We know that the traditional financial system has the characteristics of permitting, high entry barriers, additional legal costs, etc., so it is greatly restricted in terms of composability. All financial services based on traditional centralized financial services require a legally binding financial contract between the two parties, which not only increases market access barriers, but also makes it difficult for developers to create fully automated or fair financial applications , Because the continuous access permission may be cancelled at any time. In addition, because the centralized entity can control key parts of the application, third-party developers cannot obtain the desired assurance of accuracy.
Second, we found that traditional financial services are often affected by opacity or information asymmetry, because the public has very little understanding of the back-end infrastructure, which in turn will generate unknown risks and increase the risk management costs of a small number of regulators. For example, financial composability can create "mortgage-backed securities" by merging existing consumer collateral. This diversified business model seems to be good, especially internationally renowned ratings such as Moody's, Standard & Poor's and Fitch. The agency gave a AAA rating, but when the time came to 2008, many securities were actually endorsed by "toxic" subordinated debt. As a result, the outbreak of the crisis led to the global financial crisis. Therefore, if greater transparency and visibility are provided to a wider audience, this kind of "implosion" can be prevented.
Then, we can also see that if traditional financial entities want to provide their financial services or products to citizens of a certain country or region, then these entities are usually required to meet the regulatory compliance of that country or region, such as “know your "Customers" and "Anti-Money Laundering" laws and regulations. Although regulatory standards may improve the market in some cases, meeting the standards will also lead to high compliance costs, such as expensive legal consulting fees, and increase the difficulty of entry, which means that there may be only a few in the end. Only a few companies with good connections and strong capital can compete in the market and survive, especially when operating in many different jurisdictions. In addition, compliance often involves more manual participation in the process, which hinders the development of multi-party process automation.
Unique advantages of DeFi
You know, the uniqueness of decentralized finance is that developers can combine any DeFi protocol and use it without any special permissions. When these DeFi applications are connected in series, they are like "currency Lego", which can then create many financial use cases and products that were unimaginable before, thus opening a frictionless innovation cycle.
It is very different from the model we have seen in the traditional financial industry. In essence, decentralized finance can use permission-free methods to change the status quo, and then support the creation of a more open financial foundation, from which any developer can obtain Real-time access to highly tamper-proof and reliable financial infrastructure. In this case, truly impartial and deterministic applications can operate in accordance with coding rules, and no one or a centralized entity can shut them down. The use of a decentralized financial infrastructure does not require the approval of the original developers, so that seamless innovation can be achieved without any centralized bottleneck.
Secondly, in terms of transparency, decentralized finance is also different from traditional finance. Its transparency is quite high, because many projects are not only based on open source technology, but every transaction and interaction between users and DApps is recorded in an open and non-tamperable ledger distributed on a global scale. Once a centralized cryptocurrency exchange goes bankrupt, it often takes months or even years to complete debt liquidation, but the solvency and operational health of decentralized finance are always collectively "monitored" and analyzed by the open source community. Can point out potential fraud and systemic risks.
In terms of regulatory and legal barriers, decentralized finance uses a different compliance approach than traditional finance, which can make it compatible with the laws and regulations of jurisdictions without sacrificing innovation. The blockchain infrastructure is essentially open source and decentralized, which means that it is not owned by any for-profit company, and every transaction can be verified and audited on the blockchain. More importantly, the composability of decentralized financial agreements means that each agreement does not need to have a separate built-in compliance tool. As long as the terms of the agreement are complied with, then any user and enterprise using the agreement will be fully compliant. When the public ledger is combined with pluggable modular compliance support, it can effectively ensure that end users meet regulatory standards without stifling innovation.
Through the above comparison, we can see that the traditional financial industry always tries to achieve efficiency improvements and solve problems such as poor operations by controlling more stringent infrastructure, while DeFi hopes to improve market efficiency through an open source code framework. Under this framework, license-free innovation can naturally solve the problem of inefficiency.
At this stage, some decentralized infrastructures that provide support for decentralized financial applications mainly include: blockchain (Ethereum) that supports smart contracts, tamper-proof oracle network (Chainlink), permanent data storage/web hosting (IPFS), censorship-resistant domain names (ENS), and reliable data query and indexing (The Graph).
Since developers know very well that the core business logic they develop can access key infrastructure without any permission, the modular composability of the DeFi ecosystem allows them to focus on building the core business logic. When developers use decentralized financial infrastructure to create new tokens, they do not need to build their own exchanges, nor do they need to pay expensive listing fees for listing on certain proprietary platforms. They only need to focus on creating transactions and providing liquidity. stand by. Not only that, they can list their tokens on decentralized exchanges (DEX) that have been thoroughly audited and include existing user bases, so that token holders can immediately obtain liquidity and different financial use cases, thereby greatly Expanded the utility of tokens.
If you can extend this structure by connecting new decentralized financial applications to existing decentralized financial applications, it feels like you are building Lego blocks. This is why DeFi composability is also called " Lego currency" reason. Now, some "currency Lego" scenarios in the decentralized financial industry include: decentralized exchanges, automated market makers, DeFi aggregators, stable coins, etc. They all support various combinations of connections to create independent services greater than their own Part of the many building blocks of function.
Under interoperability, anyone can build products and provide a new user experience by combining two protocols (such as Aave and Synthetix). If this product is good, then liquidity will also benefit from interoperability, and then can quickly obtain network effects, which is obviously much stronger than traditional financial systems. In addition, another key feature of the composability of decentralized finance is the ability to “chain” a series of decentralized applications together. Since encrypted assets can be used in multiple applications at once, this can reduce friction costs to almost It is zero and does not require permission, so it can improve capital efficiency. Not only that, the composability of decentralized finance can also promote the accelerated growth of network effects. Each decentralized financial application in the "combo" can make other decentralized financial applications in the "combo" more powerful, More usable.
All of the above operations already exist in the decentralized finance field, and the "combinations" involved include Ethereum, MakerDAO, Compound, Chainlink, and PoolTogether. Create new decentralized applications through tokens, without having to mint stablecoins yourself, without having to think about how to guide money market protocols, let alone or figuring out how to obtain verifiable random on-chain sources. Users can also "merge" their interest-bearing stablecoins together, so that they can create a license-free and loss-free savings portfolio product, and then further expand this composability.
Use cases for DeFi composability
1. Decentralized money market: An application that makes use of DeFi composability is the decentralized money market Aave. This decentralized financial protocol can achieve asset "super liquidity" through lightning loans, thereby improving capital efficiency and deposit returns . In addition, Aave has also introduced support for unique types of collateral, which can utilize tokens generated by other decentralized financial applications. This model provides high capital efficiency for automated market makers because they can earn transaction fees for colleagues who provide liquidity on Uniswap, and can also borrow funds in the agreement. Not only that, they can even deposit these borrowed funds into Uniswap again as working capital, thereby creating long-term leveraged exposure to Uniswap transaction fees and assets in the asset pool.
2. Flash loans: Flash loans are similar to temporary, unsecured loans, but the repayment must be completed in the same transaction. If the flash loan borrower cannot or cannot repay the loan immediately, the entire transaction will be cancelled. This protects the agreement and its lenders from any breach of contract. At the same time, flash loans can also be used for arbitrage between decentralized exchanges, seamless lending, conversion of collateral or debt in loan transactions, and many other use cases, and these complex operations can be completed in one transaction .
3. Aggregate service providers. Another decentralized financial application that makes extensive use of composability is 1inch.exchange. It can bring a better experience to DeFi users, because users do not need to check or compare the exchange rate of tokens on different decentralized exchanges every time. They only need to navigate all the information and access everything on Ethereum in one application. Working capital avoids tedious processing operations. Among them, 1inch plays the role of decentralized exchange aggregation provider, which can obtain liquidity from all decentralized exchanges on Ethereum and help users avoid slippage problems when exchanging tokens. Not only that, 1inch can also split large-scale transactions into multiple orders, and even achieve cross-exchange settlement in one transaction, so that it can provide users with decentralized financial products with the best yield.
Be wary of "currency Lego" risks
However, although the composability of decentralized finance is very strong, risks coexist with it. As far as we know, the risks of DeFi composability mainly fall into the following categories:
The first is that when multiple smart contracts are combined, the attack surface will expand, increasing the scope of the “attack surface”, which will lead to more extreme situations, and even extreme measures are required to ensure the smooth operation of the combined application. This composability risk may exploit the potential lower standard of DeFi application vulnerabilities, which means that the security of the mortgage token in the combined application is only the same as the weakest mortgage token.
Secondly, some users may not know much about decentralized finance or the applications they use. This risk may be more serious than we realize. Therefore, we need to educate users that risk transparency is essential to ensure the healthy operation of the decentralized financial ecosystem. DeFi composability will quickly become very complicated, so each step needs to be broken down to a security level during the combination process so that users can know their own capital investment at any time.
Third, because the blockchain network running decentralized applications has inherent protocol-level risks, if this base layer cannot reach consensus or is attacked by malicious attackers, then all decentralized applications running on Ethereum Will be affected. Although this is not the most important risk issue of DeFi composability, it is always worthy of careful consideration by everyone decentralized application developers.
Finally, since each decentralized application is based on its own design considerations to meet the specific needs of the required use case, each smart contract application has its own so-called "implementation risk". The implementation risk may involve other key attributes such as the use of management keys for upgrades, oracle mechanisms for pricing data, distributed token management systems, and contract modifications. Moreover, there may be software bugs in the source code of the smart contract itself, which may cause decentralized applications to run in unexpected ways.
How to deal with risks?
It is important that people in the open source community must actively participate in the composability analysis of decentralized financial applications, so that they can be preemptive before problems arise. In addition, if you want to implement a combined DeFi application, you need a large number of module components to support, so we need to ensure that each component can achieve the highest quality. At the same time, set and implement industry standards to ensure that the entire DeFi ecosystem has best practices; attract developers to participate in bug bounties, audits, hackathons, and other forms; use various methods to enhance the security of DeFi applications. All are suggestions for reference. Only through a series of measures can we create a stronger and more flexible financial ecosystem, and at the same time we can use the best way to protect user funds.
to sum up
The upsurge of decentralized applications has evolved from "ownership" to unique management and transfer solutions that expand and subvert existing traditional financial products. The new financial ecosystem DeFi has its own series of unique advantages while running together with the current traditional financial system, and its composability is particularly worthy of attention. With DeFi composability, more use cases will be explored and built in the future, and developers can launch innovative financial applications at a faster speed without having to rebuild the core infrastructure or rely on centralized and licensed finance in the market Services, the future of modular finance is quite promising.