What is Defi
Defi, also called Open Finance, is a phenomena being built out primarily on the Ethereum platform. What it aims to solve is the centralised points of failure that are observed in crypto exchanges, custodial wallets and third party lending products.

This is a noble cause and goes straight to the heart of what cryptocurrency is all about, self-sovereignty, free access to financial services and open source development. Infrastructure on Ethereum is starting to fall into three key categories: Exchanges, Money Markets, and Synthetic Derivatives (including prediction markets). As another layer are the developing DAO ecosystem with the

There are loads of experiments being run to test what is possible in this space and naturally this results is some hits and many misses. The obvious selling point here is financial infrastructure that is: Trustless, Composable and Unstoppable. This is an immense value proposition and the core of the reason for my Bull case for Ethereum the other week.

The promosing projects
Overall, there are around six core projects on Ethereum that are delivering the majority of the value in DeFi and forming the base layer of the DeFi ecosystem. There are a whole swathe of additional protocols in the mix however none have the same reach or user base as these.

MakerDAO is the central bank, responsible for managing the funds rate for medium of exchange token DAI via collateralised loans. MakerDAO is governed by the MKR token which acts as the debt buyer of last resort if things hit the fan and a black swan event were to occur.

Uniswap which is the most trustless DEX and functions on pooled liquidity provided on both sides provided by other market participants. My understanding is that Uniswap is the most native to the Ethereum chain and does not have a VC backed team building in rent-seeking fees.

Compound which is a pooled money market that allows people to earn interest and take out collateralised loans. They have a governance layer directed by the Compound team where users can vote based on interest accrued and earned.

DyDx is a protocol that enables both money lending (like Compound) as well as tokenized synthetic derivatives. It is possible to bake a token with inbuilt leverage in both long and short directions.

Set Protocol is actually one of the strongest examples of DeFi on the menu. The ability to tokenise index baskets of tokens and even TA strategies like moving average crosses is immensely valuable.

MolochDAO is the poster child of the new wave of DAOs entering the mix in Ethereum. It functions as a method for participants to donate ETH as tribute in order to fund the development of projects that enhance the Ethereum ecosystem.

Composability
I mentioned before that Trustless, Composable and Unstoppable financial infrastructure is a massive value proposition. No question we are seeing composability becoming increasingly utilised with many of the above platforms enabling functionality for each others service. I’m amazed how quickly it is growing and developing. Check out the graphic below that shows all the cross pollination of users from these protocols.

The argument for DeFi is that it is unstoppable. Once smart contracts are deployed to the Ethereum blockchain, in theory nobody can stop them from executing. As such, users can be the custodian of their own coins whilst still accessing financial services making for a Trustless financial stack. Immensely compelling.

The closest equivalent that exists in the Bitcoin space are centralised and fully trusted systems like BitMEX, Deribit and BlockFi.

However…
What if DeFi wasn’t quite as unstoppable as it says on the wrapper? An example is when the 0x team (ZRX) shut off their whole relay network the other month due to a critical bug found during an upgrade roll-out.

What if DeFi was becoming increasingly reliant on a central point of failure? Almost all DeFi applications currently lean on the Maker ETH/USD oracle to manage their liquidation ratios and lending rates. This oracle also relies on a suite of centralised exchanges and the entire platform and fund is maintained by a handful of known team members (who also own 40%+ of MKR governance tokens).

How would you feel if you found out that the Compound team has access to a backdoor and can drain every single coin in their smart contract? Is that really trustless or is it a honeypot?

Composability is amazing, as long as the foundation is rock solid.

Composable risks
These events are real and highlight just how early in the technological development we are. Composability is great, but if the bottom rung in a Jenga tower gets kicked out, it will all come down.

The motivation for bringing this up is the research that Ameen Solemani, a prominent Ethereum developer and influence, undertook regarding Compound. The research revealed that the Compound team has a backdoor that can drain all funds locked in the smart contract. That means, once you lock your funds into the contract, your coins can now be stolen by anyone with those keys. They can also prevent users from transferring, exchanging and even steal from your wallet any compound tokens that you receive in return for locking funds to earn interest.

That’s right, the Compound team has access to steal any funds you have locked in their smart contract from your hardware wallet without a signature. They can even override the price oracle to liquidate the entire platform and receive the collateral at the discounted prices.

Another issue is that the protocol is close to becoming illiquid which is akin to a bank run where lenders are unable to withdraw their funds they have been lent out to others and are not available inside the smart contract to return. One must wait for borrowers to repay their debt before you will have access to withdraw your funds.

Is this trustless? Or is it a massive honeypot?

I strongly recommend reading through this research piece to understand exactly what the study found as it is quite important if you use the protocol. https://medium.com/@ameensol/what-you-should-know-before-putting-half-a-million-dai-in-compound-fafdb2645f77

So what does this mean?

It means DeFi is in alpha testing. We are along way from bulletproof and finished technology. These systems are in place to allow developers to upgrade and fix bugs. This is exactly what I was referring to in my Ethereum paper the other day where I mentioned that we may one day see a financial collapse we don’t even have a name for yet. Imagine if this system was 100x the size it is today and someone gained access to the key!

My biggest issue with the system here is that these protocols are marketed openly as trustless. They are marketed as decentralised. They are marketed as putting you in control.

And in this case, as of right now, it is just not true. Maybe one day but right now, it’s a hard no.

I am genuinely disappointed with these findings as I have used Compound many times and think it is a well rounded product. However this really woke me up again to the risks of smart contracts and semi-centralised and alpha stage technology dapps. What I am extremely concious of is that Ethereum’s entire value proposition relies on DeFi. If more of these cans keep getting opened and they are full of worms…

It is crucially important to familiarize yourself with what smart contract risk is and what it means for you as a users of these services. As always, stay vigilant out there and make sure you do the due diligence on these services as best you can before locking up anything you wouldn’t be ok if it went up in smoke.