DeFi Protocols

Understanding Decentralized Finance

What is DeFi?

Decentralized Finance (DeFi) refers to financial services built on blockchain networks, primarily Ethereum. DeFi protocols aim to recreate traditional financial services like lending, borrowing, trading, and insurance in a decentralized, permissionless manner.

Core DeFi Concepts

🏦 Lending & Borrowing

Users can lend their assets to earn interest or borrow assets by providing collateral, all without traditional banks.

💱 Decentralized Exchanges (DEXs)

Automated market makers that allow users to trade tokens directly from their wallets without intermediaries.

🌾 Yield Farming

The practice of staking or lending crypto assets to earn rewards, often in the form of additional tokens.

🔄 Liquidity Mining

Providing liquidity to DeFi protocols in exchange for rewards, typically governance tokens.

Major DeFi Protocols

Let's explore some of the most influential DeFi protocols on Ethereum:

Compound - Lending Protocol

Compound is a decentralized lending protocol where users can supply assets to earn interest or borrow assets by providing collateral.

Key Features:
  • • Algorithmic interest rates based on supply and demand
  • • Over-collateralized borrowing
  • • Governance token (COMP) for protocol decisions
  • • cTokens represent supplied assets and accrue interest

Uniswap - Decentralized Exchange

Uniswap is an automated market maker (AMM) that enables trustless token swaps using liquidity pools instead of order books.

Key Features:
  • • Constant product formula (x * y = k)
  • • Liquidity providers earn trading fees
  • • No KYC or account creation required
  • • Governance token (UNI) for protocol upgrades

Aave - Advanced Lending

Aave is a decentralized lending protocol that offers both stable and variable interest rates, along with innovative features like flash loans.

Key Features:
  • • Flash loans for uncollateralized borrowing
  • • Interest rate switching between stable and variable
  • • Credit delegation for undercollateralized loans
  • • Governance token (AAVE) with staking rewards

Understanding AMMs (Automated Market Makers)

Automated Market Makers are the backbone of most decentralized exchanges:

How AMMs Work:

1. Liquidity Pools

Pools contain pairs of tokens (e.g., ETH/USDC) provided by liquidity providers.

2. Constant Product Formula

The price is determined by the ratio of tokens in the pool: x * y = k

3. Price Impact

Large trades cause price slippage due to the constant product formula.

4. Impermanent Loss

Liquidity providers may experience losses when token prices diverge significantly.

DeFi Token Standards

DeFi protocols rely on standardized token interfaces:

ERC-20 Tokens

The standard for fungible tokens, used by most DeFi protocols.

  • • Standard transfer functions
  • • Approval mechanism for spending
  • • Balance tracking
  • • Event logging

cTokens / aTokens

Interest-bearing tokens that represent supplied assets in lending protocols.

  • • Accrue interest over time
  • • Can be used as collateral
  • • Redeemable for underlying assets
  • • Tradeable on secondary markets

DeFi Risks and Considerations

While DeFi offers many opportunities, it also comes with significant risks:

Common DeFi Risks:

  • Smart Contract Risk: Bugs in smart contracts can lead to loss of funds
  • Impermanent Loss: Liquidity providers may lose money when token prices diverge
  • Liquidation Risk: Borrowers can be liquidated if collateral value drops
  • Governance Risk: Protocol changes through governance can affect users
  • Regulatory Risk: Changing regulations may impact DeFi protocols
  • Market Risk: High volatility in crypto markets affects all DeFi activities

Building DeFi Applications

When building DeFi applications, consider these key components:

// Example: Interacting with Compound
import { ethers } from 'ethers';

const compoundABI = [
  "function supply(address asset, uint256 amount) external",
  "function borrow(address asset, uint256 amount) external",
  "function repayBorrow(address asset, uint256 amount) external"
];

const compoundAddress = '0x3d9819210A31b4961b30EF54bE2aeD79B9c9Cd3B';
const contract = new ethers.Contract(compoundAddress, compoundABI, signer);

// Supply USDC to earn interest
const usdcAddress = '0xA0b86a33E6441b8c4C8C0C4C0C4C0C4C0C4C0C4C';
const amount = ethers.utils.parseUnits('1000', 6); // 1000 USDC
await contract.supply(usdcAddress, amount);

// Borrow ETH against USDC collateral
const ethAddress = '0x0000000000000000000000000000000000000000';
const borrowAmount = ethers.utils.parseEther('1'); // 1 ETH
await contract.borrow(ethAddress, borrowAmount);

DeFi Development Best Practices

Development Guidelines:

  • Security First: Always prioritize security over features
  • Audit Smart Contracts: Get professional audits before deployment
  • Use Established Libraries: Leverage OpenZeppelin and other battle-tested libraries
  • Test Thoroughly: Test on testnets with various scenarios
  • Handle Edge Cases: Consider extreme market conditions and edge cases
  • User Experience: Make complex DeFi operations user-friendly
  • Gas Optimization: Optimize for gas efficiency to reduce user costs

Summary

In this chapter, we've explored the world of Decentralized Finance:

  • • DeFi recreates traditional financial services on blockchain
  • • Major protocols include Compound, Uniswap, and Aave
  • • AMMs use mathematical formulas to determine token prices
  • • DeFi comes with significant risks that must be understood
  • • Security and user experience are crucial for DeFi applications

In the final chapter, we'll explore NFTs and token standards, learning about non-fungible tokens and their various use cases in the Ethereum ecosystem.