The bull is getting more interesting by the day and BTC keeps pushing past the local resistances to reclaim its all-time high and the DeFi market has also been one of the major factors behind this bull rally. From the estimate, the bitcoin total locked down in DeFi in just two months is more than quadrupled with a rise from 4,975 to 20,610 BTC, this makes DeFi total value locked surpassed $4 billion once again. About $1 billion was added to DeFi market in less than two weeks to its total value and most of the protocols receive a massive surge. With this happening, analysts strongly believe that BTC rally will grow bigger than it was in 2017 when it touched $20,000 because DeFi market was not inexistent.
The last article on decentralized finance I submitted was focused on decentralized exchange protocol and decentralized order book exchange. If you miss this, read up here
Let's look at some protocols as it applies to decentralized finance
In this type of smart contract, at least two assets enter reserve which allows anyone to deposit any tokens of one type and withdraw the other type. The exchange rate at the smart contract is determined by the variation of the constant product model and the token price is determined by the smart contract's reserve ratio. This model is cool because it cannot be depleted since the lower the reserve the more expensive the token becomes. For example, if you deposit Eth and other tokens, as Eth or the other tokens approaches zero, it affects the relative price which will rise infinitely. As the price in the market of an asset takes a shift, anyone has the allowance to use the arbitrage opportunity and trade tokens with the smart contract until the liquidity pool price converges to the current market price.
Accumulation of additional funds is generated through the implicit bid/ask spread of the constant product model (plus a small trading fee) and anyone in the position of liquidity provider to the pool will receive pool share tokens that allow them to participate in this accumulation and to redeem these tokens for their share of a potentially growing liquidity pool.
As the decentralized finance system grows, UniSwap and Bancor are the typical examples of smart contract-based liquidity pool protocols but considering simpler design, UniSwap is more optimized in terms of network fees.
Here, we have a smart contract that gives an opportunity for large liquidity providers to come together and promote/advertise their prices for specific trade pairs. All the liquidity providers' prices will be compared by the smart contract and accept the best offer on behalf of the user before the execution of the trade. The advantage of this to the user is that smart contracts are used as a gateway between users and liquidity providers to ensure the best trade execution and atomic settlement. When considering liquidity pools' smart contract explained earlier, the prices are not determined within the smart contract but the prices are set by the liquidity providers. This is perfect since there is a relatively broad base of liquidity providers. However, if in this case of large liquidity providers in reserve aggregation smart contract and there is no competition for a given trade pair, this can lead to collusion risks or a monopolistic price setting, to tackle this, these protocols create control mechanisms that make the protocol look more like centralized system by setting maximum prices or a minimum number of liquidity providers. In addition, KYC and background checks are carried out on liquidity providers and a typical example of a project that implements this concept is Kyber Network.
Peer-to-Peer (P2P) / Over-the-Counter (OTC) Protocols
This is a two-step approach. In this case, participants query the network for counterparties who would like to trade a given pair of crypto assets and then negotiate the exchange rate bilaterally, until the price is agreed by the two parties, the trade won't be executed on-chain. This transaction is automated and carried out by a smart-contract. The popular project that makes use of this protocol is AirSwap.
As we all follow me closely in this literature, the clarity of DeFi becomes easy for everyone, and in the next article, we will look into the lending protocol and how this can be a benefit to all the defi followers.
See you in the next article.