Decentralized finance, or “DeFi” for short, has taken the crypto and blockchain world by storm. However, its recent resurgence has masked its roots in the bubble era of 2017. While everyone and their dogs were doing Initial Coin Offerings, or ICOs, few companies saw blockchain’s potential far beyond its rapid price rise. These pioneers envisioned a world where financial applications from trading to savings to banking and insurance would be possible simply on the blockchain without any intermediaries.
To understand the potential of this revolution, imagine having access to a savings account that yields 10% annual returns in US dollars, but without a bank and with 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 that any Citadel would want. Sound too good to be true? It’s not. That future is already here.
Building blocks of DeFi
There are some basic building blocks of DeFi that you need to know before we move forward:
Automated market making or exchanging one asset for another without trust without an intermediary or clearing house.
Over-collateralized lending or the ability to “leverage your assets” for traders, speculators and long-term holders.
Stablecoins or algorithmic assets that track the price of an underlying asset without being centralized or backed by physical assets.
Understanding how DeFi is done
Stablecoins are often used in DeFi because they mimic traditional fiat currencies like the USD. This is an important development because the history of crypto shows how fickle things are. Stablecoins like DAI are designed to track the value of the USD with minor deviations even during strong bear markets ie. even if the price of crypto crashes like the bear market of 2018-2020.
Lending protocols are an interesting development, usually built on top of stablecoins. Imagine if you could lock up a million dollars worth of your assets and then borrow against them in stablecoins. The protocol will automatically sell your assets if you default on the loan when the collateral is no longer sufficient.
Automated market makers form the foundation of the entire DeFi ecosystem. Without it, you remain in the legacy financial system where you have to trust your broker or clearing house or exchange. Automated Market Makers, or AMM for short, allow you to trade one asset for another based on a reserve of the two assets in its pools. Price discovery takes place through external arbitrations. Liquidity is collected based on other people’s assets and they get access to trading fees.
You can now tap into a wide variety of assets in the Ethereum ecosystem without ever having to interact with the traditional financial world. You can make money by borrowing assets or being a market maker.
For the developing world, this is an incredible innovation because they now have access to the full range of financial systems in the developed world without barriers to entry.