Defi talents

1) Defining DeFi

Level 1: Atomic Units of Value

in DeFi is all about the basic building blocks of value, like cryptocurrencies (ETH, DAI), stablecoins (USDT, USDC), and other assets. These are used in DeFi for things like loans and trading.

However, there are risks. For DAI, the main risk is that the system that controls it might fail, causing DAI to lose its value. For Tether, the risk is that something bad could happen to the bank accounts that hold the dollars backing Tether. Other assets like WBTC also have risks – they could drop in value if there's a security breach or if people find out the money isn't really in the bank.

If any of these basic assets fail, it can cause problems for the whole DeFi system, no matter how good the code is.

Level 2: The Transaction Layer

In DeFi Level 2, it's not just about having digital money; it's about the ability to easily use it for transactions. DeFi systems need to work smoothly and efficiently, which involves a lot of transactions. This can get expensive, especially on Ethereum, where transaction fees can be very high.

Without the ability to transact (move money around), things like tracking collateral, processing prices, and even repaying debts can't happen. If people and bots can't make transactions, it could lead to financial problems in DeFi.

To solve this, projects like Solana are making transactions faster, cheaper, and more efficient at the basic blockchain level. Other projects like SKALE, StarkWare, and Optimism are creating Layer 2 solutions that help DeFi work better on top of existing blockchains like Ethereum. This improvement in the transaction process is vital for the success and growth of DeFi.

Level 3: Price Oracles

In Level 3 of DeFi, we're talking about something called "price oracles" ( oracles -> entities that connect blockchains to external systems) . These are like trusted sources of information about the prices of things like cryptocurrencies. DeFi systems need this information to work properly.

But here's the tricky part: If these oracles are centralized and something goes wrong with them, the whole DeFi system could fail. So, we need secure and reliable sources of price data.

Some of the most popular oracles are Chainlink, MakerDAO's medianizer, and others like Band and Tellor. If something goes wrong with these oracles, it could cause problems in various DeFi applications, like liquidations or the prices on decentralized exchanges.

So, Levels 1, 2, and 3 are like the foundation of DeFi. On top of this foundation, people are creating more advanced and connected financial tools.

Level 4: DeFi Primitives

The primitive layer in DeFi is where you find the basic tools and apps for things like lending, trading, and managing assets. Some examples include:

Lending Protocols (like Compound and Aave): These let you lend and borrow cryptocurrencies.
AMM Trading Pools (like Uniswap and Curve): They are for trading various cryptocurrencies.
Order Book Exchanges (like 0x and IDEX): These are places for more traditional trading.
Derivatives Networks (like Synthetix and dYdX): They allow you to trade financial products based on cryptocurrencies.
Asset Management Platforms (like Melon): These help you manage your investments.

These tools can be used separately or together, depending on what you want to do. For example, you could use Aave to borrow, then put that borrowed money into Uniswap for trading.

Some examples of how these tools work together:

DAI is used in Augur and on Curve for stablecoin pools.
USDC is used on dYdX.
Aave relies on Chainlink for price information.
Keepers are needed to manage underwater positions during market congestion.

So, the primitive layer is like a toolbox for DeFi, where you can mix and match different tools to build the financial services you need.

Level 5: Protocol Aggregators

In Level 5 of DeFi, we have protocol aggregators, which are like super tools that use the basic DeFi building blocks below.

There are two types:

Supply-side aggregators (like Yearn Finance): These help people find the best places to earn money from their assets.
Demand-side aggregators (like 1inch): They help people find the best places to trade cryptocurrencies.

Aggregators are popular because they help people make more money, but they come with risks. If the basic tools they rely on fail, users could lose their funds. However, demand-side aggregators are safer because they don't hold funds; they just help with transactions.

So, Level 5 is like the advanced tool layer in DeFi, but users need to be careful about the risks involved.

Level 6: Wallets and Front Ends

In Level 6, we have wallets and front-end interfaces for DeFi. They make it easier for users to interact with DeFi applications.

Examples:

Relayers (like Tokenlon and Guesser): These provide a user-friendly interface for specific DeFi protocols.
Wallets (like MetaMask and Trust Wallet): These are apps that help you manage your cryptocurrencies and interact with DeFi.
DeFi-Native Front Ends (like DeFi Saver and Zapper): They simplify DeFi operations and make it more user-friendly.

These services focus on improving the user experience in DeFi, not on creating new financial tools. They compete on things like design, customer support, and ease of use, as they aim to attract more users to DeFi.

So, Level 6 is about the tools that make DeFi more accessible and user-friendly.

DeFi Stack Summary

In the world of DeFi (Decentralized Finance), we have six distinct levels. At Level 1, we start with basic cryptocurrencies and stablecoins as the foundation. Level 2 focuses on smooth and efficient transactions, which are crucial for DeFi protocols to function effectively. In Level 3, price oracles provide reliable data for smart contracts. Level 4 comprises DeFi primitives, including lending, trading, derivatives, and asset management. Level 5 introduces protocol aggregators that make money by using these primitives but come with increased risks. Finally, at Level 6, wallets and user-friendly front-end interfaces enhance the DeFi user experience, making it more accessible and appealing to a wider audience.

b) In 5 sentences, how would you define DeFi?

DeFi is a blockchain-based financial ecosystem operating on platforms like Ethereum, designed to provide open, permissionless alternatives to traditional financial services.
It empowers users to conduct financial activities such as transacting, saving, borrowing, and investing without the need for intermediaries, relying on self-executing smart contracts for governance.
DeFi spans various services, including lending, decentralized exchanges, stablecoins, and yield farming, offering decentralized and transparent asset management options.
While delivering numerous benefits, DeFi also entails risks associated with potential vulnerabilities in smart contracts and market volatility.
DeFi's fundamental principle is to redefine finance, making it more inclusive and accessible to a global audience, promoting financial innovation and autonomy.

Security risks in DeFi are on the rise. These risks encompass a variety of factors, such as vulnerabilities in smart contracts, suboptimal settings in DeFi protocols, congestion on the blockchain network, failures in oracles (which provide external data to smart contracts), and issues with automated bots and liquidity providers. The complexity and interconnectedness of different DeFi contracts and the use of leverage further amplify these risks. In essence, as DeFi becomes more intricate, its risk surface grows, demanding a heightened focus on security and risk management in the ecosystem.

2) Which stablecoin are you most likely to use to park your funds and why?

a) What are the top 5 stablecoins by market capitalization?

USDT (Tether)
USDC (USD coins)
DAI (multi-collateral)
TUSD (TrueUSD)
BUSD (Binance USD)

b) What are the different methods of how stablecoins achieve their stability?

Government-issued fiat currencies remain stable through the actions of controlling authorities like central banks, which ensure their currencies' prices remain relatively stable. Stablecoins can be backed by a physical commodity such as gold, by algorithms, or by government-issued fiat currencies.

Stablecoins take advantage of the stability provided by central banks and the government to create reserves in government-backed fiat currencies such as the U.S. dollar. To monetize stablecoin reserves, some of the funds backing stablecoins are allocated to fixed-income securities such as short-term corporate debt and government-backed debt obligations that ensure that the funds remain redeemable and adequately backed.

Stablecoins are kept stable via a few basic mechanisms, including fiat backing, crypto backing, commodity backing, and algorithm backing, to be explained in the following sections.

c) What are the risks associated with the different methods? Centralization, Regulation, etc.?

The main risk or disadvantage associated with stablecoins is counterparty risk. Counterparty risk describes the likelihood that another party involved in an agreement might default. In this case, a stablecoin issuer may not have the reserves they claim to have or may refuse to redeem tokens for their reserves.

Stablecoins that rely on central entities and auditors are subject to human error, as audits may fail to spot inaccuracies or potential problems. Moreover, fiat currency-backed stablecoins are often held in commercial paper, a form of short-term unsecured debt. The use of commercial paper adds to the counterparty risk, as the company issuing that debt could default on its obligations.

Periods of market turmoil or failure to produce audits may also lead to risk premiums. Risk premiums represent the additional compensation investors get for the added risk of investing in an asset (i.e., stablecoins). The risk premiums lower the value of stablecoins compared with their peg, which means buying cryptocurrencies with stablecoins becomes slightly more expensive than with fiat currencies.

Algorithmic stablecoins can often lead to Ponzi schemes where new tokens are only created through new users depositing collateral. A Ponzi scheme is a type of fraud that generates returns for investors with funds from new investors and eventually collapses when new investors stop making investments. This means the value of these assets can quickly implode if new users stop coming.

Finally, the central entities issuing tokens may have the power to freeze them on addresses at the request of law enforcement. Law enforcement agencies may require tokens to be frozen even during investigations related to money laundering, counter-terrorism financing, or other illicit activities.

d) Does a stablecoin pegged to the official currency of your country exist yet?

Yet not!

Wallets

a) What types of wallets are you familiar with? How do they differ in terms of use case and security? Make a one-slide overview

I'm familiar with various types of cryptocurrency wallets, including software wallets like Metamask. Metamask is commonly used for Ethereum and ERC-20 tokens. It's user-friendly and widely used for decentralized applications (DApps) and DeFi projects. In terms of security, it offers good protection through private keys and seed phrases. I've personally used Metamask in a project and found it to be a secure and reliable choice.

b) Beyond personal wallets, how do institutions, organizations, or DAOs store and manage digital wallets?

Institutions, organizations, and DAOs typically store and manage digital wallets using various methods, including:

Cold Storage: They often use hardware wallets or air-gapped systems to store large amounts of cryptocurrencies securely, as these are offline and less vulnerable to hacking.
Multi-Signature Wallets: These wallets require multiple private keys to authorize transactions, providing added security by preventing a single point of failure.
Custodial Services: Many institutions use third-party custodial services that specialize in secure wallet management and provide insurance against theft or loss.
Security Policies: They implement strict security policies, access controls, and procedures to safeguard wallet access and prevent unauthorized transactions.
Audits and Compliance: Regular audits, compliance with regulatory standards, and continuous monitoring are crucial for maintaining wallet security and transparency.
Internal Protocols: Organizations often establish internal protocols and approval processes for cryptocurrency transactions to prevent unauthorized access and fraud.

These approaches help institutions and organizations protect their digital assets while ensuring operational integrity and compliance with regulations.