Bringing DeFi to the low-cap altcoin market — Part 1
SingularityNET will soon launch their spinoff ‘SingularityDAO’ that aims to bring liquidity and DeFi instruments to the market of low-cap, high quality, utility altcoins. This undertaking will be supported by an AI-based trading toolset that has been developed over the past years by another spinoff called AutoNIO.
The purpose of this two-part article is to explore what ‘SingularityDAO’ entails, what the role is of AutoNIO and what this means for DeFi in general and SNET is particular.
This is quite a lot to digest so for those of you that are not yet familiar with DeFi, Yield Farming and the likes, let’s start with a bit of a foundation: What is meant with DeFi and where did it come from?
Read more on the impact of AI in the low-cap, DeFi market in part 2: https://medium.com/@janhorlings/bringing-defi-to-the-low-cap-altcoin-market-part-2-47afd5210dc9
Part one: Exploring DeFi and Yield Farming.
Current state of affairs in the financial world:
Since the stock exchange crash on Sept. 29, 2008, it is common knowledge that the financial world has become extremely complex, leading to risks that are unseen to most stakeholders and unmanageable by decision makers and governing entities. Moreover, the sector is dominated by large financial institutions that enjoy advantages in information and speed that are hard to combat by common individuals. At the same time these institutions appear to be protected by their governments in a situation of crisis, because they are deemed to be ‘too big to fail’. Such measures, even when beneficial in the short term, lead to ‘moral hazard’ and in fact incentivise even more risk taking by the same institutions. This puts the overall financial system even more at risk in the mid/long term.
Entrée DeFi; Decentralized Finance.
The promise of DeFi is to automate financial transactions making them transparent, predictable and low cost. This will impact a large part of the current financial institutions that work as trusted middleman or market maker. As the financial market democratizes, the large financial cooperations will loose their grip on an increasing part of financial services, which will reduce their power.
It will also make the system more transparent, predictable and less susceptible to the ‘moral hazard’ mentioned above. At least, for better or for worse, that was the idea. Unfortunately, the DEFI market is becoming very complex as well in a fast pace, which will open up whole new risks with -likely- new winners and victims. We just don’t know who they are yet.
(Note: The aim of AutoNIO in this respect is to bring intelligent trading tools to the crowd and make them compete so the best ones will surface AND be available for everyone, but more on that in part 2)
DeFi and Yield Farming.
While the term ‘DeFi’ relates to any financial operation that is facilitated by a blockchain, over the past year the term is increasingly used for profit seeking operations within the crypto-sphere such as crypto trading, -lending and arbitraging. Before diving in, let’s have a look at some of the terms and activities related to this domain.
(And skip if you are familiar with them.)
Smart contract
I expect this is a well-known concept for most readers, but in case you are new to crypto: A smart contract is an executable program that is stored on the blockchain. Because of this it is immutable, and the rules and conditions cannot be changed by anyone. This makes it easy and cheap to create a binding contract between multiple parties. (Hence the term ‘programmable money’.) However, if there are bugs or exploits in the contract, they can’t be corrected either. Not even by their creator.
DEX ‘Decentralized Exchange’
An exchange is a place where supply and demand of a value bearing entity are brought together. This works similar in crypto as in the ‘fiat’ world. A decentralized exchange is a form of ‘DAO (Decentralized Autonomous Organization), meaning that the exchange is built on a smart contract that lives in the blockchain and will therefore continue to operate without the need for anyone to actively manage the operations. This has some advantages: a DEX requires no ‘trust’ in the exchange management. It is permissionless (no-one can stop you from using a DEX), it potentially has lower trading costs and offers confidence that there is no malicious trading behind the scenes using internal knowledge. The big promise of DEXs has however not yet been fulfilled, mainly because of low liquidity. To create a healthy market and price discovery, you need to have sufficient buyers and sellers of an asset. Currently this is where the centralized indexes still have the upper hand.
Liquidity pool
This is a reserve pool of a cryptocurrency that is used to execute trades. This is best explained by an example. If I want to sell 100 AGI against x BTC, I need to find a counter-party that wants to do the exact opposite, for a price that is acceptable to both of us, and very close to what is offered on other exchanges. If this party is not present at the same DEX at the same time that I want to trade, the liquidity pool can be used to make the trade. So in this case 100 AGI is added to the AGI liquidity pool and x BTC is removed from the BTC liquidity pool and sent to me. (calculations and price discovery is a topic of its own) At a later moment, after this trade and perhaps other related trades have been completed (see also ‘flash loans’) the DEX can offer the 100 AGI or other amount to other DEXs or CEX’es (Central Exchanges) to sell against BTC and thus restore the balance of both liquidity pools to its former balance. This way, Market Making (see explanation below) is not tied to a single isolated exchange but can be linked to other exchanges, providing there is liquidity and a good price discovery system.
In this scenario money can be made by lending your crypto to a liquidity pool, where you will then be rewarded, e.g. by the transaction costs of the original trade. This is facilitated by a smart contract, and therefore fully automated.
Another way to make money is to make a profit from price differences between exchanges: Arbitraging.
Arbitraging:
This is buying and selling the same token on different exchanges, to make a profit from small (and short-lived) price differences between exchanges. The added effect is that these price differences are being levelled out in the process and that the liquidity pools are being kept in balance.
Market Making
Actively seeking opportunities of placing buy- or sell orders to facilitate trades. This can be seen as the ‘oil’ of an exchange, removing friction between buy and sell and thus giving liquidity to the system
Flash loan
Usually, the margins for arbitraging between exchanges are pretty small. Also, these margins exist for a very short time and across all assets (although currently this is mainly restricted to the Ethereum ecosystem). Therefore, successfully operating this, means you need to be fast and flexible. This is where loans are handy. Again, this is best explained with an example.
First lets view the purpose of crypto loans in general: Suppose I have an x amount of BTC, but I want to be arbitraging in different tokens depending on the market situation. In this case I will use the BTC as a security for getting a loan in, let’s say, AGI. I will use this AGI to buy Ether on exchange X and then selling the Ether back to exchange Y where the Ether price is higher (in the AGI-Ether pair)). After both transactions are done, I will have my original AGI amount back, plus some margin, assuming that the trade went on successfully and nobody beat me to it. So, now I can give back the loan, plus a very small interest rate and end up with a small profit.
A flash loan is a loan that does NOT need a security because all the operations above are being executed in one multi-transactional operation that is governed by the rules of one or more smart contracts. In fact, the operation will only be executed if the margin for trading the Ethereum between the exchanges is still profitable. Therefore, the lender of the AGI, is sure that he will be paid back in the same transaction where the original loan was executed: A flash loan.
Yield farming
As you can see this can easily get pretty complex. A chain of transactions is set off between multiple entities, involving trades and loans, based on Smart contracts, resulting in new price discovery of the related tokens, balances to be updated and value flowing in and out liquidity pools. Operating in this domain with the goal of making structural profits is called ‘Yield Farming’. Yield farming requires liquidity. Participants of yield farming liquidity pools can earn part of the pool’s profit as a reward. On top of that some Yield farming entities have created their own token that is given to the participant on top of the regular rewards. The value of these tokens, such as ‘Yam’ or ‘Sushi’ have increased in value quickly, adding fuel to the DeFi hype, even though the utility of these tokens is not always clear.
So, now that you are an expert in Defi and Yield Farming let’s have a look at the risks involved. A lot of money has been made in this area, but, not surprising in such a young industry, there have also some ‘accidents’ leading to sudden and large losses.
Let’s take a look at some of the main risk areas:
Sudden liquidity problems:
In a general sense, the toolbox from the traditional financial markets has entered crypto: Futures, options and margin trading on Bitcoin (or derivatives of Bitcoin). While this is not a problem in itself these structures can lead to sudden need for liquidity. For example a large option that expires and needs to be sold can trigger a chain reaction that leads to sudden (possibly very short lived) exceptions in the market. This kind of short-term liquidity crisis was the cause of the collapse of the market of the Ethereum based stablecoin ‘MakerDAO’, leading to trades for a near zero value of DAO (see https://blog.makerdao.com/the-market-collapse-of-march-12-2020-how-it-impacted-makerdao/ ) MakerDao was thought of one of the most sound and transparent stablecoins in the market, but, even though the markets recovered quickly, the damage was already done.
More specifically to the developing DeFi market (as outlined above) there are also other risks:
Exploited bugs in smart contracts.
New contracts are being released quickly without proper security audits. In some cases, code from existing contracts is copy-pasted. When such contracts are either created maliciously or published with an ‘experimental’ mindset, they can have unexpected results that may be hard or impossible to fix. This was the case with YAM https://cointelegraph.com/news/yam-token-holders-burnt-the-hardest-after-price-plunges-to-zero) leading to a near 0 value of the JAM tokens.
Issues related to contracts that are working in collaboration
As the complexity of the DeFi system increases the schemes to generate income get more elaborate. As outlined above multiple smart contracts can be triggered sequentially or in parallel, leading to a certain outcome. New tokens are created (such as YAM) based on the performance of these operations and those tokens can themselves be part of Yield Farming activities. If in only one of these building blocks an issue would occur, there is a non-zero chance that this will set off a chain reaction of unforeseen effects leading to exceptions that could crash a single system or the total market. Even if this is a very temporary spike of events, the impact can be very large for certain individuals.
So far this introduction to DeFi. As mentioned, the field is dominated by Ethereum-based tokens and contracts. As the domain evolves, smart people will find new ways to make money or to find exploits that offer profit on the expense of others. New strategies for Yield Farming are kept secret to defend the profits being made. This is not a simple and certainly not a safe environment for making money.
With this foundation in place we can ask: What will SingularityDAO bring to this scene? How will the AI trading algorithms of AutoNIO impact this space? Read more on this in Part 2 of this post.
