Decentralized finance, or “DeFi” for short, has taken over the world of cryptocurrencies and blockchain. However, its recent re-emergence masks its roots in the bubble era of 2017. While everyone and their dog were running an ICO or ICO, a few companies saw the potential of blockchain far beyond rapid gains in price. These pioneers envision a world in which financial applications from trading to savings to banking to insurance are simply possible on the blockchain without any middlemen.
To understand the potential of this revolution, imagine having access to a savings account that generates 10% annually in US dollars but without a bank and practically without financial risk. Imagine you can trade crop insurance with a farmer in Ghana sitting in your office in Tokyo. Imagine being able to become a market maker and earn the percentage fee that each castle wants. Sounds too good to be true? it’s not like that. This future is already here.
The building blocks of DeFi
There are some basic building blocks of DeFi that you should know before moving forward:
Automated market making or the exchange of one asset for another without a broker or clearinghouse.
Excessive lending or the ability to “use your assets” for traders, speculators and long-term contract holders.
Stable currencies or algorithmic assets that track the price of an asset without being centralized or backed by a physical asset.
Understand how DeFi is made
Stable currencies are used frequently in DeFi because they mimic traditional fiat currencies like the US dollar. This is an important development because the history of cryptocurrencies shows just how volatile things can be. Stable currencies like the DAI are designed to track the value of the US dollar with slight deviations even during strong bear markets, that is, even if the cryptocurrency price collapses like a bear market in 2018-2020.
Lending protocols are an interesting development that is usually built on top of stablecoins. Imagine if you could reserve your million dollar assets and then borrow from them in stable currencies. The protocol will automatically sell your assets if you do not pay off the loan when your guarantees are no longer sufficient.
Automated market makers form the basis of the entire DeFi ecosystem. Without that, you are stuck in the old financial system where you need to trust a broker, clearinghouse, or exchange. Automated market makers, or AMMs for short, allow you to trade one asset for another based on the reserves of each of the assets in their pools. Price discovery occurs by external arbitrage. Liquidity is pooled based on other people’s assets and they have access to trading fees.
You can now learn about a variety of assets all in the Ethereum ecosystem without having to interact with the traditional financial world. You can make money by lending to assets or by being a market maker.
For the developing world, this is a great innovation because they now have access to a full range of financial systems in the developed world without any barriers to entry.