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Decentralised Finance in Blockchain-Based Financial Markets

Decentralised Finance (DeFi) is an interoperable, open and permissionless protocol stack that is built on public smart contract platforms to enhance existing financial services in a more open and transparent way. The Federal Reserve Bank of St. Louis, recently released a review on DeFi, a system that is independent of intermediaries and centralised institutions, and rather based on open protocols and decentralised apps (DApps). With DeFi, transactions are executed in a verified and secure manner and agreements are administered by code. Any legitimate state changes continue on a public blockchain, creating a financial system that is highly interoperable. Because DeFi consists of multiple highly interoperable protocols and applications, all transactions and data is open and readily available for users to analyse.
The Building Blocks of DeFi
Each layer of DeFi’s multi-layered architecture has a distinct purpose, allowing everyone to build on, rehash or use other parts of the stack. It is critical to note that these layers are only as secure as the layers below and if the settlement layer is compromised, all subsequent layers will not be secure.

Asset Tokenisation
Tokenisation is the process of adding assets to a blockchain and the representation of the asset is referred to as a token. The logic behind tokenisation is to create assets that are more accessible and transactions that are more efficient. Tokenised assets can be transferred seamlessly and within seconds worldwide. Tokenised assets can also be used in many decentralised apps and stored within smart contracts, creating a DeFi ecosystem.

Decentralised Exchange Protocols
1. Decentralised Order Book Exchanges
Decentralised order book exchanges use smart contracts to settle transactions but differ in how the order books are hosted, either on-chain or off-chain.
On-chain order books are entirely decentralised and every order is stored within the smart contract, requiring no need for additional infrastructure or third-party hosts. The disadvantage to this approach is that it becomes costly and time-consuming as every action requires a blockchain transaction and volatile markets will require frequent order cancellations. Off-chain order books only use the blockchain as a settlement layer and are hosted and updated by centralised third parties, called relayers. Relayers provide takers with the required information to select an order they need to match, without ever putting them in control of funds or executing orders. Their job is to simply provide ordered lists with quotes.
2. Constant Function Market Maker
A constant function market maker (CFMM) is a smart contract-liquidity pool that consists of at least two cryptoassets in reserve. Anyone is allowed to deposit tokens of one type and withdraw tokens of the other type. The exchange rate is determined by a smart contract-based liquidity pool that utilises variations of the constant product model and a price that is relative to the smart contract’s token reserve.
3. Smart Contract-Based Reserve Aggregation
Smart contract-based reserve aggregation is another approach to consolidate liquidity reserves through a smart contract. This allows substantial liquidity providers to connect and advertise prices for specific trade pairs. Prices will be compared from all liquidity providers, and the best offer will be accepted on behalf of the user and the trade will then be executed. This process acts as a gateway between liquidity providers and users, offering an atomic settlement.

4. Peer-to-Peer Protocols
Peer-to-peer protocols (P2P) or over-the-counter (OTC) protocols rely on a two-step approach, in which participants can query the network for counterparties looking to trade a given pair of cyrptoassets. The exchange rate is then negotiated bilaterally, and the trade is executed on-chain through a smart contract. P2P protocols offers can be accepted exclusively by the parties involved in negotiation. 

Decentralised Lending Platforms
Decentralised lending platforms are an essential part of the DeFi ecosystem and include a number of protocols that allow people to lend and borrow cryptoassets. The unique feature of decentralised loan platforms is that neither the borrower or lender need to identify themselves and anyone with access to the platform can borrow money or provide liquidity, in turn making DeFi loans completely permissionless. Loans can be secured with collateral that is locked in a smart contract and only released once the debt has been repaid.
1. Collateralised debt positions occur when DeFi applications allow users to create collateralised debt positions and issue new tokens that are backed by collateral. In order to create these tokens, the person must lock cryptoassets in a smart contract, and the number of tokens created depends on the target price of the tokens generated, value of cryptoassets and target collateralisation ratio. This loan can be used for consumption, offering user an opportunity to overcome a liquidity squeeze or acquire more cryptoassets for leveraged exposure.

2. Collateralised Debt Markets occur when users borrow existing cryptoassets instead of creating new tokens, requiring counterparties with opposing preferences. In the avoidance of risk and lender protection, loans must be fully collateralised with collateral being locked in a smart contract. Lenders and borrowers can be matched in a multitude of ways, through P2P and pooled matching. P2P matching is when the person that provides the liquidity lends the cryptoassets to specific borrowers and the lender will only begin earning interest once the match has been made. Pooled matching uses a variable interest rate that is based on supply and demand. Lenders begin earning interest when funds are deposited into the pool, however interest rates are a function of the utilisation rate of the pool.

Decentralised Derivatives
Decentralised derivatives are tokens that have value derived from the performance of an underlying asset, the outcome of an event or the development of any other observable variable. Typically an oracle is used to track these variables which offers centralised and dependency components. Asset-Based Derivatives is when its price is a function of the asset’s underlying performance. Event-based derivatives are when it’s price is a function of any observable variable that is not the performance of an asset.
Opportunities and Risks
DeFi can increase the efficiency, transparency and accessibility of the financial infrastructure and the composability allows individuals to combine applications and protocols that create new services. The risks associated with defi include smart contract execution risk, operational security and dependencies on external data and other protocols.
Fawne Taylor
Fawne Taylor

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