DeFi Protocols

Decentralized Finance (DeFi) protocols are financial applications built on blockchain technology that aim to recreate and improve traditional financial systems in a decentralized manner. This section presents the mechanics behind the major DeFi categories: decentralized exchanges (DEXs) and their aggregators, lending protocols (also referred to as interest-rate protocols or protocols for loanable funds), crypto-backed stablecoins (also referred to as collateralized debt positions) with other classes of stablecoins, bridges (wrapped tokens) and liquid staking protocol (liquid staking tokens/derivatives).

Pegged Tokens

Pegged tokens are a category of cryptocurrency where the value of the token is tied to the value of another asset. This "peg" can be to a fiat currency, a commodity, or another cryptocurrency.

• Liquid Staking Tokens: These are synthetic assets that track the value of tokens staked in Proof-of-Stake blockchains, allowing users to participate in staking benefits without locking their tokens. Key topics include:

  • Rebase Tokens: Tokens that keep a 1:1 peg to the staked tokens and inflate supply to reflect staking yield (e.g., Lido's stETH).

  • Reward-bearing Tokens: Tokens that increase in value relative to the underlying staked token to reflect staking yields.

  • Dual Token Model: Uses two tokens, one pegged 1:1 to the staked token and another reflecting staking rewards.

  • De-Peg Risk: The risk that the liquid staking token loses its peg to the value of the underlying staked asset.

• Bridges and Wrapped Tokens: Bridges enable the transfer of tokens between different blockchains. They create wrapped tokens, pegged to the value of tokens on other blockchains. Key topics include:

  • Wrapped Tokens: Represent tokens from other blockchains (e.g., Wrapped Bitcoin on Ethereum).

  • Blockchain Interoperability: The ability to transfer assets and data between different blockchains.

  • De-Peg Risk: The risk that the wrapped token loses its peg to the original token's value.

• Stablecoins: Tokens designed to maintain a stable value, usually pegged to a fiat currency like the US dollar. Key topics include:

  • Fiat-Backed Stablecoins: Collateralized by fiat currency held outside the blockchain.

  • Crypto-Backed Stablecoins: Collateralized by other cryptocurrencies held on the blockchain.

  • Algorithmic Stablecoins: Maintain price stability by algorithmically adjusting supply.

  • De-Peg Risk: The risk that the stablecoin loses its peg to the target fiat currency.

  • Collateralized Debt Position (CDP): Users provide crypto collateral to borrow stablecoins.

Liquidity Pools

Liquidity pools are reserves of tokens locked in a smart contract that facilitate trading, lending, and other financial operations in a decentralized manner. These pools power many DeFi protocols, particularly Decentralized Exchanges (DEXs) and Interest-Rate Protocols.

• Interest-Rate Protocols: Facilitate the lending and borrowing of digital assets. Lenders provide capital to liquidity pools from which borrowers can access loans. Key topics include:

  • Interest Rate Models: Determine how interest rates are calculated based on factors like utilization rate (linear, non-linear, kinked rates).

  • Over-Collateralization: Borrowers need to post collateral worth more than the loan amount to mitigate default risk.

  • Liquidation Risk: Borrowers' collateral can be automatically liquidated if its value falls below a certain threshold.

  • Flash Loans: Uncollateralized loans that must be repaid within the same transaction block.

• Decentralized Exchanges (DEXs): Allow users to swap digital assets without intermediaries, with settlement occurring on the blockchain. Key topics include:

  • Automated Market Maker (AMM): Algorithmically determine the price of tokens in liquidity pools based on supply and demand.

  • Constant Function Market Makers (CFMMs): Various mathematical formulas used by AMMs, including Constant Product Market Maker (CPMM), Constant Mean Market Maker (CMMM), Stableswap Invariant, and Cryptoswap Invariant.

  • Concentrated Liquidity: Allows liquidity providers to focus their capital within specific price ranges, increasing capital efficiency.

  • Slippage: The difference between the expected price and the actual price executed due to price fluctuations.

  • Impermanent Loss: Potential losses for liquidity providers due to changes in the relative prices of tokens in a pool.

• Perpetuals: Derivatives contracts that allow users to speculate on the price of an asset without owning it, with no expiration date. Key topics include:

  • Virtual AMMs (vAMMs): Similar to AMMs but used for price determination and collateral liquidation in perpetual contracts.

  • Leverage: Users can amplify potential profits and losses by trading with borrowed funds.

Aggregators

Aggregators are protocols that connect to and interact with multiple other DeFi protocols, aiming to optimize certain processes. Two main types of aggregators discussed in the sources are:

• DEX Aggregators: Collect data from multiple DEXs to offer users the best possible prices for their trades and optimize trade routing.

• Yield Farming Aggregators: Automate the process of yield farming by strategically allocating users' capital to different DeFi protocols to maximize returns. Key topics include:

  • Yield Farming: Providing liquidity to DeFi protocols to earn fees and other rewards.

  • Simple Lending: Depositing tokens in interest-rate protocols to earn interest.

  • Leverage Borrow: Borrowing additional assets using existing deposits as collateral to amplify potential yields.

  • Liquidity Provision: Supplying tokens to liquidity pools on AMM-based DEXs to earn trading fees.

DeFi protocols are financial applications built on blockchain technology that aim to provide open and transparent financial services. Pegged Tokens, like Liquid Staking Tokens, Wrapped Tokens, and Stablecoins, derive their value from underlying assets. Liquidity Pools, such as Interest-Rate Protocols and Decentralized Exchanges, utilize capital from Liquidity Providers to facilitate borrowing, lending, and token swaps. DEX Aggregators search across multiple decentralized exchanges to find the best trade prices for users. Yield Farming Aggregators automate the process of earning rewards by allocating capital to different protocols, employing strategies like Simple Lending, Leverage Borrowing, and Liquidity Provision. These DeFi protocols, while offering innovative financial tools, also come with unique risks, including De-Peg Risk, Liquidation Risk, Impermanent Loss, and the potential for MEV Attacks.