Decentralized Finance, or “DeFi” for short, has taken the world of crypto and blockchain by storm. However, its recent resurgence covers the roots of the bubble era in 2017. While everyone and their dog is doing an “Initial Coin Offering” or ICO, few companies are seeing the potential of the blockchain. more of a quick price gain. These pioneers envisioned a world where financial applications from entrepreneurship to bank savings to insurance could all be simplified on the blockchain without any intermediaries.
To see the potential of this revolution, consider if you have access to a savings account that offers 10% a year in USD but without a bank and almost no risk of funds. Imagine you could sell harvest insurance to a Ghanaian farmer sitting in your Tokyo office. Imagine you could be a trader and earn fees as a percentage as each Citadel wants. How good are you really? No. The future is here.
DeFi building blocks
There are a few key building blocks of DeFi that you need to know before we move on:
Automated market creation or exchange of assets for others without trust without an intermediary or clearinghouse.
Excess collection lending or being able to “put your assets to use” for traders, speculators, and lenders.
Stablecoins or algorithmic assets that track the price of a hedge are not centered or supported by physical assets.
Understanding how DeFi is made
Stablecoins are often used by DeFi because they mimic traditional fiat currencies such as the USD. This is a significant development because the history of crypto shows how quickly things can change. Stablecoins like DAI are designed to track the USD value with small deviations even in a strong bear market, i.e. even if the crypto price breaks like the bear market 2018-2020.
Lending protocols are an interesting development that is often built on top of 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 do not repay the loan when your collateral is no longer sufficient.
Automated market makers form the basis of the entire DeFi ecosystem. Without it, you are stuck in a legacy financial system where you have to trust your broker or clearinghouse or an exchange. Automated market makers or AMMs for the short term allow you to sell one asset for another based on a reserve of the same assets in its pools. Price discovery will take place through external arbitrageurs. The clearance is filled in accordance with other people’s property and they gain access to the sale fee.
You can now be exposed to many different assets all in the Ethereum ecosystem and without having to interact with the traditional financial world. You can make money by lending assets or becoming a market maker.
For the developing world, this is a strange innovation because now they have access to the entire financial system of the developed world without barriers to entry.