Decentralized Finance, or “DeFi,” as it is colloquially known, has taken the crypto and blockchain world by storm. However, its recent resurgence obscures its origins in the 2017 bubble era. While everyone and their dog was doing a “Initial Coin Offering,” or ICO, few companies saw blockchain’s potential beyond a quick price increase. These trailblazers envisioned a world in which all financial applications, from trading to savings to banking to insurance, would be possible directly on the blockchain, without the need for any intermediaries.
To understand the potential of this revolution, consider having access to a savings account that pays a ten percent annual yield in USD but does not require a bank and poses virtually no risk of funds. Assume you can trade crop insurance with a farmer in Ghana while sitting in your Tokyo office. Imagine being able to be a market maker and earning fees in the form of a percentage that every Citadel would want. Isn’t it too good to be true? It’s not. This future has already arrived.
DeFi Building Blocks
Before we proceed, there are some fundamental DeFi building blocks that you should be aware of:
Automated market making or exchanging one asset for another without the use of a middleman or clearinghouse.
For traders, speculators, and long-term holders, overcollateralized lending or the ability to “put your assets to use”
Stablecoins are algorithmic assets that track the price of an underlying asset but are not centralized or backed by physical assets.
Understanding the Production of DeFi
Stablecoins are commonly used in DeFi because they resemble traditional fiat currencies such as USD. This is a significant development because the history of cryptocurrency demonstrates how volatile things can be. Stablecoins, such as DAI, are designed to track the value of USD with minor deviations even during strong bear markets, i.e. even if the price of cryptocurrency crashes, as it did from 2018 to 2020.
Lending protocols are a fascinating development that is typically built on top of stablecoins. Consider locking up assets worth a million dollars and borrowing against them in stablecoins. If you do not repay the loan when your collateral is no longer sufficient, the protocol will automatically sell your assets.
The entire DeFi ecosystem is built on automated market makers. Without it, you’re stuck with the legacy financial system, which requires you to rely on your broker, clearinghouse, or exchange. AMMs, or automated market makers, allow you to trade one asset for another based on a reserve of both assets in their pools. External arbitrageurs are responsible for price discovery. Liquidity is pooled based on the assets of others, and they have access to trading fees.
You can now gain exposure to a wide range of assets while remaining entirely within the Ethereum ecosystem and never having to interact with the traditional financial world. You can profit by lending assets or acting as a market maker.
This is a fantastic innovation for the developing world because it now gives them access to the entire suite of financial systems in the developed world with no barriers to entry.