A Brief Tour of Decentralized Finance (DeFi)

October 14, 2020 · Noboru Nakahara

Grocery store pic Photo by nrd on Unsplash

Introduction

The Ethereum blockchain provides a foundation on which to build many kinds of applications. Decentralized Finance (DeFi) are an emerging set of building blocks that can be combined to construct complex financial applications on the blockchain where there is often no single central party involved in the financial transaction. Trust is decentralized, and placed in the network and in the smart contract computer code.

In this post, we will look at a few of these DeFi building blocks that are prominent the Ethereum ecosystem, including DeFi in general and oracles in particular. Oracles in a blockchain context refer to software that provides information from outside of the blockchain to smart contracts deployed on the blockchain.

Regulatory, Trust, and Security Issues

It is important to note that there remain many open and unresolved regulatory issues surrounding DeFi. This post offers an overview of select DeFi concepts and projects, but is not an endorsement of their use or application. At their core, they are tools and technologies. But by deploying and using them with cryptocurrency, they become financial services that are likely to fall under the purview of one or more regulators. Users and operators of DeFi applications should do their own careful research, including consulting legal counsel, before proceeding. So & Sato, a Tokyo-based law firm, has a DeFi overview article that enumerates some of the regulatory implications.

Regulations aside, trust and security in the DeFi world is still paramount. Smart contracts are computer code and prone to bugs, hacking, malicious use, and unintended side effects. Once again, users and operators are cautioned to do their own research and consult experts.

Oracles

There are several types of oracles depending on the information source, the direction of information and reliability. Some oracles' information sources are from software and others are from hardware. Hardware oracles are usually used to manage local information where data is read from the physical world, such as supply chain and car safety premiums. Use cases of software oracles are listed below. Information can be outbound from or inbound to blockchain. Oracle can be managed by single authority, or a decentralized community.

However, relying on information from outside of the blockchain requires very close attention to the reliability of data sources, since oracle data is unrelated to the consensus agreed upon inside of blockchain. Malicious third party players can also interfere with the communication between smart contracts and oracles. Highly-secure and trustless oracles are required to guarantee the quality of information. Some sample projects of the blockchain oracles are below.

API3

API3 offers decentralized APIs (dAPIs) where first-party oracles are operated directly by API providers, promising a higher level of security and lower cost vs. other solutions. Stakeholders (API token holders) can participate in the governance of API3. dAPIs can also be connected to any smart contract platform.

Chainlink

Chainlink provides connections between smart contracts and external data sources or APIs. Chainlink relies on multiple Chainlink node providers and separate data sources to realize decentralization at the oracle and the data source level.

Provable

Provable was named Oraclize before. Instead of using untrusted party of data sources, it use Authenticity Proofs to demonstrate whether the data source is genuine and untampered.

DeFi

DeFi refers to the financial service built on top of the blockchain platform not governed by a central authority. Many kinds of financial functions are realized in a decentralized way. Money (token) lending services are currently in vogue and are one type of DeFi application. A user can pool tokens on a specific smart contract and others can borrow it with interest, and those who pool money are incentivized by this interest. This is just like a physical bank. DEX (Decentralized EXchange) is also a well known form of DeFi. Where you can exchange your token for another token. Some sample DeFi projects are below.

Aave

Aave is a money market protocol, users can pool their tokens or borrow pooled tokens. By depositing a token into Aave markets, users get ecosystem incentives. In addition, one can purchase the Aave Token to participate in the governance of the Aave protocol.

Maker

Maker’s is governed by a DAO (Decentralized Autonomous Organization). Participants who hold their governance token, MKR, are able to vote on changes to the Maker protocol. Maker is also well known for their stable coin, Dai. Stable coins are a type of cryptocurrency designed to have minimal volatility and are pegged to another currency, often a fiat currency. Users can use Oasis to deposit or borrow Dai.

Uniswap

Uniswap is one of the most popular automated market makers (AMMs), which have largely supplanted decentralized exchanges (DEXs). It is fully decentralized and users can exchange ETH and any ERC20 token or can earn interest by adding liquidity to their token pool. Liquidity is maintained by incentivizing these liquidity providers to fund the liquidity pools, and also by arbitrage traders who help keep the effective exchange rate in balance.

Conclusion

Oracles and DeFi are hot topics in the current blockchain ecosystem and the current state of the art is changing day by day. If you are a user or DeFi project and looking for a technology platform to help bring your decentralized idea to market, please do get in touch!