Decentralized finance, or “DeFi” for short, has taken the cryptocurrency and blockchain world by storm. However, its recent resurgence masks its roots in the bubble era of 2017. While everyone and their dogs were doing an “Initial Coin Offering” or ICO, few companies saw the potential of blockchain much beyond a quick profit on the market. price. These pioneers envisioned a world in which financial applications, from trading to savings, banking and insurance, would be possible simply on the blockchain without intermediaries.
To understand the potential of this revolution, imagine if you had access to a savings account that yields 10% per year in USD but without a bank and practically without risk of funds. Imagine that you can trade crop insurance with a farmer in Ghana sitting in his office in Tokyo. Imagine being able to be a market maker and earn fees as a percentage like every Citadel would want. It sounds too good to be true? it is not. This future is already here.
DeFi Building Blocks
There are a few basic components of DeFi that you should be aware of before moving forward:
- Automated market making or trustless trading of one asset for another without an intermediary or clearinghouse.
- Overcollateralized loans or being able to “put your assets to use” for traders, speculators and long-term holders.
- Stablecoins or algorithmic assets that track the price of an underlying without being centralized or backed by physical assets.
Understand how DeFi is done
Stablecoins are frequently used in DeFi because they mimic traditional fiat currencies like the USD. This is an important development because the history of cryptocurrencies shows how volatile things are. Stablecoins like DAI are designed to track the value of the USD with minor deviations even during strong bear markets, that is, even if the price of cryptocurrencies crashes like the 2018-2020 bear market.
Lending protocols are an interesting development that is generally based on stablecoins. Imagine if you could lock up your assets worth a million dollars and then borrow against them in stablecoins. The protocol will automatically sell your assets if you default on the loan when your collateral is no longer sufficient.
Automated market makers form the foundation of the entire DeFi ecosystem. Without this, you are stuck in the legacy financial system where you need to trust your broker, clearinghouse, or exchange. Automated Market Makers or AMMs for short allow you to trade one asset for another based on a reserve of both assets in their pools. Price discovery occurs through external arbitrageurs. Liquidity is pooled based on other people’s assets and they get access to trading fees.
You can now gain exposure to a wide variety of assets in the Ethereum ecosystem and without having to interact with the traditional financial world. You can earn money by lending assets or being a market maker.
For the developing world, this is an amazing innovation because they now have access to the full suite of financial systems in the developed world with no barriers to entry.
