Decentralized finance, or “DeFi” for short, has taken over the crypto and blockchain world. However, its recent resurgence hides its bubble-era roots in 2017. While everyone and their dog was making an “initial coin offering” or ICO, few companies saw the potential of blockchain far beyond quick price gains. These pioneers envisioned a world where financial applications from trading to savings to banking to insurance are simply possible 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% annually in US dollars but without a bank and virtually no financial risk. Imagine you could trade crop insurance with a farmer in Ghana sitting in your office in Tokyo. Imagine being able to be a market maker and earn a fee as a percentage 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 exchanging one asset for another without a broker or clearing house.
Excessive lending or the ability to “use your assets” to traders, speculators and long-term holders.
Stable coins or algorithmic assets that track the price of an asset without being centralized or backed by a physical asset.
Understand how to make DeFi
Stablecoins are frequently used in DeFi because they mimic traditional fiat currencies such as the US dollar. This is an important development because the history of cryptocurrency shows how volatile things can be. Stable coins like 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 the bear market in 2018-2020.
Lending protocols are an interesting development that is usually built on top of stablecoins. Imagine if you could seize your $1 million assets and then borrow 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 the old financial system where you need to trust your broker, clearinghouse or stock 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 and without having to interact with the traditional financial world. You can make money by lending assets or being a market maker.
For the developing world, this is a great innovation because they now have access to the full range of financial systems in the developed world without any barriers to entry.