Note: This article represents the author’s archaeological research on DeFi at the current stage, and there may be errors or biases. It is intended for informational purposes only and is open to corrections and discussions.

Introduction

Most people came into contact with DeFi during the DeFi Summer of 2020. I think there are several reasons why DeFi suddenly became popular.

1.No need to rely on third parties.

DeFi, like Bitcoin, does not need to rely on any third party (except Oracle). Users only need to access the encrypted wallet and sign to complete transactions on the entire chain. As long as the smart contract is safe, no one can take away the users’ assets, Notyourkey, Notyourcoin. Believe that veteran investors who experienced the Mt. Gox theft incident and players who went through the recent tragedy of FTX misappropriating user assets can better understand this lack of trust.

2.Market demand increases.

Before the occurrence of DeFiSummer, there was a huge demand for liquidity around the world. The low interest rates in the traditional financial system and the global liquidity easing policy led to funds looking for higher yield opportunities. DeFi offers a viable alternative, attracting massive inflows with higher interest rates and more investment opportunities.

Better protect personal privacy.

DeFi requires no or only a small amount of KYC. DeFi platforms are built on blockchain technology and execute transactions and protocols through smart contracts. Unlike traditional financial institutions, DeFi does not have a centralized management agency or intermediary, but is automatically executed by codes and protocols. This decentralized nature makes it impossible for DeFi platforms to directly collect and manage users’ personally identifiable information, making it impossible to conduct KYC procedures common in traditional financial institutions. There are indeed many alpha opportunities on pure chains, and those who can seize these opportunities are professional players. Professional players do not want to expose their strategies and personal information, so DeFi is indeed the best choice for these players. The threshold is lower and it is permissionless.DeFi has indeed solved some problems and deficiencies in the traditional financial system to a certain extent. For example, anyone can list your token on Uniswap, which greatly improves the breadth of transactions. As long as people have trading needs for a certain token, they can be satisfied on DeFi without having to wait for a centralized exchange to go through multiple reviews to select the currency.

Code auditability.

DeFi projects are usually open source and their smart contract code can be audited and verified by anyone. This openness and transparency allows people to inspect the code to ensure there are no hidden malicious behaviors or risks. In contrast, the back-end programs of traditional financial institutions are relatively closed source, and people cannot directly audit their internal operations.

Highly interoperable.

Different protocols and platforms in the DeFi ecosystem can connect and cooperate with each other to form a seamless financial network. Because of this, the DeFi community usually tends to maintain the principles of openness and interconnection to promote more innovation and development.

But DeFi also has some problems:

Lack of liquidity. Compared with the liquidity of centralized exchanges, DEX still has a lot of room for improvement. According to the latest data from theblock.co on October 16, 2023, DEX spot trading volume in the past month was only 13.45% compared to CEX spot trading volume in the same period last year. In addition, the lack of liquidity brings about the problem of excessive transaction slippage. For example, spending 1500 USDT on CEX can buy 1 tokenA, but in the liquidity pool on the chain with poor liquidity, the same 1500 USDT can only be used to buy 0.9 tokenA, and one transaction is equivalent to a 10% drop.
Transaction fees are high. Because DeFi transactions are conducted on the chain, they will be subject to the performance and storage space of the public chain. For example, Uniswap’s transaction fees may rise sharply due to congestion on the Ethereum main network. For example, I’ve had an experience where a regular transaction incurred a fee as high as $200, which really felt like a discouragement.
Fewer features. Compared to the extensive services offered by centralized exchanges, such as grid trading, dollar-cost averaging robots, and customized financial products, DeFi’s current operations are still quite basic and decentralized. It mainly includes simple swap transactions, liquidity mining, staking, farming, etc. The user experience is subpar. DeFi’s user experience is much worse than that of mature CEX (Centralized Exchanges). For example, transactions take a few seconds, the signature process is not straightforward, terminology is inconsistent, and the product flow logic is not smooth. However, this issue is relatively manageable because as standards gradually unify, many front-end codes and product logics can be developed into mature and user-friendly templates. At that point, various platforms will be quite similar.

In the past: The history of DeFi can be traced back to the day when Bitcoin (BTC) was introduced. Since then, people have been hoping to conduct transactions in a decentralized manner, and various innovations in on-chain finance have emerged. Due to the limited programmability of BTC, people did not explore this path too much. Later, with the advent of Ethereum, the imagination space expanded, and many projects started raising funds in the form of ICOs. After the establishment of the ERC-20 protocol, the flow of on-chain assets became more abundant, leading to the emergence of a series of innovative financial products. Now, let’s dig into the history and explore the challenging journey of DeFi, as well as the remarkable innovations made by various products and personalities.

The earliest discussions about decentralized finance can be traced back to July 2013. At that time, JR.Willett, the founder of Mastercoin, initiated the first ICO on the bitcointalk forum. He declared that only those who participated in the donation could enjoy new features such as decentralized trading and distributed betting that surpassed Bitcoin. This initiative successfully raised 4,740 Bitcoins, valued at $500,000 at the time. In 2014, Robert Dermody and others co-founded the Counterparty Protocol, a peer-to-peer financial platform and distributed open-source network protocol built on the Bitcoin blockchain.

The problem it solves: Counterparty allows users to create their own tokens on the Bitcoin blockchain. Counterparty has a native currency called XCP, which is produced from Bitcoin through a “proof-of-burn” mechanism. Counterparty provides financial tools, such as derivatives, that Bitcoin cannot offer. Overstock.com once used Counterparty to trade traditional securities on the blockchain. Counterparty also created a decentralized asset exchange where various digital assets can be traded. Users can utilize the counterparty node software and the Counterwallet web wallet for Counterparty transactions. Counterparty has implemented something similar to smart contracts and dApps on Bitcoin. It offers an open-source and decentralized platform for conducting financial activities without relying on any central authority. Several well-known NFT projects, such as Spells of Genesis and Rare Pepe, are built on the Counterparty platform. In summary, the Counterparty protocol leverages the Bitcoin network and technology to address financial products and services that Bitcoin itself cannot provide, making it a more comprehensive decentralized finance platform. Moreover, the Counterparty protocol is still alive today, making it one of the oldest and most famous decentralized finance (DeFi) platforms.

On September 15, 2015, Gnosis founder Martin posted his thoughts on how to combine MarketMaker and OrderBook on his own forum.This is also the earliest post I have found about decentralized prediction markets. Gnosis is a decentralized prediction market built on the Ethereum protocol. It provides an open platform for people to predict the outcome of any event, greatly simplifying the creation process of customized prediction market applications. At the same time, Gnosis uses the characteristics of blockchain trust machines and automatic execution of smart contracts to allow players to enter the prediction market more flexibly and freely, bringing greater room for imagination to the prediction market. By the way, thisMartin is very powerful, and the following GnosisChain (formerlyxDaiChain), Balancer, SAFE wallet and CowSwap are all related to him.

On October 27, 2015, Gnosis founder Martin initiated another discussion on his community forum, addressing how to provide a certain amount of funds for the newly created PredictionTopic to ensure the normal operation of the market. This could be achieved through project funding or by collaborating with other investors or foundations to secure financial support. The post emphasized the importance of community involvement. It can be said that this is one of the earliest discussions I discovered during my archaeological research on how to attract more liquidity and participation.

On September 26, 2016, Nick Johnson, the Chief Developer of Ethereum and ENS, posted a concept on Reddit for a decentralized exchange called Euler. The main points included:

Euler allows users to purchase Euler coins with different types of tokens.

Euler holds these tokens, and the quantity of tokens determines how many Euler coins users can exchange.

The purchase of the first Euler coin requires 1 token, the second requires “e” tokens, the third requires “e^2” tokens, and so on. Prices for each Euler coin increase exponentially.

When adding a new token, a collection phase is initiated. Users can submit bids to provide the new token for exchanging with Euler coins, and the initial price of the new token is determined during this phase.

The total value of Euler coins should equal the total value of all tokens held by Euler. This design aims to resist the impact of individual token price fluctuations on its value to some extent.

A mechanism should be established to quickly halt the purchase of a token that is deemed to be compromised to prevent its excessive issuance for cashing in other tokens.

In summary, this system is designed to be simple and decentralized, marking the beginning of the Automated Market Maker (AMM) era, although there are economic impacts that need further investigation.

On October 3, 2016, Vitalik posted an article on Reddit, inspired by Nick Johnson and referencing some emerging decentralized exchanges (DEX) at the time. In this post, he proposed a new approach to operating decentralized exchanges using a “chain-based automated market maker” mechanism, similar to prediction markets. This approach eliminates the need for placing and canceling orders, as seen in traditional exchanges.

Users can “invest” in this market maker, increasing depth (DEPTH) and earning a share of the profits, thereby reducing the market maker’s risk. This method significantly reduces spreads compared to traditional exchanges, and transactions only require on-chain processing during actual trades, eliminating the need for order placement and cancellation.

The post also raised concerns about stopping purchases when adding new tokens and when prices fluctuate significantly. Subsequent discussions explored supporting multiple assets, and considerations regarding fees when investors contribute or withdraw. It can be said that this post laid the foundation for Automated Market Maker (AMM) type decentralized exchanges, marking the beginning of a market worth billions of dollars.

In June 2017, EtherDelta officially launched and began operations, becoming the first decentralized exchange on Ethereum to obtain regulatory approval. This recognition was achieved because EtherDelta had completed registration procedures with the U.S. Securities and Exchange Commission (SEC) well before its official launch. In fact, as early as June 23, 2016, EtherDelta’s founder, Zachary Coburn (Zack), had submitted the first commit on Github. EtherDelta holds the distinction of being the first decentralized exchange to register with the U.S. Commodity Futures Trading Commission (CFTC).

Overall, EtherDelta became the first Ethereum decentralized exchange (DEX) in 2017 due to its key advantages: achieving a purer form of decentralization, low entry barriers, strong anonymity, low costs, and stable performance. The technical principles of EtherDelta are as follows: it utilizes smart contracts to implement an order book trading system. Users can publish, cancel, and match buy/sell orders through the trading contract. Order book information and transaction records are stored on the Ethereum blockchain, enabling decentralized trading. Users can access the EtherDelta website through web browsers or mobile devices without the need to download a dedicated application. The EtherDelta website interacts with the EtherDelta smart contract using JavaScript, retrieving order book information and facilitating trades with counterpart users. When users publish or cancel orders, they need to broadcast the transaction to the Ethereum network and pay gas fees. Upon the counterparty’s click on an order, the trading contract automatically deducts the buyer’s assets and sends them to the seller, realizing on-chain transactions. Smart contracts record each transaction, including involved account addresses, traded token types, and quantities. User assets are always kept in their own wallets and are not controlled by EtherDelta’s services. EtherDelta charges a 0.3% transaction fee, entirely borne by the buyer. The entire transaction process ensures decentralization and transparency but relies on the performance of the Ethereum network.

Some drawbacks of EtherDelta include the manual operation required in the order matching process. Traders need to manually search for orders on the website to see if they meet their requirements. Once a suitable order is found, they must manually match it with the counterparty’s order. This means that at the same point in time, both parties need to reach a consensus on the price manually. In summary, the entire process requires manual intervention and cannot be automated. The order matching process is slow. After placing an order, users may have to wait a long time for it to be executed because Ethereum’s processing speed is inherently slow, and liquidity is not strong. Gas fees may be wasted. Due to the high latency of the EtherDelta order book, some takers may overlook each other’s orders. This could lead to multiple takers competing to match with the same maker order, resulting in order failures, delays, and all recipients except the winning one wasting gas fees. Later, EtherDelta also faced some scrutiny, such as the former CTO being accused of internal trading issues. For details, refer to the lawsuit published by the U.S. SEC on November 8, 2018. The conclusion drawn in the report is that certain digital assets, such as ERC-20 tokens, are considered securities and can be regulated by the SEC. The SEC stated that all platforms trading such assets need to register with the SEC as securities exchanges, which EtherDelta failed to do.

While Coburn did not formally confirm or deny the SEC’s allegations, he agreed to settle with the regulatory agency, paying $300,000 in disgorgement, a $75,000 penalty, and $13,000 in pre-judgment interest. To establish Zachary Coburn’s personal responsibility, the U.S. Securities and Exchange Commission (SEC) demonstrated that EtherDelta violated securities laws, and Coburn caused EtherDelta to violate the Securities Exchange Act, knowing or should have known that his actions would lead to EtherDelta’s violation of securities laws. EtherDelta faced misfortune as it registered with the U.S. Commodity Futures Trading Commission (CFTC) but failed to register with another significant U.S. regulatory body, the Securities and Exchange Commission (SEC). EtherDelta’s registration with the CFTC was primarily due to its consideration that it traded mainly in cryptocurrencies rather than financial securities. However, the SEC later issued guidance classifying many tokens as securities, theoretically requiring EtherDelta to register with the SEC. At that time, regulations from the SEC regarding blockchain innovations were not explicitly defined, and EtherDelta did not proactively register with the SEC.

There is a rather dramatic story of internal team conflicts within EtherDelta, including the creation of a fork called ForkDelta. Due to centralized equity disputes, EtherDelta even became the first decentralized exchange to exit the scene. A rough timeline of events is as follows: In early 2018, the EtherDelta founding team sold the platform to Chinese businessman Chen Jun. According to a document exposed with a signing date of December 15, 2017, EtherDelta underwent an equity transfer, preparing to raise ETH (Ether) in the market. On February 9, 2018, the team issued a statement mentioning technical upgrades on EtherDelta. On February 18, media reported that EtherDelta had suspended trading. On February 19, the foreign founding technical team, after selling the EtherDelta platform and obtaining funds, forked the EtherDelta project and launched the new “ForkDelta” trading platform. On February 21, 2018, EtherDelta suspended trading again, and the actual controller Chen Jun was reported to have disappeared.

The era of AMM officially began with Bancor Protocol’s launch on June 12, 2017. Through an ICO that raised $153 million, Bancor’s most significant innovation was introducing the AMM mechanism into the decentralized exchange (DEX) space. This addressed a series of challenges in decentralized trading, laying the foundation for AMM applications within the Ethereum ecosystem. Unlike the traditional method of matching buy and sell orders in an order book, Bancor utilized liquidity pools to solve pricing and matching issues, allowing users to trade without waiting for counterparties.

On September 29, 2017, IDEX, co-founded by brothers Alex Wearn and Philip Wearn, officially launched its beta version. However, the project’s source code was initially uploaded to Github in January 2017. The year 2017 marked the peak of the ICO bubble, with numerous projects emerging, varying widely in quality. As the ICO market cooled down, token holders sought ways to liquidate their assets. Mainstream exchanges at the time were not decentralized, involving third-party entities and associated risks. This situation provided an opportunity for IDEX. Emulating the Counterparty protocol built on Bitcoin, IDEX implemented decentralized trading on the first generation of the Ethereum blockchain. Users could trade various Ethereum and ERC-20 standard tokens on IDEX, avoiding the need to trust third-party organizations and institutions.

IDEX is known for its speed. It employs an offline order matching system, offering faster transaction speeds than EtherDelta and providing a user experience similar to centralized exchanges. It prioritizes high security, relying on smart contracts to ensure that user assets are not controlled by intermediaries, resulting in lower risks. With comprehensive functionality, IDEX supports features such as immediate cancellation of unfilled orders (free of charge, as it is done off-chain) and market orders, enhancing ease of use. It also supports a variety of tokens, with over 200 ERC-20 tokens available for trading since its launch in 2017.

The platform boasts low transaction fees, charging only 0.3%, making it more cost-effective compared to other decentralized exchanges. IDEX emphasizes high anonymity, initially not requiring user identification, making it suitable for privacy-conscious users. However, during its early days, the overall DEX ecosystem was still in its infancy, with low trading volumes. In 2017, IDEX recorded approximately $50 million in total trading volume for the entire year, indicating the immaturity of decentralized exchange products and the need for continuous improvement in product offerings and user experience.On November 8, 2018, an article summarized IDEX as a leading DEX at that time.

MakerDAO, launched in December 2017, introduced several key innovations. These include low volatility through the introduction of the stablecoin Dai, which is pegged to the US dollar, reducing price volatility risks. MakerDAO’s decentralized model, utilizing smart contracts and collateral assets, mitigates risks associated with centralized institutions and allows direct user participation and control over the system. The platform also embraces transparency and autonomy through the decentralized autonomous organization (DAO) model, enabling MKR token holders to participate in decision-making and platform governance, thereby enhancing system transparency, community involvement, decision fairness, and overall reliability.

KyberNetwork, launched on February 26, 2018, introduced several key innovations:

Instant Exchange: KyberNetwork enables users to perform direct token-to-token exchanges without the need for traditional exchanges. Users can execute transactions directly through Kyber Networks smart contracts, eliminating the necessity of buying and selling on centralized exchanges.

Decentralized Liquidity Pools: KyberNetwork introduced decentralized liquidity pools that aggregate funds from multiple participants, creating deeper and more liquid markets. These liquidity pools are provided by users holding specific tokens and are managed through smart contracts.

Best Price Execution: KyberNetwork automatically selects the best prices and liquidity sources through smart contracts to execute trades. This ensures users obtain the most favorable exchange rates without the need to compare and choose among multiple exchanges.

Flexible Integrations: KyberNetwork offers open APIs and smart contract interfaces, facilitating seamless integration for other decentralized applications (DApps) and services to leverage KyberNetwork’s liquidity.

0x Protocol, launched in May 2018 with an ICO raising $24 million, addresses the following issues and introduces key innovations:

Open-Source Decentralized Trading Protocol and API: 0x provides an open-source decentralized trading protocol and API, supporting DApps in building on top of it, thereby reducing development barriers and integration costs.

Positioned as a Settlement Layer for Decentralized Trading: 0x positions itself as a “settlement layer” for decentralized trading, serving as infrastructure upon which various types of platforms can be built, including eBay, Amazon, order book DEX, and those with the granularity and control of order flow familiar to traditional financial giants.

Support for Arbitrary ERC20 Token Trading: 0x supports trading of any ERC20 token pairs, not limited to just two types of tokens.

Economic Incentive Model Using Governance Token ZRX: 0x adopts an economic incentive model based on the governance token ZRX.

0x Mesh Network for Relay Nodes: 0x Protocol builds the 0x Mesh network, connecting various relay nodes.

In addition, 0x Protocol developed the consumer-oriented DEX aggregator Matcha, utilizing 0x API and smart order routing to aggregate liquidity and provide optimal trade execution. Subsequently, other DEX aggregators have emerged, leveraging on-chain liquidity aggregation, similar to wholesalers sourcing goods from different factories and selling them together to earn a margin.

Compound, launched in September 2018, saw its Total Value Locked (TVL) surpassing $100 million for the first time in 2019. The key innovations of Compound include:

Introduction of Digital Asset Lending to the Ethereum Ecosystem: Compound pioneered cross-asset lending on Ethereum, becoming the first protocol to facilitate lending for both ETH and ERC20 tokens. Without the need for physical collateral, users can simply deposit digital assets into smart contracts to access loans, significantly lowering the cost threshold for obtaining loans.

Interest Rate Market-Driven Mechanism: Compound dynamically adjusts interest rates for different assets in real-time based on supply and demand, ensuring market equilibrium. This mechanism supports multiple mainstream stablecoins and token lending, such as USDC and DAI, offering users greater flexibility.

Direct Use of Borrowed Assets: Borrowed assets can be used directly without the need for settlement, streamlining the lending process. Users can repay loans and retrieve collateral at any time.

Open and Non-Custodial APIs: Compound provides open and non-custodial APIs, greatly facilitating the application of lending services across DApps.

Implementation of Simple and Auditable Smart Contracts: Compound utilizes smart contracts that are easy to operate and audit, contributing to the global surge of DeFi. In essence, Compound leverages digital assets and blockchain technology to offer users worldwide convenient and efficient decentralized lending services. It addresses the cost efficiency and localization issues faced by traditional finance, paving the way for new developments in the DeFi space.

In summary, Compound leverages digital assets and blockchain technology to provide a convenient and efficient decentralized lending service for users worldwide. It addresses the cost efficiency and localization challenges faced by traditional finance, ushering in a new era of development for DeFi.

dYdX, launched in October 2018, experienced a peak Total Value Locked (TVL) surpassing $1 billion. The key innovations and problem-solving aspects of the dYdX protocol are as follows:

Establishment of a Decentralized Perpetual Contract Trading Platform: dYdX has built a decentralized platform for perpetual contract trading, enabling users to conduct such transactions on-chain, mitigating the risks associated with centralized exchanges and asset custody.

Utilization of a Hybrid On-Chain and Off-Chain Order Book: The hybrid on-chain and off-chain order book enhances trading efficiency, with the off-chain order book improving transaction speed, and the on-chain order book ensuring transparency.

Lower Slippage and Deeper Liquidity through Off-Chain Order Book: dYdX can provide lower slippage and deeper liquidity by leveraging the off-chain order book, enabling high-frequency trading and low transaction costs.

User Participation in Governance and Mining Rewards through Asset Collateral: Users have the opportunity to participate in governance and receive mining rewards by collateralizing assets.

Provision of Decentralized Leveraged Trading: dYdX supports decentralized leveraged trading for a variety of assets, allowing users to achieve leverage of up to 20X.

Support for Overnight Margin Trading and Isolated Margin Trading: The platform supports overnight margin trading and isolated margin trading, enabling users to adjust position margin rates based on their risk preferences.

(To be continued)

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