Learning Objectives:
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Understand what DeFi is and why it matters
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Master the core components of DeFi ecosystem
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Learn about DeFi composability and money legos
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Understand DeFi risks and challenges
.1.1: What is DeFi? The Evolution of Finance
Definition and Core Concepts
DeFi (Decentralized Finance) is a financial system built on blockchain technology that operates without traditional intermediaries like banks, brokerages, or insurance companies. Instead, it uses smart contracts to automate financial services.
The Evolution of Finance: Traditional Finance (TradFi): ┌─────────────────────────────────────────────────────────────────────┐ │ Centralized Intermediaries: │ │ • Banks hold your money │ │ • Brokerages execute trades │ │ • Insurance companies underwrite risks │ │ • Regulators oversee operations │ │ │ │ Problems: │ │ • High fees │ │ • Slow settlement │ │ • Limited access │ │ • Opaque operations │ │ • Censorship possible │ └─────────────────────────────────────────────────────────────────────┘ DeFi Revolution: ┌─────────────────────────────────────────────────────────────────────┐ │ Decentralized Protocol: │ │ • Smart contracts automate services │ │ • Users control their funds │ │ • Anyone can participate │ │ • Transparent and verifiable │ │ • No single point of failure │ │ │ │ Benefits: │ │ • Lower fees (10-100x cheaper) │ │ • Instant settlement │ │ • Global access │ │ • Full transparency │ │ • Censorship resistance │ └─────────────────────────────────────────────────────────────────────┘
Key DeFi Value Propositions:
| Value Proposition | Description | Impact |
|---|---|---|
| Permissionless | Anyone can use DeFi services | Financial inclusion |
| Trustless | Code enforces agreements | No need to trust counterparties |
| Transparent | All transactions visible | Accountability |
| Composable | Protocols work together | Innovation |
| Interoperable | Assets move freely | Efficiency |
| Non-Custodial | Users control funds | Security |
| Programmable | Customizable logic | Flexibility |
5.1.2: The DeFi Ecosystem
Major DeFi Categories:
DeFi Ecosystem Map: ┌─────────────────────────────────────────────────────────────────────┐ │ DeFi Ecosystem │ │ │ │ ┌─────────────────────────────────────────────────────────────┐ │ │ │ Layer 0: Settlement │ │ │ │ ┌─────────────┐ ┌─────────────┐ ┌─────────────┐ │ │ │ │ │ Ethereum │ │ Polygon │ │ Arbitrum │ │ │ │ │ │ Mainnet │ │ (L2) │ │ (L2) │ │ │ │ │ └─────────────┘ └─────────────┘ └─────────────┘ │ │ │ └─────────────────────────────────────────────────────────────┘ │ │ │ │ │ ┌───────────────────────────▼─────────────────────────────────┐ │ │ │ Layer 1: Core Protocols │ │ │ │ ┌─────────────┐ ┌─────────────┐ ┌─────────────┐ │ │ │ │ │ DEXs │ │ Lending │ │ Stablecoins│ │ │ │ │ │ (Uniswap) │ │ (Aave) │ │ (DAI) │ │ │ │ │ └─────────────┘ └─────────────┘ └─────────────┘ │ │ │ └─────────────────────────────────────────────────────────────┘ │ │ │ │ │ ┌───────────────────────────▼─────────────────────────────────┐ │ │ │ Layer 2: Aggregators │ │ │ │ ┌─────────────┐ ┌─────────────┐ ┌─────────────┐ │ │ │ │ │ Yield │ │ DEX │ │ Portfolio │ │ │ │ │ │ Aggregators│ │ Aggregators│ │ Managers │ │ │ │ │ └─────────────┘ └─────────────┘ └─────────────┘ │ │ │ └─────────────────────────────────────────────────────────────┘ │ │ │ │ │ ┌───────────────────────────▼─────────────────────────────────┐ │ │ │ Layer 3: Applications │ │ │ │ ┌─────────────┐ ┌─────────────┐ ┌─────────────┐ │ │ │ │ │ Wallet │ │ Analytics │ │ Insurance │ │ │ │ │ │ Interfaces │ │ Tools │ │ Products │ │ │ │ │ └─────────────┘ └─────────────┘ └─────────────┘ │ │ │ └─────────────────────────────────────────────────────────────┘ │ └─────────────────────────────────────────────────────────────────────┘
Core DeFi Protocols:
| Category | Protocols | Key Features |
|---|---|---|
| DEXs | Uniswap, Curve, Balancer | Token swapping, liquidity provision |
| Lending | Aave, Compound, MakerDAO | Borrowing, lending, interest |
| Derivatives | Synthetix, dYdX | Options, futures, perpetuals |
| Yield | Yearn Finance, Convex | Automated yield optimization |
| Stablecoins | DAI, USDC, USDT | Price stability, pegged assets |
| Oracles | Chainlink, Band | External data feeds |
| Insurance | Nexus Mutual, Cover | Smart contract coverage |
| Aggregators | 1inch, Paraswap | Best price execution |
5.1.3: DeFi Composability – Money Legos
What is Composability?
Composability means DeFi protocols can be combined like Lego blocks to create new financial products and services.
Composability in Action: 1. Basic Example: ┌─────────────────────────────────────────────────────────────────────┐ │ │ │ User deposits ETH → Aave (lending) │ │ Gets aETH → Uniswap (swap for USDC) │ │ USDC → Yearn (yield farming) │ │ │ │ Result: Earn yield on ETH while maintaining liquidity │ │ │ └─────────────────────────────────────────────────────────────────────┘ 2. Complex Example: ┌─────────────────────────────────────────────────────────────────────┐ │ │ │ User deposits ETH → Lido (staked ETH) │ │ stETH → Aave (borrow USDC) │ │ USDC → Uniswap (swap for DAI) │ │ DAI → MakerDAO (vault) │ │ Vault → Yearn (yield farming) │ │ │ │ Result: Multiply yield through multiple protocols │ │ │ └─────────────────────────────────────────────────────────────────────┘
The Money Lego Effect:
Benefits of Composability: 1. Innovation: - New products built from existing ones - Faster development - Shared security 2. Efficiency: - Capital efficiency - Better yields - Lower costs 3. User Experience: - Single interface for complex operations - Simplified interactions - One-click strategies 4. Network Effects: - More protocols = More value - Positive feedback loops - Ecosystem growth 5. Risks: - Cascade failures - Complex interactions - Systemic risk
5.1.4: DeFi Market Overview
Total Value Locked (TVL):
TVL is the total value of assets locked in DeFi protocols. It’s a key metric of DeFi adoption.
TVL Growth: 2019: $0.5B 2020: $15B 2021: $200B 2022: $50B (post crash) 2023: $80B 2024: $100B+ Top Protocols by TVL (2024): 1. Lido: ~$30B (liquid staking) 2. Aave: ~$10B (lending) 3. MakerDAO: ~$8B (stablecoin) 4. Uniswap: ~$6B (DEX) 5. EigenLayer: ~$5B (restaking)
DeFi User Adoption:
User Growth: 2020: 1M unique addresses 2021: 4M unique addresses 2022: 5M unique addresses 2023: 8M unique addresses 2024: 12M+ unique addresses Demographics: - Majority: 18-35 years old - Geography: US, Europe, Asia - Average Transaction: $5,000-$50,000
5.1.5: DeFi Risks and Challenges
Risk Categories:
DeFi Risk Matrix: 1. Smart Contract Risk: ┌─────────────────────────────────────────────────────────────┐ │ • Bugs in code │ │ • Exploits and hacks │ │ • Protocol failures │ │ • Mitigation: Audits, bug bounties │ └─────────────────────────────────────────────────────────────┘ 2. Economic Risk: ┌─────────────────────────────────────────────────────────────┐ │ • Impermanent loss │ │ • Liquidation risk │ │ • Market volatility │ │ • Mitigation: Risk management, diversification │ └─────────────────────────────────────────────────────────────┘ 3. Systemic Risk: ┌─────────────────────────────────────────────────────────────┐ │ • Cascade failures │ │ • Flash loan attacks │ │ • Oracle manipulation │ │ • Mitigation: Circuit breakers, insurance │ └─────────────────────────────────────────────────────────────┘ 4. Regulatory Risk: ┌─────────────────────────────────────────────────────────────┐ │ • Unclear legal status │ │ • Compliance requirements │ │ • Jurisdictional issues │ │ • Mitigation: Legal review, compliance frameworks │ └─────────────────────────────────────────────────────────────┘ 5. Operational Risk: ┌─────────────────────────────────────────────────────────────┐ │ • User errors │ │ • Wallet security │ │ • Phishing attacks │ │ • Mitigation: Education, secure wallets │ └─────────────────────────────────────────────────────────────┘
Major DeFi Attacks (2023-2024):
| Attack | Amount | Protocol | Vector |
|---|---|---|---|
| Euler Finance | $196M | Euler | Flash loan |
| Mango Markets | $100M | Mango | Oracle manipulation |
| BonqDAO | $120M | Bonq | Oracle manipulation |
| Curve Finance | $61M | Curve | Reentrancy |
| KyberSwap | $48M | Kyber | Arithmetic |
ADDITIONAL DEEP TECHNICAL NOTES:
1. DeFi vs CeFi Comparison
| Feature | CeFi (Centralized Finance) | DeFi (Decentralized Finance) |
|---|---|---|
| Custody | Exchange holds funds | User holds funds |
| Access | KYC required | Permissionless |
| Fees | 0.1-2% per trade | 0.01-0.3% per trade |
| Settlement | 1-3 days | Instant |
| Transparency | Limited | Full |
| Insurance | Limited | Protocol-specific |
| Innovation | Slow | Rapid |
| Global Access | Limited | Unlimited |
Lesson 5.5: Yield Farming and Liquidity Mining
Learning Objectives:
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Understand yield farming mechanics
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Master liquidity mining economics
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Learn about yield optimization strategies
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Analyze farming risks and APY calculations
5.5.1: What is Yield Farming?
Definition:
Yield farming is the practice of generating returns by strategically moving assets between DeFi protocols to maximize yield.
Yield Farming Components: ┌─────────────────────────────────────────────────────────────────────┐ │ Yield Farming │ │ │ │ Base Yield: │ │ ┌─────────────────────────────────────────────────────────────┐ │ │ │ • Lending interest (Aave, Compound) │ │ │ │ • Trading fees (Uniswap, Curve) │ │ │ │ • Staking rewards (Lido, Rocket Pool) │ │ │ └─────────────────────────────────────────────────────────────┘ │ │ │ │ │ Bonus Rewards: │ │ ┌─────────────────────────────────────────────────────────────┐ │ │ │ • Liquidity mining tokens │ │ │ │ • Governance tokens │ │ │ │ • Protocol incentives │ │ │ └─────────────────────────────────────────────────────────────┘ │ │ │ │ │ Total Yield = Base Yield + Bonus Rewards + Compounding │ └─────────────────────────────────────────────────────────────────────┘
5.5.2: Liquidity Mining
How Liquidity Mining Works:
Protocols distribute native tokens to users who provide liquidity.
Liquidity Mining Example: 1. User deposits ETH + DAI into Uniswap pool 2. Receives LP tokens (liquidity provider tokens) 3. Stakes LP tokens in farm 4. Receives UNI rewards + trading fees Rewards Distribution: - Trading fees: 0.3% per trade - UNI rewards: Distributed proportionally - Total APR: 20-100%+ Farm Economics: ┌─────────────────────────────────────────────────────────────────────┐ │ Token Emission: │ │ • Daily: 100,000 UNI │ │ • TVL: $10M │ │ • Rewards per $1: 0.01 UNI │ │ │ │ User: $10,000 deposit │ │ Rewards: $5/day in UNI │ │ APR: (5 × 365) / 10,000 = 18.25% │ └─────────────────────────────────────────────────────────────────────┘
5.5.3: Yield Optimization Strategies
Popular Strategies:
| Strategy | Description | Risk Level |
|---|---|---|
| Single Asset Staking | Deposit one token for rewards | Low |
| LP Farming | Provide liquidity + farm rewards | Medium |
| Yield Aggregation | Auto-compound yields | Medium |
| Leveraged Farming | Borrow to increase exposure | High |
| Arbitrage Farming | Profit from price differences | High |
5.5.4: Yearn Finance – Automated Yields
Yearn Architecture:
Yearn Vaults: 1. Depositors deposit tokens 2. Vaults find best strategies 3. Strategies deployed across protocols 4. Returns auto-compounded 5. Depositors earn yTokens Strategy Examples: - Lend DAI on Aave - Farm CRV on Curve - Deposit in Convex
5.5.5: Yield Farming Risks
| Risk | Description | Mitigation |
|---|---|---|
| Impermanent Loss | LP position loses value | Monitor pairs |
| Smart Contract Risk | Protocol bug | Audits |
| Rug Pulls | Malicious exit | Verify contracts |
| APY Volatility | Variable returns | Diversify |
| Liquidity Risk | Cannot withdraw | Check liquidity |
Lesson 5.6: DeFi Derivatives
Learning Objectives:
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Understand DeFi derivatives and their mechanics
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Master options, futures, and perpetuals
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Learn about synthetic assets
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Analyze derivative risks
5.6.1: What are DeFi Derivatives?
Definition:
Derivatives are financial contracts whose value depends on an underlying asset. DeFi derivatives bring these instruments on-chain.
Derivative Types: 1. Futures: - Agreement to buy/sell at future date - Locked price - Settlement at expiration 2. Options: - Right (not obligation) to buy/sell - Premium paid - European vs American style 3. Perpetuals: - No expiration date - Funding rate mechanism - Most popular in DeFi 4. Synthetics: - Synthetic assets tracking real assets - Collateralized by crypto - Example: sETH = synthetic ETH
5.6.2: Perpetual Contracts
How Perpetuals Work:
Perpetual Mechanics: 1. Position: - Long: Betting on price increase - Short: Betting on price decrease 2. Leverage: - 1x to 100x - Margin requirement - Liquidation risk 3. Funding Rate: - Periodic payment between longs/shorts - Tracks spot price - Interest rate component Funding Rate Calculation: Rate = (Mark_Price - Index_Price) / Index_Price If Mark_Price > Index_Price: - Longs pay shorts (bullish market) If Mark_Price < Index_Price: - Shorts pay longs (bearish market)
5.6.3: Options in DeFi
Option Basics:
Option Types: Call Option: - Right to buy at strike price - Pays premium - Profits if price rises Put Option: - Right to sell at strike price - Pays premium - Profits if price falls Example (ETH Call): - Strike: $3,000 - Premium: $100 - Expiry: 1 month If ETH > $3,000 at expiry: - Exercise, profit = ETH - $3,000 - $100 If ETH < $3,000: - Option expires worthless, loss = $100
5.6.4: Synthetic Assets
What are Synthetics?
Synthetics are tokenized derivatives that track the price of real-world assets.
Synthetic Asset Example: sUSD (Synthetic USD): - Collateral: SNX tokens - Pegged to USD - No underlying USD needed sETH (Synthetic ETH): - Collateral: SNX tokens - Tracks ETH price - No underlying ETH needed Benefits: - Access to any asset - No custody needed - Permissionless trading Risks: - Collateral risk - Oracle dependency - Liquidation risk
5.6.5: Derivative Risks
| Risk | Description | Mitigation |
|---|---|---|
| Liquidation | Position liquidated | Maintain margin |
| Oracle Risk | Wrong price feed | Use multiple oracles |
| Leverage Risk | Amplified losses | Manage position size |
| Counterparty Risk | Protocol failure | Use established protocols |
Lesson 5.7: DeFi Oracles and Data Feeds
Learning Objectives:
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Understand oracle importance in DeFi
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Master oracle mechanisms (Chainlink, etc.)
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Learn about oracle attack vectors
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Analyze oracle security
5.7.1: What are Oracles?
Definition:
Oracles are services that provide off-chain data to smart contracts. They bridge the gap between blockchain and the real world.
Oracle Types: 1. Inbound Oracles: - Bring off-chain data on-chain - Example: Price feeds - Most common in DeFi 2. Outbound Oracles: - Send on-chain data off-chain - Example: Event triggers 3. Consensus Oracles: - Aggregated data from multiple sources - More reliable 4. Computation Oracles: - Off-chain computation - Result sent on-chain
5.7.2: Chainlink Architecture
How Chainlink Works:
Chainlink Oracle Flow: ┌─────────────────────────────────────────────────────────────────────┐ │ Chainlink Architecture │ │ │ │ Data Sources: │ │ ┌─────────────┐ ┌─────────────┐ ┌─────────────┐ │ │ │ Exchange A │ │ Exchange B │ │ Exchange C │ │ │ └─────────────┘ └─────────────┘ └─────────────┘ │ │ │ │ │ ▼ │ │ Chainlink Nodes: │ │ ┌─────────────┐ ┌─────────────┐ ┌─────────────┐ │ │ │ Node 1 │ │ Node 2 │ │ Node 3 │ │ │ │ (Fetch) │ │ (Fetch) │ │ (Fetch) │ │ │ └─────────────┘ └─────────────┘ └─────────────┘ │ │ │ │ │ ▼ │ │ Aggregation: │ │ ┌─────────────────────────────────────────────────────────────┐ │ │ │ Median price from all nodes │ │ │ │ Remove outliers │ │ │ │ Submit to smart contract │ │ │ └─────────────────────────────────────────────────────────────┘ │ └─────────────────────────────────────────────────────────────────────┘
Chainlink Price Feeds:
Price Feed Example (ETH/USD): Aggregator: 0x5f4eC3Df9cbd43714FE2740f5E3616155c5b8419 Data Providers: - Coinbase: $2,850 - Binance: $2,851 - Kraken: $2,849 - Median: $2,850 Heartbeat: 1 hour (or on deviation) Deviation Threshold: 0.5% Failsafe: Multiple nodes required
5.7.3: Oracle Attack Vectors
Common Oracle Attacks:
| Attack | Description | Impact |
|---|---|---|
| Flash Loan Manipulation | Temporary price manipulation | Liquidations, theft |
| Data Provider Compromise | Single source manipulated | Wrong price |
| Node Collusion | Multiple nodes compromised | Wrong price |
| Front-Running | Price updates front-run | Arbitrage profit |
Real Attack Example (Mango Markets):
Mango Markets Attack (2022): 1. Attacker deposited $5M USDC 2. Used deposit to manipulate MNGO price 3. Used manipulated price to borrow from protocol 4. Took out $100M in assets 5. Profit: ~$100M 6. Exploited oracle manipulation vulnerability
5.7.4: Oracle Best Practices
Oracle Security: 1. Multiple Sources: - 3+ independent sources - Weighted average - Outlier removal 2. Time Weighting: - TWAP (Time-Weighted Average Price) - Resists manipulation - 1-2 hour window 3. Circuit Breakers: - Monitor price changes - Pause if too large - Human intervention 4. Fallback Oracle: - Backup source - Emergency switch - Protocol guard
Lesson 5.8: DeFi Security and Risk Management
Learning Objectives:
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Master DeFi security best practices
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Understand risk management strategies
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Learn about insurance and safety mechanisms
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Analyze attack vectors and prevention
5.8.1: DeFi Security Framework
Security Layers:
DeFi Security Layers: ┌─────────────────────────────────────────────────────────────────────┐ │ Security Framework │ │ │ │ Layer 1: Smart Contract Security │ │ ┌─────────────────────────────────────────────────────────────┐ │ │ │ • Audits │ │ │ │ • Formal verification │ │ │ │ • Bug bounties │ │ │ └─────────────────────────────────────────────────────────────┘ │ │ │ │ │ Layer 2: Protocol Security │ │ ┌─────────────────────────────────────────────────────────────┐ │ │ │ • Circuit breakers │ │ │ │ • Timelocks │ │ │ │ • Multi-sig controls │ │ │ └─────────────────────────────────────────────────────────────┘ │ │ │ │ │ Layer 3: User Security │ │ ┌─────────────────────────────────────────────────────────────┐ │ │ │ • Wallet security │ │ │ │ • Risk management │ │ │ │ • Education │ │ │ └─────────────────────────────────────────────────────────────┘ │ └─────────────────────────────────────────────────────────────────────┘
5.8.2: Common Attack Vectors
Attack Types:
| Attack | Description | Prevention |
|---|---|---|
| Reentrancy | Recursive call | Checks-effects-interactions |
| Flash Loan | Uncollateralized loan | Circuit breakers |
| Oracle Manipulation | Price attacks | Multiple oracles |
| Governance Attack | Malicious proposal | Timelocks, quorum |
| Front-Running | Transaction ordering | Commit-reveal |
| Phishing | User tricked | Education, verification |
5.8.3: DeFi Insurance
Insurance Protocols:
Insurance Types: 1. Smart Contract Insurance: - Covers protocol bugs - Example: Nexus Mutual 2. Protocol-Owned Insurance: - Protocol provides coverage - Example: Aave Safety Module 3. Parametric Insurance: - Trigger-based coverage - Example: Etherisc 4. Custom Insurance: - Tailored coverage - Example: COVER Coverage Examples: - $1M coverage for Aave deposit - Annual premium: 1-5% of covered amount - Payout if protocol hacked
5.8.4: Risk Management Strategies
Risk Management Framework:
Risk Management: 1. Diversification: - Spread across protocols - Different asset types - Multiple strategies 2. Position Sizing: - Risk per position: 1-5% of portfolio - Stop losses - Take profit levels 3. Monitoring: - On-chain monitoring - Price alerts - Protocol health 4. Hedging: - Use options - Stablecoins - Short positions
5.8.5: DeFi Safety Checklist
User Safety Checklist: ☐ Use reputable protocols ☐ Check audit reports ☐ Review code (if possible) ☐ Use hardware wallet ☐ Enable 2FA where possible ☐ Diversify positions ☐ Set slippage limits ☐ Monitor positions ☐ Use gas optimization ☐ Back up seeds ☐ Stay informed on threats ☐ Check protocol status ☐ Use multi-sig for large funds ☐ Consider insurance ☐ Test with small amounts
MODULE 5 SUMMARY COMPLETE
You now have comprehensive notes for Module 5: DeFi Protocols and Applications covering:
Lesson 5.1: DeFi Overview and Foundations
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What is DeFi, ecosystem components
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DeFi composability and money legos
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Market overview and risks
Lesson 5.2: Decentralized Exchanges (DEXs)
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AMM mathematics (x × y = k)
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Impermanent loss
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DEX aggregators
Lesson 5.3: DeFi Lending and Borrowing
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Collateralization and LTV
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Interest rate models
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Liquidation mechanics
Lesson 5.4: Stablecoins
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Types (fiat-backed, crypto-backed, algorithmic)
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DAI architecture
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Death spiral risks
Lesson 5.5: Yield Farming and Liquidity Mining
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Liquidity mining mechanics
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Yield optimization strategies
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Risks and APY calculations
Lesson 5.6: DeFi Derivatives
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Perpetuals, options, synthetics
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Funding rates
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Risks and leverage
Lesson 5.7: DeFi Oracles
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Chainlink architecture
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Oracle attack vectors
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Best practices
Lesson 5.8: DeFi Security
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Security framework
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Common attack vectors
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Insurance and risk management
Ready to continue with Module 6? Module 6 covers NFTs and Digital Asset Tokenization