Perspectives are what define our view of the world. Consequently, each one of us approaches the world through the many personalized looking glasses which we have crafted throughout our experiences. The purpose of this piece is to hopefully enable you to start forging another looking glass through which your journey into the world of Defi can begin.
Ultimately, the end goal is relatively simple, I want to be able to trade something that I own with something that I want. Both the traditional and the Defi methods achieve this but the means through which this is done are fundamentally different. Like much of our understanding of what is the “right” way to do a trade, Defi has also taken inspiration from the traditional world and modified the concepts to fit a new world order. To this end, I thought it would be useful to summarize these differences via a side-by-side comparison against 5 standard questions below.
Trigger warning: Oversimplifications up ahead
Who am I trading with?
- Traditional: Directly with another buyer/seller (peer-to-peer) or in most cases, via an intermediary (principal/broker/agent) which matches a buyer and a seller. Nowadays, this is done on an online marketplace (i.e. Amazon) or exchange (i.e. Interactive Brokers).
- **Defi: **Directly with the Defi smart contract code. Note that this is different from the above online marketplace/exchange as the execution of the smart contract code does not rely on an entity processing it (i.e. Amazon owns and runs the code). Instead, the smart contract code is deployed to a network where any network participants can interact with it by paying a fee to run the code (i.e. gas fees in the case of Ethereum). If the above sounds like gibberish, just know you are interacting directly with a computer owned by all its participants.
Where are the assets coming from?
- Traditional: The broker usually holds the buyer/sellers’ assets in custody (i.e. broker holds the asset on behalf of) or in a depository (i.e. deposited for safekeeping). In both cases, the buyer/seller enters into a contract with the broker which identifies them as the ultimate owner of the assets. To improve liquidity, many exchanges rely on market makers who actively buys and sells for their own account.
- Defi: Users who provides assets to the smart contract, liquidity providers, get** liquidity provider tokens **in proportion to the liquidity they provide to the liquidity pool. These newly created LP tokens allows the user to reclaim a proportion of the assets from the **liquidity pool **when redeemed/burned. Note that these LP tokens can themselves be traded and also enables defi to be non-custodial.
How and when are my trades executed?
- Traditional: Trades are done via an order book model where an intermediary matches a buy order with a sell order. Note that in this case, a trade can only be done when both the buy and sell order matches (i.e. the buy price is greater than the sell price for trade quantity). Additionally, this requires a buy/sell order to be placed for a market to be formed.
- **Defi: **Trades are against the smart contract which indirectly holds both the assets being traded. The smart contract owns the liquidity of the assets in question hence the name liquidity pool. There are no concept of orders in this case as the trade is executed immediately against the smart contract at the “market” price.
What’s up with the “Market” price?
- Traditional: Price discovery is implicit when a buy order matches with a sell order (i.e. the last traded price indicates the price someone was willing to pay to get the asset from the person who was willing to let go off it). For more volatile assets or assets lower volumes, there is a higher chance of slippage which is the difference between the expected price of the trade and the actual price of the trade when executed.
- **Defi: **Price data is obtained via an external feed hence the reference to oracles. Critically, different protocols have different approaches to ensuring the accuracy and integrity of this price feed. This will serve as reference data for Defi protocols to then create a price curve against which the price and quantity combination can be determined. Many Defi 1.0 protocols implement a price curve as a constant function market maker where the product of both asset values in the liquidity pool is equal to a constant. Note that slippage in this case still occurs as there is a timing gap between when a transaction is signed and when it is confirmed on the network.
Are there any fees?
- Traditional: The broker typically charges a base fee plus a certain percentage of the trade value as part of their commission. This fee not only covers the broker’s fee for settling the trade but can also extend to cover other costs such as custody services and other supplementary services required to fully execute the trade.
- **Defi: **Most defi protocols tend to charge a flat percentage fee (0.3% for UNI and SUSHI) of the trade value. Majority of this fee is paid out to liquidity providers to compensate them for the opportunity cost of locking their assets in the smart contract. Part of the fee might also go back into the protocol as incentives for ecosystem users to grow the protocol.
Hopefully from the above you can start to relate the Defi concepts to that of the traditional world. This will then serve as guiding posts as you dive deeper into the many elegant, soon to be proven, solutions which exists in the crypto-space. I know I’m definitely excited for what this future holds.
Thanks for reading! It’s been a long time since my last article but it’s good to be back at it. I would love to know your thoughts around this, is it good or does it still sound like gibberish, so do drop a comment! :)
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