If you have been anywhere near the crypto and DeFi world, projects like Aave, Curve, and Yearn would have definitely piqued your interest. Having been exposed to the unparalleled yields from the DeFi world, experiencing an unbiased ecosystem of lending and borrowing, and being a part of a decentralized ecosystem makes everyone want to create and launch DeFi protocol
However, if you believe that a DeFi protocol is something that can be done easily, get ready to learn about the true powers of DeFi.
First things first, let us go through the core concepts that you need to understand.
A deep dive into DeFi
In contrast to the traditional centralized financial ecosystem, the DeFi world operates on smart contracts. Based on Blockchain, DeFi protocols offer an unbiased and transparent ecosystem for carrying out our financial interactions, digitally.
Blockchain-based smart contracts are used to define all the rules and regulations governing the activities on a DeFi protocol. These smart contracts are essentially pre-programmed pieces of code that are stored on the Blockchain’s immutable ledger. Once deployed on the Blockchain, they can never be altered and the functions defined inside them are used for specific financial activities, creating a standardized environment. Therefore, the use of smart contracts replaces the need for third-party interference.
As a result, lenders can come to the DeFi network from anywhere in the world and simply supply their digital assets on the platforms money market. These assets are then provided to the borrowers at a defined interest rate, giving an APY or Annual Percentage Yield to the lenders.
Let us understand a few components of DeFi to gain a deeper insight.
- What is a liquidity pool?
Every DeFi protocol like Aave or Yearn needs to have an unabated flow of liquidity in order to accommodate the needs of the borrowers. If it is unable to keep sufficient balance, the borrowers will shift to another platform and there will be a situation of more supply and less demand which eventually means lower returns for the investors.
To ensure that funds are available on the platform, these protocols use liquidity pools.
Liquidity pools are large collections of tokens that are secured and regulated by complex algorithms.
On protocols such as Aave, lenders deposit their digital assets to the liquidity pool and they get LP tokens in return. On every trade, a specific amount of fee is charged which is gathered and then distributed among all the liquidity providers.
The lenders or liquidity providers, in this case, play a crucial role in maintaining the liquidity of the network. For being a liquidity provider, these investors are rewarded with tokens. This distribution of tokens is called liquidity mining.
- What is AMM?
While the liquidity pools ensure that both the needs of the borrowers and lenders are met, the regulation of the protocol in terms of interest rates and other mathematical operations is done by an Automated Market Maker or an AMM.
An Automated Market Maker is nothing but a complex mathematical algorithm that defines what interest rate to charge to the borrowers and how much reward to be given to the lenders. In essence, the AMM removes the need for a third party and allows for a decentralized, unbiased ecosystem.
With the AMM in place, the DeFi protocol is able to create an unbiased ecosystem where each entity enjoys transparency in terms of interest rates, supply, and trading volume. Therefore, the liquidity pools do not require any centralized market maker to deal with the costs of such assets.
These AMMs are one of the most essential parts of a decentralized money market.
- What is yield farming?
Until now, we have gone through the liquidity model of a deFi protocol, how it is maintained and how it is regulated. However, when it comes to making profits, a new concept comes into play.
Getting returns on a DeFi protocol is not that straightforward. Users have to identify which DeFi protocol offers the highest APY.
Therefore, the DeFi users follow a practice wherein they shift from one DeFi protocol to another in order to reap the benefits of the highest APY available in a specific protocol at a specific point in time.
This process is called yield farming.
Leverage, High Risk & High Returns, and Liquidity Mining are a few of the popular techniques used for yield farming.
It is important to note that yield farming is currently being done using ERC-20 tokens only and might support other Blockchain platforms or token standards in the future. This is one of the main reasons why Ethereum should be your choice of a Blockchain platform if you are creating a decentralized borrowing and lending protocol.
- What is staking?
At the very core, staking is locking your cryptocurrencies or digital assets in a smart contract to earn profit in the form of reward or interest.
You can either stake directly from your wallet or through an exchange. If you are staking your tokens, it means that you are essentially facilitating the financial services of the protocol
However, the process of staking is more than that. Staking in the Blockchain world originates from the proof of stake consensus. Staking in this consensus means that a node of the Blockchain becomes a validator by putting their own money at stake.
The stake is required to ensure that the node will not perform any malicious activity on the platform as it will result in its own personal loss. By staking a large amount, the nodes become validators of the transactions and create blocks on the network for which they are rewarded.
Calculating the reward system or the staking system is one of the key components of the popular DeFi protocols such as Aave, Curve, and Yearn.
Tokenomics is the most important part of a DeFi protocol. As the name suggests, it consists of two words token and economics. Therefore, tokenomics is a collection of different characteristics that impact the value of a protocol’s token. The different components included in the tokenomics are token allocation, public relations & branding, token structure, token type, business model, and much more.
A well-defined tokenomics can make all the difference in defining the success of a DeFi
How you can create and launch DeFi protocol
Once you understand these concepts, the creation of a DeFi protocol like Aave, Curve, and Yearn does not become easy, it just becomes more clear.
Certain factors involved in creating and launching such a protocol are:
- Selecting the right Blockchain platform(most preferably Ethereum)
- Business analysis of the DeFi Idea
- Technical architecture and experienced developers, such as the ones at QuillHash, to carry out the complex development
- Marketing and business model for the project such as ICOs, IDOs, or Airdrops
These factors are still the tip of the iceberg. Once a project is initiated, many more things come to light.
The DeFi ecosystem has been flooded with borrowing and lending protocols and other such DeFi protocols. If we take a close look at how protocols such as Aave or Yearn became popular, we can easily notice certain key factors.
Aave came a decentralized money market which introduced more efficient borrowing and lending activities along with the provision of flash loans. This made Aave stand out from the crowd.
Yearn finance on the other hand is an Ethereum-based Yield aggregator allowing crypto users to make unprecedented profits by maximizing their yield.
Curve is another innovative project and a perfect example in this context. It is an Ethereum-based decentralized exchange built specifically to support stablecoins. One of the key characteristics of the protocol is low slippage and low handling fee (0.04%) for stablecoin exchange. It also introduced a CRV governance token to reward liquidity providers.
Similar to these protocols, every popular DeFi protocol possesses some key features that add more value to this ecosystem. Even if they are not bringing something unique, they become an upgraded version of the existing protocols, for example, Curve.
Another crucial aspect is getting a quality audit. Without the assurance of security, the usability of the protocol can never reach its true potential. Moreover, an audit by a reputed firm such as QuillAudits ensures that your protocol has no back doors otherwise your protocol might end up being one of the victims of the growing DeFi hacks.
Visit this link to view the list of deFi protocols that suffered huge losses due to several reasons such as bugs in the smart contract.
For more information on DeFi security, you can view our detailed DeFi security audit report here.
Reach out to QuillHash
With an industry presence of years, QuillHash has delivered enterprise solutions across the globe. QuillHash with a team of experts is a leading blockchain development company providing various industry solutions including DeFi enterprise, If you need any assistance in the DeFi protocol development, feel free to reach out to our experts here!
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