DIGITAL ASSETS ON THE MOVE
DeFi Apps Are Popular, But What Do They Currently Offer?
Open finance, or decentralized finance (DeFi) applications, is currently one of the hottest topics in the crypto space. We wrote an introduction to the DeFi space a few newsletters ago. Space is very active, with new applications emerging monthly and using one another to offer more convenient and new, previously impossible options for users.
The first building block of the DeFi system was DEX protocols, which enabled token exchange without the need for a centralized entity. They can also be automated and run in the background. The second building block was applications in the lending field. On-demand, permissionless asset borrowing enables other applications to offer more complex services, like financial products that enable leveraged long or short positions with the convenience of buying an ERC20 token. Below are some of the specific applications of DeFi apps.
MakerDAO enables users to issue debt in the form of the Dai stablecoin to themselves. Issued debt is overcollateralized, currently only with ether, but this will change in the future. Since the collateral has to be at least 150% of issued debt at all times, the loan is not directly comparable with traditional loans. Users can open up to 3x leveraged long positions or get some spendable funds without selling their initial ether position. In the first case, leveraged long positions can be synthetic, meaning users who issue Dai are long on ether in the first place. Additionally, they can buy any other asset with the proceeds, creating a diversified leveraged long position. In the second case, the user is confident enough that ether will increase in price, so he doesn’t want to sell it, but he still needs some money for ongoing costs. An example of this could be a DAO that stores capital in ether but needs some cash to pay for ongoing costs.
These two use cases are the main reasons to issue Dai, but when Dai is already issued, it offers other use cases to the rest of the ecosystem participants. Bearish users will buy Dai on the open market to hedge their position without a centralized third party, and different applications on the network will use Dai as a monetary unit. Augur recently announced that in version 2, users will be able to participate in prediction markets with Dai, ignoring the volatility of ether. Dai is becoming a building block of the DeFi system, but it also increases systemic risk.
Lending applications like Compound, Lever, and Nuo enable permissionless lending and borrowing between users. Suppliers of reserves earn interest while borrowers can construct interesting synthetic financial positions. The first and most important feature they enable is short selling. A financial market without short selling is incomplete, as traders can only speculate on asset price increases, while bears have no way of expressing their opinion with a financial position. Most ERC20 tokens did not have a short market prior to lending protocols. A short position constructed using these protocols can differ from a traditional short position because users can pick the type of collateral they want to deposit and define what they want to short the borrowed asset against. For example, a trader deposits BAT to Compound as collateral, borrows ether, and then short sells it into BAT. Effectively, he is shorting ETH against BAT, meaning his position is very specific, as he will profit if BAT outperforms ETH, even if they both appreciate against the dollar, not counting the interest rate. When Dai, which is pegged to the dollar, is used as collateral, the short position is similar to a margin short sell on Bitfinex or Poloniex. Users can also short sell Dai itself.
Prediction markets offer bets on different outcomes. These can be non-asset related markets such as who the 2020 Republican nominee for US president will be, or asset-related ones, enabling complex financial positions and tools for hedging. For example, the prediction market for ETH’s closing price on April 19, 2019 is a multiple-choice market, offering betting on the closing price at different levels—below $100, above $100, above $180, and so on. This enables users to hedge or even leverage their position by betting on the different outcomes. If a user bought ether at $100 and wants to partially hedge his position, he can simply bet that ether will close below $100, or he can bet that it will close above $100 and leverage his position.
Prediction markets also enable hedging against specific risks that are not directly related to hedging market risk. For example, a user who trades actively is always exposed to counterparty risk, such as the risk that an exchange they use will lose his funds or get hacked. Such a user could open a prediction market for whether the exchange will be hacked or not, enabling him to hedge against the specific risk he is exposed to. For another example, miners could hedge against difficulty increases and being squeezed out of profitability by betting that mining difficulty will increase above the point where he can profitably mine.
In theory, prediction markets offer many possibilities, but they are currently limited by liquidity, which is not very high, as well as participation—there is always the possibility that no one will want to participate on the other side of a particular market.
DEX and lending protocols enable even more complex derivatives protocols. They enable margin positions with the convenience of buying a token, meaning that when a user buys this token, smart contracts in the background interact with a DEX and with permissionless lending protocols on behalf of the user. For example, Expo, a derivatives DEX using the dYdX protocol for margin and derivatives trading, enables users to open a short or leveraged long ether position just by buying a derivative token representing this financial position. The system will execute all the required operations on the lending market and spot market in a single transaction, instead of the user having to make the deposit, borrow the asset, exchange it for another asset, and deposit it again.
Ethereum Development Conference in Full Swing
EDCON is an annual global conference series aiming to improve communication between Ethereum communities and promote Ethereum ecosystem development. This year’s conference opened yesterday in Sydney, with Karl Floersch and Vitalik Buterin rapping on stage. Their lyrics focused on the scaling and development of ETH 2.0, the next stage of the Ethereum roadmap. The conference will host nearly 100 speakers in total, representing mostly Ethereum and projects surrounding the Ethereum ecosystem.
We’ll write about any interesting announcements or developments from the conference in the next edition of our newsletter.