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2020: The year of DeFi

The decentralized finance or ‘DeFi’ sector has exploded in popularity in 2020, as new Defi coins like UMA, COMP, and BAL introduce the concept of an 'Initial DeFi Offering' - and move traders onto booming decentralized exchanges.

In 2020 the DeFi sector is booming and cryptocurrency users around the globe can make use of traditional financial services such as borrowing, lending, trading, and investing in a decentralized and transparent manner – with just an internet connection and a cryptocurrency wallet.

The rise of DeFi

Bitcoin (BTC) was the first implementation of decentralized finance. It enabled people to make financial transactions with other individuals without the need for a financial intermediary in the digital age. Bitcoin and similar cryptocurrencies were the first wave of DeFi.

The second wave of DeFi was enabled by the Ethereum blockchain which added another layer of programmability to its blockchain. Now in 2020, individuals (and businesses) can borrow, lend, trade, invest, exchange, hedge, and store cryptocurrencies in a trustless manner thanks to the growing number of decentralized finance applications on the Ethereum network.

According to data compiled by DeFi Pulse, the US dollar value of ETH locked in DeFi protocols has grown from $674 million at the start of January to over $8.2 billion today – a 1116% increase in just over eight months. Compare this to 2019, when the value of ETH locked in DeFi protocols grew by just 130 percent over the course of the year, from $293 million to over $687 million.

Eth locked in Defi

What does the DeFi market offer today?

Today, there is a wide range of DeFi apps available that provide much of what the traditional, centralized financial system provides. From borrowing and lending to investing and insuring, the largely Ethereum-powered DeFi market caters to many of the most pressing financial needs of the individual.

The DeFi market’s current key offerings include:

  • Earning interest on cryptocurrency has become easier than ever, thanks to the Compound protocol and DApps like Dharma and Celsius.
  • Converting your ETH to other Ethereum tokens can be done securely and privately decentralized exchanges such as Uniswap or IDEX.
  • Hedging your cryptographic asset portfolio is now possible thanks to decentralized derivatives trading platforms, such as dYdX.
  • Insuring yourself against the failure of smart contracts has become possible thanks to Nexus Mutual.
  • Betting on the outcome of elections, sporting events or whether John McAfee’s bitcoin price prediction will come true can be done on prediction markets platforms, such as Augur.
  • Storing funds in crypto-backed stablecoins during times of extreme market volatility is now as easy as buying DAI.

DeFi in 2020

The DeFi sector has continued to grow in popularity in 2020. DeFi applications and products include borrowing and lending protocols such as Compound and Synthetic asset builders such as UMA.

Increasingly DeFi projects like these are choosing to launch their native tokens or ‘DeFi coins’ on Decentralized Exchanges (Dexes), which allow tokens to launch without having to pay the hefty listing fees charged by centralized exchanges. They are permissionless – allowing any DeFi builder to make use of a publicly available trading infrastructure to launch tokens via decentralized smart contracts.

Liquidity pool based platforms like Uniswap have increasingly become the system of choice for distributing this new class of DeFi tokens, and trade volume on these decentralized exchanges has boomed in 2020. Uniswap uses an alternative method to settle cryptocurrency trades. Instead of pairing up buyers and sellers, tokens are bought and sold at a rate determined by a bonding curve. With this mechanism as tokens are purchased, the price goes up. As tokens are sold, the price goes down. In both cases, the exchange rate is determined by a supply curve instead of a market of orders placed by buyers and sellers.

New DeFi Coins 2020

The new DeFi coins are often governance tokens, that confer token holders the right to vote on, and thus manage, the direction of an underlying protocol. This has become an increasingly valuable commodity in the growing DeFi sector with a number of DeFi governance tokens enjoying periods of bullish price performance in 2020. These tokens allow DeFi protocols to hand over governance rights to token holders allowing the protocols to operate without a central power-broker and in a decentralized form. With a governance token, the community of token holders supply decision-making apparatus and earn rewards for their services.

DeFi coins can also launch with distribution schemes where tokens are allocated to users who have provided services such as liquidity provisions to the platform, or, where users are incentivized to provide services to the platform in order to earn tokens set to be allocated in the future. In many cases such as with Compound and the COMP token, the Initial DeFi Offering (IDO) may be issued by protocols that have finished products with a history of activity on the Ethereum mainnet. Unlike with the Initial Coin Offering (ICO) or Initial Exchange Offering (IEO) model, many IDOs launch to an existing community of users who may already have a stake in the governance of the platform.

UMA Protocol

In December 2018 the UMA Protocol (“Universal Market Access”) decentralized financial contracts platform launched. The UMA Protocol specializes in powering priceless synthetic tokens, which are collateral-backed ERC20 tokens that can track anything without needing a continuous on-chain price feed from an oracle. In May 2020 the project launched its first synthetic token ETHBTC, The token tracks the ETH/BTC price ratio, allowing investors the ability to short or long the ether price against bitcoin.

In April 2020, UMA Protocol announced plans to launch a new governance token called UMA via for an initial Uniswap listing or Initial DeFi Offering. The token was created to give holders the ability to govern important parameters of the UMA Protocol, as well as the ability to help resolve contract disputes by fulfilling price requests through the project’s Data Verification Mechanism (DVM). The UMA network pays an inflationary reward to token holders that participate in governance and respond accurately to price requests. This reward is not paid to token holders that do not participate, penalizing inactive participants.

To launch the UMA, the project’s backers took 2 million UMA tokens which was 2% of the starting 100 million UMA supply and opened up a Uniswap liquidity pool. The team added approximately $535,000 worth of ETH to the pool. This gave $UMA an initial price of around $0.26.

The bonding curve model used by Uniswap, meant as early investors lined up to purchase the UMA token, its price quickly moved up. Additionally, some UMA traders decided to front-run others by paying higher gas costs. This led to the UMA price jumping to more than $2.00 only minutes after its launch, before stabilizing at around $1.20, which made some buyers complain about getting a higher price than pre-sale investors. The token currently trades for USD17.24.

Compound

The Compound platform was released for the Ethereum mainnet in September 2018. Its whitepaper describes Compound as a platform built on the Ethereum (ETH) blockchain that establishes money markets, “which are pools of assets with algorithmically derived interest rates, based on the supply and demand for the asset.”

Suppliers and borrowers of assets on the Compound platform interact directly with the protocol. platform. Users earn or pay a floating interest rate and do not have to negotiate terms such as maturity, interest rate, or collateral with a peer or counterparty. Supplied asset balances are represented by cTokens or Collateral tokens. These tokens are unique to Compound but conform to ERC20 smart contract token standard. cTokens represent an underlying asset which users will earn interest on, and serve as a representation of collateral used for a loan.

The COMP coin was unveiled in February 2020 and it was released as a means to distribute power to the Compound community from Compound’s builders, who maintained from the start that COMP wasn’t a “fundraising device or investment opportunity.” Using the token’s governance mechanism, any user can propose a change to the Compound protocol. Changes might include adding new assets, changing the model for setting a given asset’s interest rate or sunsetting an asset.

A proposed governance change will only go to a vote if 1 percent of the total supply of COMP tokens signals that it should do so. From there, the full process from voting to code change takes several days.

In May 2020, Compound’s creators outlined an initial COMP token distribution scheme that entailed setting aside more than 4.2 million of the 10 million total COMP supply into a “Reservoir” contract. For every block executed on the Ethereum chain, 0.5 COMP gets automatically and proportionally distributed among Compound’s borrowers and lenders. 0.25 COMP is allocated to the suppliers of the asset, and 0.25 COMP is allocated to the borrowers of the asset. The distribution of COMP was allocated proportionally to interest paid/received. Initially, the distribution was allocated to each individual money market and was proportional to the interest being accrued. As market conditions changed and assets on Compound become more or less popular, the allocation of COMP between assets changed too.

This model created issues as users began to manipulate the allocation system through yield farming. Users began to identify markets with a high maximum interest rate such as BAT; they would borrow all liquidity, maximizing borrowing costs for all users, and supply the same asset from a second account. The extreme interest cost to borrow is offset by supply income on the other side. This model began to create issues with the gap between the cost of yield farming COMP and the price of COMP on the market beginning to widen dramatically.

In July the rules for the COMP distribution changed. The same amount of COMP would still be distributed daily to users. However, under the new rules, users will simply earn COMP on the dollar value of assets they have put in or borrowed from the system. The upgrade removed interest from the allocation of COMP across markets and instead allocates COMP proportional to borrowing demand. “By distributing on the basis of total borrowed, the incentive to self-deal in niche asset pools largely dries up, and we’re likely to see much of this capital (particularly the BAT market) flow out of the protocol,” said Brendan Forster of Dharma.

Balancer

Launched in March 2020, Balancer is an Ethereum asset management protocol that uses a flexible automated market maker (AMM) protocol to open up liquidity pools that are not constrained by the 50/50 two-token split liquidity model used by platforms like Uniswap. Instead, Balancer supports customizable pools that can be made of up to eight ERC20 tokens.

Within an eight asset pool, users can swap between assets with the AMM setting the price and custom trading fees set by the creator of the pool. Every Balancer pool has its own customized pool swap fee; whenever a user performs a trade that utilizes the pool’s liquidity, this fee is distributed equally to that pool’s liquidity providers. So when you provide liquidity not only are you earning this fee, but you’re also earning BAL

In May 2020, Balancer Labs publicly proposed the BAL governance token, which was created to “decentralize and diversify governance of the Balancer Protocol”.

Of a total supply, 25 million BAL tokens were proposed to be allocated to Balancer’s founders and key contributors, while 75 million tokens were allotted to be distributed to liquidity providers who would be able to earn BAL tokens by supplying liquidity to Balancer pools.

145,000 BAL were slated to be distributed to Balancer liquidity providers weekly, which equates to roughly 7.5 million BAL a year in so-called liquidity mining potential. BAL tokens for liquidity are allocated proportionally to the amount of liquidity each address and its contribution relative to the total liquidity on Balancer. Since liquidity in Balancer pools is made up of several different tokens, the total USD value of liquidity was used as the common measure.

A unique mechanism of the BAL token distribution is that it is designed to incentivize pools to have low pool swap fees. The USD value of each pool is multiplied by a variable called a feeFactor to determine how many BAL the pool is eligible to receive. The higher the fee, the lower this feeFactor is, and the less BAL tokens that a pool’s liquidity providers will receive each week. The logic is that pools with lower fees pull in more users willing to trade on Balancer and so these pools should receive greater rewards.


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