What will DeFi bring to the financial industry?

5 min readJun 19, 2022


What is the form of realizing finance with smart contracts? Such as Libra or central bank digital currency, if smart contracts are attached in the future, how should it be designed?

As the imaginary boundaries of the combination of blockchain technology and finance continue to expand, the emergence of decentralized finance (referred to as “DeFi”) may bring some inspiration.

“DeFi has already emerged in 2019. 2019 can be defined as the first year of DeFi. The value of locked positions has increased by 2 times throughout the year. This trend has continued in 2020. At present, the overall locked position has exceeded 2 billion US dollars.

According to the latest data from The Graph, a blockchain data indexing company, the number of Defi monthly queries exceeded 1 billion in June. In previous months, The Graph hosting service was seeing 20–30 million daily queries, but in June, it hit 40–60 million per day.

According to the report of DappReview, a blockchain-based decentralized application (Dapps) information and analysis platform, in the second quarter of 2020, the total transaction volume of Ethereum DeFi increased by 403% compared with the same period last year, and the market value of several Ethereum DeFi projects was in The value-added more than doubled in the second quarter.

So, what exactly is Defi? How is it different from traditional finance? What will it bring to traditional finance?

Ethereum is a global open source platform for decentralized applications. On Ethereum, you can manage digital assets and run programs by writing code without geographical restrictions. The cryptocurrency it produces is called ether

Compared with traditional finance, DeFi is more open and inclusive: first, DeFi does not need to rely on any centralized subject to provide credit intermediaries or endorsements; second, there are no access restrictions, any networked person can enter; third, no third party can prevent any transaction, nor can it reverse any transaction.

DeFi and traditional finance are two things on different tracks and cannot be compared. Traditional finance serves the real economy and is the financing of capital. The process is accompanied by the transfer of risks, the allocation of resources, and the discovery of prices, and it deals with legal currency. DeFi has nothing to do with the real economy, and has nothing to do with fiat currencies. It is more about the cryptocurrency field.

For example, if a bitcoin miner produces bitcoins, he needs to use fiat currency to buy mining machines or pay electricity bills to hire people. Usually, he digs out bitcoins and sells them. However, if the market conditions are good, he may not want to sell them. In such applications, Bitcoin-based over-collateralization is carried out, and stablecoins are lent for RMB to meet their payment needs. The so-called stablecoin refers to a cryptocurrency pegged to another asset (such as gold, USD, another cryptocurrency, etc.).

“Although some financial engineering product design methods may be used, financial risks are also involved, and traditional financial risk analysis methods can also be used, but the service scenarios, objects and goals are completely different, so it is different from traditional financial services. Ratio is a completely different concept.”

Some people believe that DeFi based on distributed ledger technology not only solves the problem that funds are earned by intermediaries in traditional finance but also eliminates the credit barriers between countries.

Credit borrowing is very common in traditional finance. There is a risk pricing mechanism based on credit. DeFi does not have intermediaries based on smart contracts, but it is double-sided. , reduce risk. This leads to reduced cryptocurrency liquidity, tying up cryptocurrency resources, and high costs.

“From the perspective of resource allocation efficiency, it is difficult to say that it is an advanced financial resource allocation method.

DeFi is similar to Lego building blocks, in which some basic financial modules are implemented with different smart contracts. Then call each other between these smart contracts to put together some financial functions, “some provide loans like Compound, some provide decentralized exchanges, and some provide mechanisms to monitor the adequacy of collateral.”

Take MakerDAO, an automated mortgage loan platform in the lending platform as an example. MakerDAO was established in 2014. It pledges users’ digital assets through smart contracts, and then lends users the same amount of stable currency Dai. And it adopts a dual-currency model. On the one hand, it produces stable currency Dai, which is the form in which users eventually borrow assets, and on the other hand, it also provides equity tokens and management token MKR, which are used to pay interest when redeeming the mortgaged cryptocurrency.

Dai is a debt contract at the level of collateralized debt positions. A uniform overcollateralization ratio requirement applies to all collateralized debt positions. If the market value of the collateral falls, the issuer needs to replenish the collateral or return part of the Dai to maintain the collateralization ratio. If the mortgage rate is lower than the liquidation rate, the liquidation of the collateralized debt position will be triggered, which is similar to the liquidation mechanism in equity pledge financing. If the collateral disposal is not enough to cover the debt gap, then MKR will be additionally issued and auctioned to obtain Dai, which is equivalent to the MKR holder as the last loss bearer.

Similar to lending in traditional finance, lending in the cryptocurrency field also has the problem of term mismatch, that is, the contradiction between “the lender wants to repay the funds for a shorter period of time” and “the borrower wants to borrow for a longer period of time”. In traditional finance, maturity mismatches are mediated by banks, but in the cryptocurrency field it is difficult to solve them through algorithms.

Compound is a decentralized lending platform. Depositors can transfer their own Tokens to the Compound smart contract (deposit), and transfer the deposited Tokens from the Compound smart contract back to their own address (withdraw) in the future. Borrowers can use the deposited Token as collateral to borrow money from Compound. The Tokens borrowed by the borrower can be inconsistent in quantity and type with the Tokens deposited by themselves, but they must meet the requirements of the over-collateralization rate. If the borrower’s collateral is insufficient, the Compound protocol will force liquidation of the collateral.

The risks of the Compound platform are also obvious, because based on over-collateralization, the price of collateral fluctuates greatly, and if it falls sharply, there may be insufficient collateral. According to the agreement, there are two processing methods, one is to supplement the collateral, and the other is that the smart contract will liquidate the collateral. Therefore, once the price drops sharply, whether it is additional collateral or the disposal of collateral, transactions will be carried out on the Ethereum blockchain, there will be transaction congestion, and market asset risks will be difficult to clear.

DeFi is still in its infancy and faces three major challenges: first, code loopholes, programmable finance represents the power of technology, but loopholes after code stacking are always unavoidable; second, systemic risks, whether traditional finance or programmable For the type of finance, systemic risks must be considered, such as whether the DeFi ecosystem can carry it when faced with extreme market fluctuations; the third is asset on-chain, and the complexity and uncertainty of asset on-chain is very large for the entire DeFi industry. The challenge requires pioneers to try.

There are actually many security issues in DeFi, including the fundamental security of smart contracts, the value fluctuations of collaterals that are highly dependent on over-collateralization, and the efficiency of risk clearing.

DeFi has liquidity risks, and there is no way to solve the problem of term mismatch through algorithms, and there is no unified plan by building blocks, and there is no way for different modules to communicate with each other.