Decentralized Finance (DeFi) in 2020 and its future trajectory
Section 0: Introduction
This post, intended to explore some of the aspects of Decentralized Finance (DeFi) and Ethereum, the platform these applications reside on, was inspired by the landmark events that occurred on November 23, 2020. The threshold to launch the eth2 mainnet has officially been reached, and on December 1 the Ethereum 2.0 will be launched (1, Coindesk). You can even see a record of the transaction here on Etherscan.
That being said, I’ve conducted a decent amount of research to start with the basics and the foundational building blocks of Ethereum & DeFI, as well as some specific applications and how the next phase of Ethereum will benefit the entire ecosystem. Let’s dive in.
Section 1: What baseline knowledge do I need to understand first in order to learn about DeFi?
Understand blockchain and cryptocurrency.
If your starting point is ground zero, and needs to include the basics of blockchain technology, start here:
Bitcoin Whitepaper: the original whitepaper discussing a Peer-to-Peer Electronic Cash System, which brought about Bitcoin. Read here.
Ethereum Whitepaper: the original whitepaper discussing a Next-Generation Smart Contract and Decentralized Application Platform. Read here. You can go even further down the rabbit hole with the Ethereum Organization and Ethereum Wiki.
Vitalik Buterin. As the co-founder of Ethereum, it’s a great start to understand his thinking behind the Ethereum project. Read his blog here.
Get up to speed on current events. The breakneck speed of change and innovation is unparalleled, so learning the basics while also understanding current topics is a good idea. Coindesk is a good resource as well as many others.
What is Ethereum and how is it foundational to DeFi?
If you already understand the basics of blockchain technology & cryptocurrency, understanding Ethereum and its basic layers is key, as well as the components that are foundational to DeFi: smart contracts, stablecoins.
Ethereum definition from Consensys is as follows: Ethereum is an open source blockchain that was officially launched in 2015. Built by developers for developers, Ethereum is often considered the most programmable blockchain for creating smart contracts and decentralized applications, also known as Dapps. In recent years, Ethereum has also emerged as the default platform for enterprise deployments. It is currently the most actively developed blockchain in the world, with the highest daily value transfer of any blockchain network (2, Consensys).
What are smart contracts?
Smart contracts are computer protocols that facilitate, verify, or enforce the negotiation and performance of some sort of agreement. For instance, a smart contract could be used to represent a legal contract emulating the logic of contractual clauses or a financial contract specifying responsibilities of the counterparts and automated flows of value (2, Consensys).
In order to best describe the Ethereum Layers, a comparative analysis with the layers of the Apple ecosystem is a great way to understand the layers of Ethereum in a very simple way:
· Application Layer: Web / app / wallet based software applications that end users directly interact with
o Apple provides the App Store and applications: in a marketplace style storefront, e.g. social media, traditional finance, collaboration & productivity, gaming
o Ethereum has Distributed applications (Dapps): which all are built and reside upon the Ethereum ecosystem, e.g. DeFi use cases, arts & collectibles, gaming, technology. Check out a list of Ethereum Dapps here.
· Platform Layer: a software based “minimum viable ecosystem” of common, baseline services & protocols to build applications upon
o Apple built, operates and updates iOS: the baseline operating system that is independently updated by the vendor, decoupled from both infrastructure & application layers; “Apple HW exclusive”; SDK for application developers
o Ethereum has a native, community driven platform & ecosystem: via a decentralized open source blockchain featuring smart contract functionality; decentralized replicated virtual machine (EVM), which can run Dapps; HW agnostic
· Infrastructure Layer: Web / app / wallet-based software applications that end users directly interact with
o Apple has the iPhone hardware: custom mobile device HW made exclusively for the Apple ecosystem to host and run both iOS platform and App Store marketplace for applications
o Ethereum resides on the Public internet: World wide web, cloud infrastructure, local infrastructure that support Ethereum nodes & validators by individuals, institutions & the enterprise
What is Ethereum 2.0 and how will it change the ecosystem and future?
Expected to launch by the end of 2020, Ethereum 2.0 (or Eth2) is a “major upgrade to the current Ethereum public mainnet, designed to accelerate Ethereum’s usage and adoption by improving its performance.” (5, Consensys).
In order to trigger the launch of the smart contract for Phase 0 of Ethereum 2.0, a deposit contract required that 524,888 ETH be staked, of which the threshold just recently cleared! (1, Coindesk)
One of the biggest aspects of the upgrade is shifting the Ethereum consensus mechanism from a Proof of Work (PoW) to Proof of Stake (PoS) model. PoW is the most common consensus mechanism currently used by Bitcoin, Ethereum, and others. Network nodes are run by miners which expend compute resources in order to solve complex mathematical problems in a competition to mine the next block, execute those transactions and add that block to the blockchain, adding to the authoritative distributed ledger. This time and computational energy (money) to run their node hardware, electricity consumption, etc., is rewarded to the miners that successfully mine a block into existence. While extremely secure, this model does not lend itself toward scalability and accessibility (5, Consensys).
On the other hand, PoS replaces these components of miners and electricity with validators and staking. A validator replaces a miner as the individual or node that contributes toward the agreed upon state of the network and confirmation of transactions on the blockchain, and rather than providing their computational resources, provide their “stake” by committing 32 ETH to the system. Rather than using their nodes to “work” toward the answer, they “stake” their ETH in order to propose and attest to new blocks on the Ethereum 2.0 blockchain (5, Consensys).
The anticipated benefits and improvements from PoS include: scalability, energy efficiency, lower barriers to entry, stronger crypto-economic incentives, and greater revenue-generating capabilities for a broader set of users (6, Consensys).
You can read more about the characteristics and differences between Proof of Work (PoW) and Proof of Stake (PoS) here.
Section 2: What is DeFi, what are its benefits, and how does it differ from the traditional financial ecosystem?
DeFi is defined by Consensys as “refers to the shift from traditional, centralized financial systems to peer-to-peer finance enabled by decentralized technologies built on the Ethereum blockchain. From lending and borrowing platforms to stablecoins and tokenized BTC, the DeFi ecosystem has launched an expansive network of integrated protocols and financial instruments. Now with over $7 billion worth of value locked in Ethereum smart contracts, decentralized finance has emerged as the most active sector in the blockchain space, with a wide range of use cases for individuals, developers, and institutions” (1, Consensys).
Effectively, DeFi is a global, open source alternative (or even complementary construct for some use cases) to every financial service used today, accessible with a smartphone and internet connection (2, Coinbase).
Key characteristics of DeFi:
· Governed by code:
· Public and transparent
· Global by design
· Permissionless to build and consume
· API-led connectivity and interoperability
(2, 3, Consensys) (4, Coinbase)
What are the use cases & financial products for DeFi?
Some key use cases include:
· DAOs (Decentralized Autonomous Organizations):
· Developer and infrastructure tooling
· Decentralized exchanges (DEXs)
· Lending and borrowing
Section 3: What are the emerging DeFi institutions and products, and where is the market headed?
The current DeFi ecosystem.
At a very high-level, the current DeFi ecosystem looks something like this categorically, with some notable example solutions for each:
Selected highlights ecosystem players:
· Wallets (HW/SW) & DeFi native front ends: are the mechanisms by which end users store tokens and cryptocurrencies and interact directly with exchanges to execute transactions
· Decentralized exchanges (DEX): are distributed exchanges for various financial instruments, including lending, borrowing, derivatives, yield farming, and trading / liquidity pools. Also check out the centralized exchanges (CEX) below and how they also fit into the ecosystem
· Oracles: a decentralized oracle network provides reliable, tamper-proof inputs and outputs for complex smart contracts on any blockchain (e.g. Chainlink). Chainlink is the most widely recognized solution here, and Coinbase has also developed native oracles
· Transaction layer (1 & 2): there are a number of “base layer” (e.g. Ethereum) level transaction capabilities, as well as many “Layer 2” solutions which reside on top of Ethereum, many of which are intended
· Currencies & units of value: most of which include stablecoins (currencies pegged to the value of another asset, e.g. the US Dollar), and many of which are also “exchange native” (e.g. USD Coin on Coinbase, Gemini Dollar)
How are enterprise organizations & traditional financial institutions reacting to these innovative disruptions?
The Enterprise Ethereum Alliance is by far the largest organization and best indication of how enterprises, namely Financial Services Institutions, are best supported to “adopt and use Ethereum technology in their daily business operations. We empower the Ethereum ecosystem to develop new business opportunities, drive industry adoption, and learn and collaborate with one another.” (9, EEA). The members list is pretty extensive and includes high profile companies such as Microsoft, JP Morgan, technology systems integrators and Big 4 Tax and Accounting firms.
The EEA works to understand the unique, cross-industry requirements of various enterprise organizations to implement Ethereum-based solutions, as well as establish certain baseline standards for protocols, interoperability (e.g. API-led connectivity), and where suitable, work these innovations into aspects of the public Ethereum blockchain.
In addition to the EEA, we have seen significant collaboration and integration with enterprise organizations and blockchain-native institutions. For example, ConsenSys recently acquired J.P. Morgan’s Quorum to Advance Enterprise Blockchain Adoption.
Section 4: How do I get started to get involved with DeFi?
Research and understand what you want to develop, invest in, or utilize both personally and professionally.
Onboard with Centralized and decentralized exchanges (CEX/DEX).
Research Centralized Exchanges (CEX) and how they fit into both the ecosystem and your personal, such as Coinbase and Gemini as far as crypto natives. Additionally, PayPal is one of the first traditional financial institutions to introduce a cryptocurrency exchange.
With respect to Decentralized Exchanges (DEX), Uniswap is a great example and at the time of this writing, by far the largest DEX in volume and market share. Uniswap is a protocol for automated token exchange on Ethereum. It was launched on November 2, 2018. Uniswap describes itself as a simple smart contract interface for swapping ERC20 tokens. It has a formalized model for pooling liquidity reserves. It serves as an open-source frontend interface for traders and liquidity providers and is committed to providing free and decentralized asset exchange (10, Coinmarketcap).
There are also many other DEX options to include lending platforms (Compound, Aave, Cream, MakerDAO, dForce) and trading platforms (Uniswap, dYdX, Kyber, Curve, 0x), as referenced above. (11, the DeFi Stack).
Understand digital wallets (both hardware and software) and the key differences between maintaining each versus an exchange.
Ledger products are excellent hardware based wallet options and can interact directly with various exchanges and online platforms.
Argent is an excellent mobile based app, specifically for ERC-20 (Ethereum) assets and DeFi. More broadly with browser based, software native wallets for all cryptocurrencies include Metamask and MyEtherWallet.
1. Ethereum 2.0 Deposit Contract Secures Enough Funds to Launch. https://www.coindesk.com/eth-2-0-deposit-contract-secures-enough-funds-to-launch
2. About Ethereum. Consensys. https://consensys.net/knowledge-base/about-ethereum-eth/
3. Consensys. Blockchain for Decentralized Finance (DeFi). https://consensys.net/blockchain-use-cases/decentralized-finance/
4. Coinbase. A Beginner’s Guide to Decentralized Finance (DeFi). https://blog.coinbase.com/a-beginners-guide-to-decentralized-finance-defi-574c68ff43c4
5. What Is Ethereum 2.0? https://consensys.net/blog/blockchain-explained/what-is-ethereum-2/
6. What is Proof of Stake? https://consensys.net/blog/blockchain-explained/what-is-proof-of-stake/
7. How Ethereum Works Part 1: Cryptography, Consensus, and Transactions. https://consensys.net/blog/blockchain-explained/how-ethereum-works-part-1-cryptography-consensus-and-transactions/
8. How Ethereum Works Part 2: Smart Contracts, Gas, and Dapps. https://consensys.net/blog/blockchain-explained/how-ethereum-works-part-2-smart-contracts-gas-and-dapps/
9. Enterprise Ethereum Alliance. https://entethalliance.org/
10. Uniswap. https://coinmarketcap.com/exchanges/uniswap-v2/
11. The DeFi Stack. https://multicoin.capital/2020/11/24/the-defi-stack/
Blockchain & Cryptocurrency:
1. How Banks Can Succeed With Cryptocurrency. BCG. https://www.bcg.com/en-us/publications/2020/how-banks-can-succeed-with-cryptocurrency
2. Bitcoin Whitepaper. https://bitcoin.org/bitcoin.pdf
1. Ethereum 2.0: How it Works And Why It Matters. Coindesk. https://www.coindesk.com/research/reports/ethereum-2-0-how-it-works-and-why-it-matters
2. A 101 Noob Intro to Programming Smart Contracts on Ethereum: https://medium.com/@ConsenSys/a-101-noob-intro-to-programming-smart-contracts-on-ethereum-695d15c1dab4
3. Eth2 Launchpad. https://launchpad.ethereum.org/
4. What Is Ethereum 2.0? https://medium.com/coinmonks/what-is-ethereum-2-0-1c8ad1cface6
5. Ethereum Learning. https://ethereum.org/en/learn/
6. Key Ethereum Resources (EthHub). https://docs.ethhub.io/ethereum-basics/resources/
7. Mastering Ethereum (GitHub). https://docs.ethhub.io/ethereum-basics/resources/
8. A Beginner’s Guide to Ethereum. https://blog.coinbase.com/a-beginners-guide-to-ethereum-46dd486ceecf
9. Guide to Staking on Ethereum 2.0. https://someresat.medium.com/guide-to-staking-on-ethereum-2-0-ubuntu-medalla-nimbus-5f4b2b0f2d7c
10. Consensys Ethereum 2.0 Guide: What is Ethereum 2.0? | Ethereum 2.0 FAQ | What Happens to My ETH on Ethereum 2.0? | The ETH 2.0 Staking Ecosystem Report | What is Proof of Stake? | What’s New in Eth2?
1. Consensys. Blockchain for Decentralized Finance (DeFi): The Complete Guide to DeFi. https://consensys.net/blockchain-use-cases/decentralized-finance/?utm_campaign=ConsenSys%20Newsletter&utm_medium=email&_hsmi=94195961&utm_content=94164102&utm_source=hs_email
2. Conensys. The Q1 2020 Ethereum DeFi Report. https://consensys.net/blockchain-use-cases/decentralized-finance/
3. Consensys. 2019 Was The Year of DeFi (and Why 2020 Will be Too). https://consensys.net/blog/news/2019-was-the-year-of-defi-and-why-2020-will-be-too/
4. Bankless. Ethereum: The Digital Finance Stack. https://bankless.substack.com/p/ethereum-the-digital-finance-stack
5. DeFi Pulse. https://defipulse.com/
6. Coinbase. A Beginner’s Guide to Decentralized Finance (DeFi). https://blog.coinbase.com/a-beginners-guide-to-decentralized-finance-defi-574c68ff43c4
7. Coinbase. An Introduction to Building on DeFi with Ethereum and USDC. https://blog.coinbase.com/introduction-to-building-on-defi-with-ethereum-and-usdc-part-1-ea952295a6e2
8. Huobi Global DeFi Alliance (MakerDAO and Compound). https://www.coindesk.com/huobi-defi-makerdao-compound
9. What is Yield Farming? The Rocket Fuel of DeFi, Explained. https://www.coindesk.com/defi-yield-farming-comp-token-explained
10. DeFi Pulse. https://defipulse.com/
11. The DeFi Stack. https://multicoin.capital/2020/11/24/the-defi-stack/
12. Ethereum DeFi Ecosystem. https://defiprime.com/ethereum
Bankless (excellent resource for Ethereum and DeFi learning):
1. Guide #1: Starting with Bankless. https://bankless.substack.com/p/-guide-1-starting-with-bankless
2. Bankless. The Bankless Skill Cube. https://bankless.substack.com/p/the-bankless-skill-cube
3. USDC. https://www.circle.com/en/usdc
4. DAI. https://www.dai.com/
5. Chainlink. https://chain.link/
Lending Products / Derivatives:
6. Compound Finance. https://compound.finance/
7. Maker. https://makerdao.com/en/
8. Aave. Open source DeFi protocol. https://aave.com/
9. Synthetix: A protocol for trading synthetic assets on Ethereum. https://www.synthetix.io/
Decentralized Exchanges & Technologies:
10. Kyber. https://www.kyberswap.com/swap
11. Loopring. zkRollup Exchange and Payment Protocol. https://loopring.org/#/
12. Uniswap. A decentralized protocol for automated liquidity provision on Ethereum. https://uniswap.org/
13. Synthetix. https://www.synthetix.io/
User Applications and Wallets:
14. Argent. https://www.argent.xyz/
15. MetaMask. https://metamask.io/