transaction per second) rails for transacting on blockchains. In this work we will not go through a thorough description of every alternative out there, but the diagram below should offer a global overview of the ecosystem and what options are available to a blockchain user.

It should be noted that initially all the blockchains were completely disjointed with no way to transfer value from one to another without going through a centralized exchange where the user would be able to sell an asset and buy another one on a different chain. Today multiple options are available to “bridge” tokens and cryptocurrencies from one ecosystem to another, those bridges are basically intermediaries (with varying levels of decentralization) that permit to lock tokens on one side in a smart contract and release on the other side an equivalent number of tokens, effectively enabling the users to transfer value. While interesting, bridges are still quite immature today as demonstrated by the quantity of hacks that happened in the last months, including the famous wormhole hack that resulted in a loss of nearly $325 million (Corin Faife, 2022)[i] due to a basic mistake on the GitHub repository of the project.

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[i] The Verge (2022). Wormhole cryptocurrency platform hacked for $325 million after error on Github. Corin Faife. Link

The term “DeFi” itself was born in 2018 in a “telegram chat populated by Ethereum developers and entrepreneurs” according to coinmarketcap (Camila Russo, 2020)[i]. DeFi is the nickname for Decentralized Finance, a new nascent space living on the internet that offers to emulate traditional financial services in a decentralized manner, it is a blockchain-based ecosystem of fully transparent and permissionless financial services.

Traditionally financial services were always managed by centralized entities such as banks. Trust was playing a big role in the management of wealth and financing; companies and private individuals were looking for centralized entities that would bear the risk linked to the custody of capital, entrust them with their money in exchange for fees and in return those entities would offer either a yield on the deposits or services to facilitate financial operations (credit lines, loans…). Banks would accept deposits and lend the money to other customers or invest it to get a financial return.

DeFi is shaking this paradigm upside down, users are connecting to protocols leveraging web3 wallets (hence without any form of KYC), without knowing precisely who they are dealing with and interacting directly via smart contracts, all of this without handing over their assets to a centralized custodian and while retaining full control over them.

DeFi was truly made possible with the introduction of smart contracts by Ethereum, by embedding smart contracts and programmability on a public blockchain users are now empowered to access and transact on a public open network directly. The DeFi protocols are managing the smart contracts that are effectively acting as the intermediary between the users and handling the lifecycle of the products that their offer.

In short, DeFi permits a trustless, peer-to-peer financial infrastructure without any financial intermediary in the middle. DeFi is truly one of the biggest use cases and technical advancements made possible by the birth of blockchains, it started as a way to emulate the traditional financial system but eventually also evolved into a source of innovation, developing completely new products and markets altogether.

Professor Dr. Fabian Schär from the university of Basel describes the Defi “stack” as following:

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[i] Coinmarketcap (2020). What is decentralized finance? A deep dive by the defiant. Camila Russo. Link

The settlement layer is the blockchain itself, this is where the transactions are being processed and settled. The global security of the DeFi space is directly inherited from the blockchain.

The asset layer is where the objects that are being transacted are created and managed, whether the asset is the native protocol cryptocurrency (such as Ether for Ethereum) or any other kind of token (fungible or non-fungible). Tokens as opposed to native cryptocurrencies must be issued and managed via smart contracts.

The protocol layer contains all the “rules to play” for a DeFi protocol, those are sets of smart contracts that are coded and published by the developers of the protocols. The smart contracts directly dictate in a deterministic and transparent way what can a user do or cannot do for a given protocol. Anyone can audit and check the code, which ensures transparency and trust.

The application layer contains the front end and integration tools for the protocols to present, publish and enhance the accessibility to their services, whether those are websites or more complex interfaces.

Finally, the aggregation layer permits to pick and choose specific services from a wide variety of DeFi protocols to offer a holistic service to clients. Platforms aggregate offerings from different protocol and propose them to their users.

DeFi presents the following characteristics:

Openness: Public blockchain infrastructures is heavily influenced by the open-source ethos, anyone whoever they are and wherever they are located can leverage their internet connection to access a fully decentralized, global, and entirely peer-to-peer financial network. Any user with a wallet and the ability to sign transaction can interact with the smart contracts operated by a protocol and as such can use the service. But it goes even beyond that, if any user can access the service, any developer can also do the same, which results in permissionless composability. Composability enables developers and creators to easily pick and integrate products and services from multiple DeFi protocols into new offerings, this in turn generates new value for the whole ecosystem as the structure created is often more valuable than the sum of its parts. Developers can re-use easily components of existing infrastructure like Lego bricks and then focus on creating new rules and new products around those, all of this without any permissions or constraints. This greatly accelerates the growth of the ecosystem and the speed at which new products can be released to the market. It should be observed that even in the traditional banking world we can observe trends that go into the same direction, such as open banking for example.

Transparency: The code that composes the smart contracts is entirely open source, as such it is trivial to audit and to check how are the protocols functioning. This combined with the deterministic characteristic of the blockchain itself makes the whole system able to function in a trustless manner. No matter the conditions, a function call to a smart contract will always yield a pre-determined result, as such the whole ecosystem benefits from:

• An accelerated innovation pace, as all the code is available and ready to be re-used
• Trust in the handling of the transactions, as those operate in a fully auditable environment (unlike the traditional banking system that is more assimilable to a black box)

On top of that, the data is also available at any point in time, all transactions are fully accessible on the blockchain itself, which makes it easy for the users to consult the exact way their favorite protocols handle transactions or manage their treasury. Websites such as dune analytics publish dashboards that permit to track the exact financial figures of all the most popular DeFi protocols.

In addition, the code describes the “rules to play” and as such details in an accurate way how the whole ecosystem behaves, governance rules and improvement proposals for the DeFi protocols are handled in a semi-decentralized manner, votes are conducted on-chain and shape the outlook of the protocol. This permits the users to have a say and to be an actor of the change rather than a simple user.

To finish, resiliency is also a fundamental aspect of DeFi. The learnings we had from the 2009 subprime crisis is that banks and centralized financial institutions not always act in a responsible manner, pushed by the expectations that financial results will grow quarter over quarter, corporations are sometimes backed into a corner and may take increasingly risky bets and decisions. Eventually, a black swan event appears, and the market recedes like a tide and some big fishes are left on the shore. The same could be witnessed in the crypto space, centralized companies such as Celsius (retail interest-bearing and crypto-lending platform) or 3 arrows capital (Singapore based crypto hedge fund) have proven to have poor risk management frameworks. In bull market times this works fine, but when a bear market hits the trouble begins. In the recent crypto winter (since Q2 2022) centralized services have defaulted, resulting in buyouts, bail outs or simply bankruptcy. At the same time, DeFi protocols did not move by an iota. As every aspect of it is solidly scripted in the smart contracts that are dictating the behavior, even in bear markets the DeFi protocol continue to behave exactly as expected.

DeFi is still a nascent industry, it’s creation dates to 2015 with the birth of MakerDAO protocol, but it really took off in 2020 during what is called “the DeFi summer” where users joined in numbers and new protocols were created daily. With the apparition of MakerDAO, the first use case was the decentralized stable coin minting in the form of DAI, the space then eventually evolved into multiple directions and expended into the following directions:

Lending and Borrowing: The ability to borrow cryptocurrencies or tokens in an overcollateralized fashion and the possibility to deposit assets to earn interest, a business that was traditionally locked in the hands of bankers. Main actors in that space are AAVe and Compound.

Trading: Decentralized exchanges, “DEXs”, offer the ability to swap user’s assets for other kinds of tokens leveraging liquidity pools and smart contracts. Main actors in the space are Curve, Uniswap and Sushiswap. DEXs are merely offering a decentralized and self-custody option for trading in opposition to centralized exchanges such as Binance and Coinbase that request a proper KYC and operate all the wallets of their clients on their behalf.

Asset Management: The ability to deposit your assets that will be managed by the protocol, the users will be able to optimize their earnings by pooling their assets together for governance influence or to save on the transaction fees regarding compounding of their interests. Leaders in that space are Yearn Finance, Enzyme Finance or Convex.

Insurance: With the raise of hacks and the global lack of maturity of the ecosystem, users have been looking for solutions to insure their funds. Decentralized protocols have been created to cater to this need and offer to the users a way to share insurance risk together and hedge themselves against either hacks or potential bugs in smart contract code. The two main players in that field are Nexus mutual and Armor.

Stablecoins: With the raise of MakerDAO and its stable coin DAI multiple other options have appeared to permit the minting of stable coins in a decentralized fashion. While DAI is entirely backed by ETH tokens, FRAX for instance is only partially backed by collateral and partially stabilized algorithmically.

Derivatives: Trading and speculation has been a central part cryptocurrency since years. Investment can be done via traditional spot products but also through derivatives for more sophisticated investors, it was therefore only natural that derivatives platforms have also made their appearance. Synthetix for instance is a protocol that enables the issuance of synthetic (derivatives) assets, it supports synthetic commodities such as gold and silver, synthetic cryptocurrencies, inverse cryptocurrencies (for shorting), indexes and fiat currencies.

There are currently several hundred DeFi applications offering a wide range of financial services. Around $50bn are currently deployed and locked in the DeFi space, down from around 250 early in 2022.

The top 10 list of the DeFi protocols sorted by TVL (total value locked) is changing daily, please find below a snapshot. As we can see MakerDAO remains one of the biggest ones even if it is also the oldest, demonstrating its resilience over the years.

Decentralized exchanges, or DEXs for short are p2p marketplaces enabling their users to trade and exchange cryptocurrencies and tokens in a non-custodial fashion. Non-custodial means that the assets are always in the control of the users via their own web3 wallets and are never delegated or controlled by the protocol itself, shielding the users from the risk of hack of the platform. The trades are done via blockchain-based smart contracts, those are effectively substituting traditional intermediaries such as banks, payment processors or the centralized exchanges in the context of crypto. The very fact that the funds do not transit via centralized wallets or accounts during the operations drastically reduces the counterparty risk as the funds are always in the hands of the users. DEXs are open by nature, accessible by anyone and their code is auditable freely, which really sets them apart from traditional intermediaries that offer very limited transparency into their operations and business processes.

DEXs are running on smart contracts, this permits to generate very high efficiency gains as most of the operations are completely automated and self-executing on public and decentralized infrastructure. For the sake of comparison, in December 2021 Uniswap cleared $70Bn of volume (Uniswap, 2021)[i] while the SIX Swiss Exchange had a trading turnover of CHF 152.1Bn (Finance Magnates, 2022)[ii] in March 2022, roughly 2x in comparison to Uniswap. The main difference being that Uniswap employs 53 people (Craft.co, 2022)[iii] while SIX employs 2600 (Six, 2022)[iv]. This puts into perspective the level of automation on DEXs and how smart contracts could benefit the trading houses worldwide.

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[i] Uniswap (2021). Statistics. Link

[ii] Finance Magnates (2022). SIX Swiss Exchange sees a 29.5% Surge in Treading Turnover for March. Felipe Erazo. Link

[iii] Craft.co (2022). figures . Link

[iv] SIX Group Services LTD (2022). Drive! Link

Multiple types of DEXs exist, order book DEXs and automated market makers (AMMs) are the two main ones, we will focus on the latter as AMMs are the most widely used and the most innovative.

In a nutshell, an AMMs is a decentralized exchange that enables their users to:

• Create new trading pairs by creating new liquidity pools, the user provides a position of token A and token B into a new pool and will collect trading fees paid by users using the pool to swap Token A for Token B and vice versa.
• Provide additional liquidity to existing liquidity pools, they can openly provide new liquidity to existing liquidity pools and will be also rewarded with trading fees on trades leveraging the liquidity pool.
• Withdraw their position from an existing liquidity pool
• Use any existing liquidity pool to swap tokens, user pays trading fees to the underlying protocol, the liquidity providers, and the token holders of the governance token of the protocol
• Participate in the governance of the protocol and in the roadmap by buying and holding governance tokens, which are like “shares” of the protocol, and then voting on propositions

AMMs permit a public access to liquidity provision and usually to the market creation for any token pair, as such any user can create a new liquidity pool for a new token pair and effectively create a new swap feature for the pair, any subsequent users will be able to add capital into the liquidity pool or use it to swap their tokens. In the case of order book DEXs or exchanges, a seller must be matched with a buyer to process the trade, a seller’s order might even never execute as the matching, this is not the case for AMMs. For AMMs, the rate used for the swap is established dynamically by the smart contract and users can have instant access to liquidity and execute their trades on the spot, as they are not trading with buyers or sellers but rather with liquidity pools.

The innovation brought by DEXs is articulated around the open AMM concept, where liquidity is provided by users openly and enabling users to swap their tokens instantly. The open policy of DEXs permits to list extremely fast new tokens and create trading venues for those tokens in a matter of minutes, immensely faster than centralized alternatives. Nevertheless, it also brings the additional risk of listing nefarious tokens as not much control is being done on the onboarding of the new liquidity pools.

In the traditional financial world, to get a loan, a person must open an account with a bank, go through KYC and AML screening and then provide assurance of solvency as well as potential collateral. The person will then have to pay back the principal of the loan on a fixed schedule and pay interest on top of it.

In the DeFi space, borrowing and lending are done differently. The user connects to a borrowing and lending protocol via its web3 wallet, deposits collateral and then can borrow funds. In a nutshell, a DeFi borrowing and lending protocol is a set of smart contracts that enables users to lend and borrow cryptocurrencies, all of this without having to register and use a centralized intermediary. Potentially, a front end will be built as well to enable users to go through a graphical user interface. When a user lends his crypto (deposit), the user earns interest, when the user borrows crypto, the user pays interest to the lender. Like the decentralized exchange example presented in the previous section, users also pay transaction fees to the protocol that redistributes the earnings to the various stakeholders.

The ability to take a loan while being potentially completely anonymous and interacting with a stranger over the internet is one of the two main innovations that borrowing, and lending platforms have brought to the world. This is entirely enabled by:

1. The fact that all the loans are overcollateralized, to borrow 100 worth of USD a user must deposit on the platform >100, the exact amount being determined by the risk level of the collateral. If a user deposits a stable coin, then the risk level is low as the volatility of a stable coin is basically null, if a user chose to use a cryptocurrency, then the collateral ratio must be higher as the volatility can be quite high. If the price of the collateral dives deep and the amount of the collateral does not cover the loan anymore, the collateral will be liquidated. The main difference with traditional finance would be that in the conventional world a trader would get a margin call, while in the DeFi space, as users are connecting via wallets with no KYC, no warning will be issued, the collateral will be liquidated on the spot by liquidators that are incentivize via a liquidation premium. 
2. All the interactions between the users are handled and guaranteed by code, by the smart contracts that are operated in the background by the platform. This enables a trusted way to transact as the user is not dependent on a centralized party.

A good question to ask now is, why would a user desire to borrow cryptocurrencies while locking a high amount as collateral. One of the reasons would be that if a user, such a mining company, needs liquidity but does not want to sell any cryptocurrencies to generate cash (either because they are long on the asset or they do not wish to pay capital gain tax) then borrowing the funds to pay a bill or to fund an investment makes sense. Another reason would be for arbitrage opportunities, where a user might want to borrow funds to buy and sell on different exchanges. While this is tempting, transaction fees and spreads might be a barrier to efficient trades. The AAVe protocol came up with a solution for that, the flash loans.

Flash loans are the second main innovation that was created in the borrowing space in DeFi. A flash loan is basically a tool that permits a user to borrow a cryptocurrency without any collateral then use it to conduct a trade (such as buying and then selling an asset) and then repay the loan completely in a single transaction. Flash loans must be executed in a single transaction and the transaction will not go through if the flash loan is not repaid.

We mentioned before that lending and borrowing protocols are peer to peer, this is not entirely true. In fact, the protocols are usually pool-to-peer. In a similar fashion to the DEXs, AAVe and other borrowing and lending protocols operate liquidity pools where users deposit their funds. Those funds are then “pooled” together and lent out by the smart contracts of the protocol. The interest rates applied are completely dependent on the supply and demand. Deposits made into pools that are in surplus won’t yield as much interest as pools that are in big demand and are in search for additional liquidity, similarly, loans out of pools with high surplus will cost less from an interest standpoint than pools which are in high demand.

The main lending and borrowing protocol in the DeFi space is AAVe and has today nearly $5.2bn of total value locked, down from around $22bn at end of 2021.

Besides loans and the safekeeping of funds, banks propose multiple ways for their clients to increase their wealth, it is only natural that DeFi would try to also propose ways to grow capital and manage wealth. In this section we will present one product, convex as it will permit to introduce two new innovations that DeFi invented: yield farming.

Convex finance is a platform built on top of the Curve protocol. Before explaining what Convex does, it is necessary to explain briefly what Curve is. Curve is a “classic” DEX with the only difference that it focuses on Stablecoins and assets that have low volatility between each other (to avoid impermanent loss). For a time, it was the largest DEX on the market. Curve incentivize its users with CRV tokens as a reward (yield farming) for providing liquidity. CRV tokens can be converted to veCRV tokens (vote-escrowed CRV). Those can in turn be used in the governance process of Curve, they can boost the rewards received from liquidity providing, earn trading fees and receive airdrops. In a nutshell, the more veCRV a user has the higher they can boost their CRV rewards from their liquidity pools. The maximum boost that can be received on a specific liquidity pool on curve is a bout 2.5x, but to reach this boost level it takes an astronomic amount of veCRV tokens. As a single user or even a decently sized liquidity provider it will be very unlikely to reach high levels of boost.

Enter Convex finance. Convex appeals to two different types of investors:

• CRV holders: users can stake their CRV tokens on Convex, by staking those the user will earn the usual rewards from veCRV plus a share of the Convex platform earnings, CVX tokens and airdrops that veCRV holders are entitled to.
• Curve liquidity providers: users can stake their Curve liquidity provider tokens on Convex. Curve liquidity providers gets the following benefits from staking their LP tokens on Convex: base interest rate (same as on curve), part of Curve platform trading fees, convex-boosted rewards and CVX tokens as a liquidity mining incentive.

Convex permits their users to basically pool their resources together, hoard CRV tokens, convert them into veCRV and then use the veCRV to maximize the boost on the Convex supported curve LP tokens. All of this by mutualizing the transaction costs on curve among all the users of Convex and the ability to frequently compound the interest for additional earnings.

The example described above can seem to be complicated, but the concept applies to most yield farming and liquidity mining mechanism. A platform is built on top of a DEX or a lending and borrowing solution and offers to its users pooled benefits and frequent rebalancing coupled with native token incentives to boost their earnings, the users are therefore using the underlying platform and then delegating the LP tokens or the governance token to the yield farming platform to boost their earnings. 

Cryptocurrencies are extremely volatile, as such it makes it difficult to transact with them or to store value in a sustainable way for long periods of time. Prices can fluctuate by more than 30% in a single day, making transactions difficult, especially in the field of payments. Stability is therefore a wished perk in the crypto markets, the solution that was conceived are stablecoins. A stablecoin is essentially a token, issued on a blockchain leveraging a set of smart contracts. The stablecoin aims at pegging itself to the dollar (or other fiat currencies).

A stablecoin can be either “centralized” or “decentralized”, centralized stablecoins such as USDT or USDC are entirely managed by a company and are usually backed by fiat currency, short term debt, commercial papers, or commodities. Decentralized stablecoins are usually backed by single, or baskets, of cryptocurrencies. DAI is an example of decentralized Stablecoin as its emission and redemption are not managed by companies but rather by a DeFi protocol: MakerDAO.

MakerDAO released the DAI stablecoin in December 2017, since then its pegging to the dollar has remained quite stable and has never diverted by more than 0.04% from its baseline in 2022, 1 DAI = 1 $.

DAI is emitted and redeemed by a set of smart contracts running on the Ethereum blockchain and accessible to anyone. That means that any person on earth can provide Ether tokens as collateral and mint DAI and then return the DAI to get their collateral back. The decentralized aspect and the public access qualify MakerDAO as a true DeFi protocol, it was even arguably one of the first ones out there!

An interesting question would be, how does DAI remain so close to the 1=1 pegging? Well, MakerDAO uses game theory and economic incentives to stabilize back the price of DAI when it deviates from the baseline. When the price drops below the threshold of $1, the pricing smart contract incentivizes the users of MakerDAO to stop issuing DAI and return it to the protocol, lowering the supply, if the price goes over $1 the opposite happens and users are incentivized to issue new DAI. The tool to enable this operation is called the stability fee, which is paid to the protocol when redeeming DAI to get back the ETH collateral.

One might ask, what happens if the collateral is dropping in value and does not cover anymore the DAI that was issued by a user? In that case the Maker system will simply automatically liquidate the collateral and sell it, the owner will then receive the leftover of the collateral minus the debt, stability fee and a liquidation penalty. As with lending and borrowing platforms, it is the responsibility of the user to monitor closely its risk levels as no margin call will be issued.

Let’s now have a look at how DAI is created.

When a user wants to create new DAI, the user must first deposit ETH into MakerDAO, this will create a new CDP for the user, a “Collateralized Debt Position”. Once a user has a CDP, the user can now issue DAI tokens, while new DAI is created the ratio of debt (in other words the collateralization Ratio) in this specific CDP increases as well, the ratio has to remain over 150%, meaning that for 150 USD worth of ETH a user can mint a maximum amount of 100 Dai, of course it would be wise to keep the ratio higher to hedge against sudden moves of ETH price.

MakerDAO has created the distinctive innovation that permits users to issue and trade Dai Stablecoins in a completely decentralized fashion, it is worth to note that the system has been extremely resilient as it has survived all the big movements in the price of ETH in the last couple of years, including the Covid crash in 2020 and the crypto winter in 2022 without any interruption of its activities or big moves in the pegging of the stablecoin to the USD.

For the last section on the topic of use cases and distinctive innovations brought by the DeFi space, we will investigate oracles, and more specifically into Chainlink. Arguably, oracles are not necessarily considered as DeFi, but they are a necessary piece of the ecosystem. Chainlink is the main oracle service that is being leveraged across the DeFi space, it is a decentralized oracle network that provides in real time data to smart contracts on the blockchain. When running a DEX, MakerDAO or a lending and borrowing platform, it is paramount to have access to reliable asset price feeds, as those are needed to calculate collateral ratios and swap details. Smart contracts are basically pieces of code deployed on a blockchain and as such they are immutable, for those to deal with operations involving data that is not residing on a blockchain, they need off-chain data in an on-chain format. It is difficult to connect off-chain information sources to blockchain smart contracts, that is exactly the problem that Chainlink solves. Chainlink aggregates and bridges data to the blockchain and supplies other smart contracts with price feeds (among other things). One might ask why those feeds could not be provided by centralized entities such as exchanges, this is a valid point, but one must remember that prices are extremely sensitive as pretty much all operations in the DeFi space are completely automated and cannot be “shut down”. Centralized exchanges can shut down their operations if they have issues with their prices, this is not possible for a DeFi platform. As such sourcing the prices in a decentralized fashion from a network of oracles is safer. Chainlink operates a decentralized network of nodes, those nodes provide data and information, the process along with secured hardware eliminates reliability issues that could occur by using a centralized feed. Let’s see how.

The illustration above described the operational process to receive a data feed from Chainlink as a consumer, it should be noted that Chainlink requires that the feeds are paid for by the users using the LINK token which is the native token of the Chainlink ecosystem.

What would be interesting now would be to analyze the verification of the data as well. The consumer expects to receive valid data, here is how Chainlink processes the data from a supplier perspective:

By aggregating the data and eliminating outliers Chainlink sources the data from a wide variety of suppliers and makes sure to provide a consistent result to the customers. This decentralized supply and consumption of data to feed into smart contracts is one of the foundations upon which the DeFi ecosystem operates.

The regulation around the DeFi space is a hot topic today, as those platforms operate in a decentralized fashion with very little regulatory oversight, they are currently completely unsupervised. This of course is expected to change soon as all the main regulators are either implementing or deciding on how to provide a regulatory framework to this industry. The point being that the produced regulation must be well balanced to:

• Protect consumers, investors, and businesses
• Protect global financial stability and mitigate systemic risk
• Mitigate illicit finance and National security risks

And at the same time:

• Support and encourage technological advances, not hinder innovation
• Retain potential leadership in this field by the concerned countries

A fine line must be drawn between too much regulation that will completely kill the innovation while mitigating the risk inherent to unregulated platforms.

Regulatory frameworks for DeFi are starting to take shape based on TradFi (traditional finance) policies, several key topics are at hand:

Accountability and ownership of decentralized protocols: As the protocols are decentralized and usually operated by a foundation, it is difficult to pin down clear accountability and ownership. Who is responsible? Are those the developers? The governance token holders? Who is to blame in case of problems and who bears the responsibility of reporting back to the authorities? And which authorities are those? Most of decentralized protocols are operating over the internet and assemble a heteroclite and geographically diverse group of people, often anonymous and finally what would be the jurisdiction of a decentralized finance protocol?

Lack of market and liquidity risk controls and standards, particularly in protocols that offer leverage. Some protocols such as DyDx or Synthetix offer to create and trade perpetual contracts, options, and other kinds of derivatives with high leverage, of course those markets are in their biggest part not regulated and can suffer from low liquidity in periods of turbulence. To protect the investors, regulators will eventually impose more drastic controls over those protocols.

KYC/AML and user transparency is also a big topic. The openness and the accessibility of DeFi is one of its main strengths today and frankly what makes it such an innovative space and perfectly inclusive. Open and permissionless are the reasons why DeFi offers limitless opportunities but also brings with it risk of money laundering and fraud. For regulators and policy makers it is difficult to admit that anyone, from anywhere could access financial services in the form of DeFi, without any intermediaries. As such, the international financial action task force (FATF) has published recently new recommendations for virtual asset service providers (VASP). Those recommendations for DeFi protocols include enforcing KYC checks and AML (FATF, 2021)[i]. It is quite probable that at some point all DeFi protocols will have to comply with those rules.

Tax treatment of yield instruments and capital gains are also a difficult question, new exotic products and earning mechanisms are sprouting daily in the blockchain space and regulators or tax authorities have immense problems to first understand the products and then craft an adapted taxation guidance. As an example, the treatment of staking products where the users are blocking tokens in a smart contract in exchange for voting rights into the governance of the protocol or to secure the network represent strong yield generating instruments, granting about 5 to 15% of interest annually. Staking has been around for a couple of years and is a simple mechanism, but so far, no consistent approach regarding its taxation has been enforced, leaving investors and users in the dark regarding their tax obligations. In a second step, it might be quite difficult for the tax authorities to make sure that the DeFi users are indeed declaring all their assets and income as the creation of wallets is free and without any KYC obligation, a user could perfectly hide its trade and avoid declaring his wallets to the authorities. This might be the case today as the authorities are completely lacking proper tooling to track blockchain trades, nevertheless it will change in the future as new tools are being developed and used by the tax authorities. Companies such as TRM Labs and Chainalysis are indeed already proposing tools today that can track addresses and connect a wide network of addresses and wallets to detect links between them. As such, if a user uses a wallet on a KYC’d platform such as the traditional on and off ramp options which are the centralized exchanges, and then proceeds to make a transfer to his regular private wallet, as the transaction is public it would be also detectable and a link would be made permitting to follow the money and see in which DeFi protocols it is put to use, offering a global and open registry to all tax authorities.

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[i] FATF (2021). Updated guidance for a risk-based approach to virtual assets and virtual asset service providers. Link

The DeFi space is nascent, it is exciting, it is moving fast but it is also crippled by numerous hacks and security issues. Rekt.news is maintaining on its website a leaderboard regarding the biggest hacks that have happened:

Smart contract vulnerabilities, deficient operational processes, lack of risk management and human risk are all at fault regarding the DeFi hacks and are hindering trust and mainstream adoption.

As an interesting example, let’s take the case of the wormhole bridge. The wormhole is a bridge between blockchains, it is in essence an escrow system that permits users to deposit assets in one smart contract sitting on blockchain A and then get the same assets from another smart contract on blockchain B, effectively bridging blockchain A and B. In the case of wormhole, the bridge is between Ethereum and Solana. In mid-January an error was detected in the code of the smart contract, which if exploited, would permit to work around the signature verification mechanism and permit to a nefarious actor to mint new tokens on the Solana blockchain. A commit was made on January 13^th to patch the vulnerability and was then pushed to GitHub on February 2^nd but not deployed yet into production. The hacker was able to see the proposed change, sitting in validation, and then exploit it himself before it was effectively deployed by the development team, resulting in a USD 320 million hack, all due to evident lack of controls and risk management by the wormhole staff.

According to Chainalysis, “Illicit transaction activity reached all-time high in value and all time low in share of all cryptocurrency activity” (Chainalysis, 2022)[i].

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[i] Chainalysis (2022). Crypto Crime Trends for 2022: Illicit Transaction Activity Reaches All-time high in value, all-time low in share of all cryptocurrency activity. Link

Contrary to the narrative that is pushed by the traditional financial world, only 0.15% of cryptocurrencies transaction volume was linked to crime and nefarious activities in 2021. Which is small, smaller than the US dollar share of illicit activity in fact, but still represents more than USD 14 B of illicit activity, creating barriers for adoption as a lot of the victims are retail users that might get scammed out of their life savings. According to Chainalysis, the two main sectors that have seen growth in terms of hacks and crime are stolen funds and scams, the two are closely linked with DeFi. Most of the scamming increase was generated in 2021 by rug pulls, a type of scam where a team of developers build what seems to a be a legitimate platform and then suddenly disappear with all the funds. Rug Pulls are quite common in the DeFi space due to the hype that surround the space, where users are eager to make increasingly absurd returns and are willing to close their eyes to the inherent risk of delegating funds to un-audited and recent protocols. Regarding theft, it grew as well quite a lot in 2021 in the DeFi space, mostly due to errors in the smart contract code of the impacted protocols or governance issues and lack of security standards. In any case, the industry is growing and with time the maturity level of its processes will also evolve.

Finally, let’s have a quick talk about two interesting events that happened this year: the collapse of the Luna ecosystem and the domino effect on more centralized players.

The Terra Ecosystem was founded in 2018 by Do Kwon, the whole objective of the Terra protocol is to basically mint a new kind of stable coin, the TerraUSD, commonly called the UST. The UST is not backed by deposits, fiat, or common kinds of cryptocurrencies, it was backed by another token from the Terra ecosystem, the LUNA token, the peg to USD 1 was ensured by an algorithm. The pegged was ensured by the convertibility at any time of $1 worth of Luna for $1 UST. So, if the UST price goes down to $ 0.95, then arbitrage traders will be able to redeem 1 UST for $1 worth of Luna and as such make an immediate profit of $0.05, eliminating the burned UST from the supply and as such putting pressure to restore the peg. The same applies if the price of UST goes to $ 1.05, in that case the arbitrage traders will rather exchange $1 worth of Luna for 1 UST and make a profit of $ 0.05. Eventually the whole LUNA ecosystem collapsed this year on May 13^th, erasing $24 billion of value, and eventually costing the wider cryptocurrency market nearly a trillion dollars.

Here is an overview of the chain of events that led to the downfall in a matter of days of the Luna ecosystem (coindesk, 2022)[i].  

1. May 7^th: Large swaps of UST to USDC are done on the Curve decentralized exchange (around USD 85 million worth of UST)
2. May 8^th: Large dumps of UST in the anchor protocol (lending for terra) and curve, UST depegs to $0.985, the Luna Foundation Guard commits to allocate $750 million of BTC to protect the peg
3. May 9^th: Deposits on the anchor protocol are down to below $9 billion from $14 billion, UST is back at $1 but quickly falls back to 35 cents!
4. May 11^th: LUNA price drops tremendously, Anchor protocol loses more deposits
5. May 12^th: The Luna price falls 96% in a day, as more LUNA must be created to try to conserve the peg of the UST, its supplies skyrockets. The Terra blockchain is halted.

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[i] Coindesk (2022). The Fall of Terra: A timeline of the meteoric rise and crash of UST and LUNA. Krisztian Sandor, Ekin Genc. Link

The LUNA catastrophe was fueled by greed and by an unsustainable business model. Anchor protocol was offering around 20% of interest per year for the users that were depositing UST there, and while the 2021 bull market helped sustain those rates and fueled the growth of the price of LUNA, things got out of control when the macro-economic environment changed in early 2022, eventually resulting in its collapse.

The collapse of LUNA in May was really the beginning of the end for other more centralized players. Eventually the famous Singapore based three arrows capital crypto fund (3AC) defaulted in June this year. They were heavily exposed to LUNA, had over 10mn LUNA tokens that were locked and thus could not be sold once it collapsed. They also owned significant amount of stETH (liquid staked Ether on the Lido platform). Without going into details, many investors wrongly assumed that stETH would always trade at par with ETH. The Luna collapse led to stETH trading below ETH, forcing 3AC to sell at large losses. The story is quite similar with Celsius, a centralized lending app, where customers can deposit crypto assets to earn interest, or borrow funds.

In the case of Celsius, the returns offered on deposits were very unsustainable. The business model worked well during the bull market when deposits are increasing and it’s relatively easy to make money on investing the assets. The reverse is true during a bear market. In addition, Celsius was also directly exposed to the Terra ecosystem and stETH which finally led to Celsius filing voluntary petitions for Chapter 11 Bankruptcy relief.

Eventually, the subsector will consolidate and rebound on a sounder basis, many unsustainable business models and protocols with failed risk and security practices will be wiped out and disappear, which is good for the whole sector. We foresee more regulation being enforced on the lenders such as Celsius and therefore, more conservative lending standards.

Point to highlight is that DeFi worked well in the past months, but it was the centralized players that were causing the trouble. Protocols such as AAVe, Curve, Uniswap and others behaved exactly as expected, whether in times of bull run or bear market, everything being automated there was little room for mistake. Another interesting aspect is that Celsius did reimburse its loans on AAVe in priority and filed for Chapter 11, the day after it finished repaying the loans. We believe that Celsius did so because there was simply no other way for them to get back the collateral that they had deposited on the platform, with time they were getting closer and closer to being liquidated and as such their priority, before doing anything else, was indeed to repay their loans in the DeFi space to get back their collateral, which is quite astounding.