Decentralized finance, or DeFi for short, has taken over the crypto and blockchain world. However, its recent resurgence has its roots in the bubble era of 2017. While everyone and their dog were making an “initial coin offering” or ICO, few companies saw the potential of the blockchain far beyond the rapid profit in price. These pioneers envisioned a world in which financial applications from trading to savings to banking to insurance would be possible simply on a blockchain, without intermediaries.
To understand the potential of this revolution, imagine if you had access to a savings account that gives 10% per year in US dollars, but without a bank and virtually no risk of funds. Imagine being able to trade crop insurance with a Ghanaian farmer sitting in your Tokyo office. Imagine being able to become a market maker and earn a fee as a percentage that any citadel would want. Sounds too good to be true? It’s not. This future is already here.
DeFi building blocks
There are some basic building blocks of DeFi that you need to know before moving on:
Automated creation or exchange of one asset for another without trust without an intermediary or clearing house.
Over-indebted loans or the ability to “use your assets” for traders, speculators and long-term holders.
Stable coins or algorithmic assets that track the price of the underlying base without being centralized or backed by physical assets.
Understanding how to make DeFi
Stablecoins are often used in DeFi because they mimic traditional fiat currencies such as the USD. This is an important development because the history of crypto shows how unstable things are. Stable coins such as DAI are designed to track the value of US dollars with small deviations even during strong bear markets, ie. even if the price of crypto collapses like the bear market of 2018-2020.
Lending protocols are an interesting development, usually built on stable coins. Imagine if you could lock up your million-dollar assets and then borrow against them in solid coins. 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 this, you are stuck with the inherited financial system, where you have to trust your broker, clearing house or stock 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. The opening of prices is done through external arbitrations. Liquidity is pooled based on other people’s assets and they gain access to trading fees.
You can now get exposure to a wide variety of assets in the Ethereum ecosystem without having to interact with the traditional financial world. You can make money by borrowing assets or being a market maker.
For developing countries, this is an incredible innovation, as they now have access to the full range of financial systems in the developed world without barriers to entry.