DeFi Primitives: Understanding the Mechanics of Decentralized Finance

Course Overview

• Second Course: Focuses on DeFi primitives (fundamental building blocks of decentralized finance).
• First Course Recap: Covered DeFi infrastructure and key concepts in blockchain technology.
• Course Modules:
  • Mechanics of Decentralized Finance (current module)
  • Supply (increasing and decreasing supply, ownership)
  • Collateralized Loans
  • Swaps (exchanges)
  • Setting up a Wallet (using MetaMask)
  • Big Picture Review (blockchain tech and key concepts)

Upcoming Courses

• Third Course: Deep dive into existing popular DeFi protocols.
• Final Course: Risks and opportunities in decentralized finance.

Mechanics of DeFi

Transaction Mechanics

• Bitcoin vs. Ethereum: Ethereum offers additional functionalities not present in Bitcoin.
• Types of Accounts in Ethereum:
  • Externally Owned Account (EOA): Simple addresses that users will set up using a MetaMask wallet.
  • Contract Account: Smart contracts that live on each Ethereum node, capable of sending and receiving funds.
• Smart Contracts: Unlike Bitcoin, Ethereum enables interaction with multiple contracts through a single transaction.

Atomicity

• Definition: Transactions are atomic; if one step fails, the entire transaction reverts to its initial state.
• Example: If a 10-step transaction fails at step 9, the system reverts to the state before step 1.
• Importance: Crucial for operations like trading, arbitrage, and particularly for flash loans, which are essentially risk-free due to this property.

Gas

• Concept: Gas quantifies the computing power needed for a transaction.
• Simple Transactions: Require less gas (e.g., peer-to-peer Ethereum transfer).
• Complex Transactions: Involving multiple smart contracts require more gas.
• Gas Auction: The price of gas is determined competitively in an auction.
• Refunds: Excess gas is refunded; insufficient gas results in the transaction failing and no refund is given.
• Network Congestion: High gas prices during congested periods; Ethereum developers aim to minimize these costs.
• Competition: Other blockchains offer lower transaction fees, pushing Ethereum to reduce costs.

Memory Pool

• Definition: A holding area for proposed transactions awaiting validation.
• Validation Process: Miners gather transactions, check fees, and ensure validity before mining a block.

Miner Extractable Value (MEV)

• Front Running: Miners can legally prioritize their transactions based on visible pending transactions.
• Impact: Creates another revenue stream for miners but can negatively affect user experience.
• Solution: Transitioning to proof-of-stake in Ethereum aims to reduce front running issues.

Summary

• Key Points Covered: Transactions, gas, smart contracts, atomicity, memory pools, and miner extractable value.
• Advantages and Challenges: Current technology has both benefits and drawbacks, with ongoing efforts to address issues like high gas prices and front running.