Money Markets on DeFi With Aave and Tendex

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The success of Defi platforms this year such as Aave has proven the demand for decentralized money markets and yield  generation opportunities. But as the industry matures and looks to scale, these networks will need to overcome obstacles if broader institutional adoption is to follow.  

Coinscrum host Alex Batlin, who is the CEO of Trustology, spoke with Stani Kulechov, founder and CEO of Aave, a blockchain startup focused on decentralized lending, and James Kilroe, co-founder of Tendex, an algorithmic trading company, to discuss some of these opportunities as well as the challenges. 

Stani explained how the Aave protocol is essentially a money market where you can deposit crypto-graphic assets into the protocol and earn interest, while a credit line is granted to borrow against other assets. He said, 

(33:26) “I started building DeFi when it wasn’t really called DeFi, but just so-called dApps, back in 2016-2017. We launched the first lending protocol on Ethereum and Aave is an evolvement of that.” 

James explained how Tendex is a systematic market-neutral fund that tries to hold algorithmic systematic strategies completely across the DeFi space. He fell into crypto in 2015/2016 and has been involved in designing some token economies, including that of blockchain-fueled identity startup Civic. 

(34:55) “I’m very interested in incentives and how technology and finance come together. I believe that DeFi offers a lot of very interesting potential and on the fund side for us interesting arbitrage opportunities and other opportunities to earn yield. Although there are still a number of hurdles before big institutions enter, this is still [at a]very early stage, but it’s exciting and it’s nice to be involved at ground zero,” said James. 

Stani explained that when he was planning the business model before he actually started to build applications such as deposits and lending facilities on smart contracts, he had a choice whether to build them on smart contracts or do off-chain execution. While many of his closest advisors and friends recommended that he go with the centralized model, for him the properties of what a smart contract-based development provides was too powerful. 

He explained that when users deposit onto Aave or interact with it in any way, they see everything that’s happening on the protocol, adding that this applies to the whole network. With Ethereum or Bitcoin, you have “transparent finance” without any black-boxing in the sense of how interest rates are decided, which algorithms are used, is everyone paying equally or earning equally from the interest rate, etc. 

(37:41) “This transparency is a very important factor. And also because smart contracts can be built in a way that they are hard to change, so basically immutability or governance, it ensures that transparency,” said Stani. 

He went on to say that as the ecosystem started to grow, he realized that it wasn’t only about the transparency or the functionality, adding that other things were in the DeFi sector. Before Aave, there were decentralized exchanges and the rise of market-making protocols such as Uniswap and many others. Stani described an ecosystem where smart contracts could talk to each other and end users have permissionless access to this facility and can access this ocean of liquidity, which he finds fascinating. 

Tendex’s James said when he came into the DeFi space, there was a lot of hype and even “necessary hype” and excitement surrounding DeFi, much of which came about through yield farming. It bordered on speculative and after a “crazy period” in June, July and August, and people are now busy trying to work it out in more detail. 

(40:01) “The challenge with that is the risks that come about. So the dangers with these protocols isn’t, of course when you design a smart contract, that has obvious dangers. But I think what people are struggling to grapple with is the complexity as these different protocols begin to attack each other. And it appears to be those failing points, whether it’s an oracle failure or through some sort of attack, is costing the space a lot of money. But I guess it’s a messy way of finding the best solution,” said James. 

(40:34) Alex asked James about the barriers and concerns for adopting DeFi as part of the fund’s strategy. James explained that they are a market neutral fund. But with any money manager, there is a layer that involves explaining the risks to your LPs, because at the end of the day, you are custodying somebody else’s money. So LPs have begun to understand and quantify the risks around a centralized exchange getting hacked, for instance, where you can use multiple exchanges. Smart contract risks, he adds, are still very unknown to the average person. And then you have the fact that a big part of the DeFi space is built on DAI, and if that project were to experience some catastrophic failure, the whole space is quite vulnerable. 

(43:55) Stani explained that in the past, he’s seen DeFi generally driven by retail interest in the crypto market. He adds, however, that there is interest from institutional investors and he is also seeing some retail segments becoming more institutionalized. For instance, there might be some new functionality that becomes institutionalized, such as the liquidation networks on DeFi. He says that some liquidity providers are becoming more professional. 

There definitely is institutional interest, Stani said. But the biggest concerns revolve around security because not every DeFi project is equal. Each DeFi protocol has its own complexities, risk assessment on different kinds of assets that the protocol has listed and risk parameters. 

 (45:34) “Safety is one of the things that institutions are eager to understand more and basically, what are the risks,” said Stani, adding that all the data in DeFi and on the blockchain is transparent, available, and auditable by anyone.  

Flash Loans 

(46:00) Alex also asked about the new stuff that is being done on the blockchain right now, such as flash loans. 

Stani explained how the Aave protocol has always been about unlocking liquidity. So a user might deposit one asset to earn interest. But they might also borrow some stablecoin and have a long position in the deposit asset. Roughly 75% of depositors are depositing into Aave but they’re not accessing their credit lines, which means that there is roughly USD 1.5 billion worth of value in the smart contracts sitting there as collateral. Flash loans allow them to borrow all that liquidity in one single transaction and use it in one transaction on the Ethereum network. It supports different functionalities, such as arbitrage, refinancing loans from one protocol to another and swapping your collateral from one to another if you have a long position, as well as other functions. 

(47:24) “So it’s kind of like a way to get that liquidity into usage and it also generates additional interest for the depositors who are providing that liquidity into the smart contracts,” said Stani. 

He went on to explain that because you access the capital on demand, you basically pay on demand. And if it comes down to liquidiations on MakerDAO or other protocols, it’s difficult to compete with flash loans because you get the liquidity and it’s kind of like a gas cost. 

Eth2 

Tendex’s James believes the Eth2 launch will be one of the biggest POS launches ever, second only to Tezos. The excitement for him surrounds what it enables, which will hopefully be thousands of transactions per second. He says, 

(51:58) “This whole ecosystem is being built on Ethereum and it’s been optimal and it’s brilliant. The hive mind that’s sitting on the Solidity platform is huge. And one of the big sticklers is transaction costs…transaction costs are too high…Eth2 enables a myriad of other opportunities and other spaces like DeFi and other specialities within crypto and that’s very exciting,” said James. 

In terms of the yield being different between Eth2 and Eth2, he thinks it’s just the market working out its terms of efficiency. 

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