Decentralized finance, or “DeFi” for short, has taken the world of crypto and blockchain by storm. However, its recent revival masks its roots in the 2017 bubble era. While everyone and their dog were doing the “Initial Coin Offer” or ICO, only a few companies saw the potential of the blockchain far beyond the rapid rise in price. These pioneers envisioned a world where financial applications from trade to savings and banking to insurance would be possible just on the blockchain without any intermediaries.
To understand the potential of this revolution, imagine if you had access to a savings account that yields 10% per year in dollars, but without a bank and virtually risk-free funds. Imagine being able to trade crop insurance with a farmer in Ghana who is sitting in your office in Tokyo. Imagine being able to be a market maker and earn fees in the form of interest that every Citadel would like. Sounds too good to be true? This is not the case. This future is already here.
DeFi building blocks
There are some basic DeFi building blocks that you need to know before moving forward:
Automated market-making or distrustful exchange of one asset for another without an intermediary or settlement center.
Lending with over-security or the ability to “use 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 such as the USD. This is an important development because crypto history shows how changeable things are. Stablecoins, such as DAI, are designed to track the value of the dollar with minor deviations even during strong bear markets, that is, even if the crypto price breaks off like the bear market of 2018-2020.
Lending protocols are an interesting development, usually based on stablecoins. Imagine if you could lock up your million-dollar assets and then borrow under them in stablecoins. The protocol automatically sells your assets if you do not repay the loan, if your collateral is no longer enough.
Automated market makers form the basis of the entire DeFi ecosystem. Without this you are stuck in an outdated financial system where you need to trust your broker, clearing or exchange. Automated market makers, or AMMs, for short, allow you to trade one asset to another based on the reserve of both assets in its pools. Price detection is done through external arbitrage. Liquidity is pooled based on other people’s assets and they gain access to trading fees.
You can now access a wide range of assets in the Ethereum ecosystem and without having to interact with the traditional financial world. You can make money by lending assets or being a market maker.
For developing countries, this is a surprising innovation because they now have access to a full set of financial systems in the developed world without barriers to entry.