Decentralized Finance, or “DeFi” for short, has taken the crypto and blockchain world by storm. However, the recent resurgence masks its roots in the bubble era of 2017. While everyone and their dog were doing an “Initial Coin Offering,” or ICO, few companies saw the potential of blockchain much beyond a rapid price increase. These pioneers envisioned a world where financial applications from trading to savings, banking and insurance would all be possible simply on the blockchain, without intermediaries.
To understand the potential of this revolution, imagine having access to a savings account that yields 10% per annum in USD, but with no bank and virtually no risk of funds. Imagine being able to trade crop insurance with a farmer in Ghana sitting in your office in Tokyo. Imagine being able to be a market maker and earn fees as a percentage like any Citadel would like. Sounds too good to be true? That’s not it. This future is already here.
Building blocks of DeFi
There are some basic building blocks of DeFi that you should know before we go any further:
Automated market making or the trustless exchange of assets for another with no intermediary or clearing house.
Borrowing with too much collateral or being able to “use your assets” 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 made
Stablecoins are commonly used in DeFi as they mimic traditional fiat currencies such as USD. This is an important development because the history of crypto shows how volatile things are. Stablecoins like DAI are designed to track the value of USD with small deviations even during strong bear markets, so even if the price of crypto crashes like the 2018-2020 bear market.
Lending protocols are an interesting development usually built on top of stablecoins. Imagine if you could lock up your million dollar assets and then borrow against them in stablecoins. The protocol will automatically sell your assets if you fail to repay the loan when your collateral is no longer sufficient.
Automated market makers are the foundation of the entire DeFi ecosystem. Without it, you are stuck with the old financial system in which you have to trust your broker or clearinghouse or an exchange. Automated market makers or AMMs for short let you trade one asset for another based on a reserve of both assets in the pools. Price discovery is done through third-party arbitrageurs. Liquidity is pooled against other people’s assets and they get access to trading fees.
You can now gain exposure to a wide variety of assets, all in the Ethereum ecosystem and without ever interacting with traditional finance. You can make money by lending assets or being a market maker.
For developing countries, this is an amazing innovation as they now have access to the full suite of financial systems in the developed world without barriers to entry.