Decentralized finance (“DeFi” for short) has taken the encryption and blockchain fields by storm. However, its recent recovery obscured its roots in the 2017 bubble era. When everyone and their dogs are conducting an “initial coin offering” or ICO, few companies see the potential of blockchain far beyond the rapid price increase. These pioneers envisioned a world like this: from transactions to savings to banks to insurance, financial applications will be simply implemented on the blockchain without any intermediary.
To understand the potential of this revolution, imagine if you have a savings account with an annual rate of return of 10%, but without a bank, there is almost no capital risk. Imagine you can sit in a Tokyo office trading crop insurance with a farmer in Ghana. Imagine being able to become a market maker and earn a fee according to the percentage each castle wants. Sounds too good to be true? It’s not. The future has arrived.
The building blocks of DeFi
Before proceeding, you should understand some of the basic building blocks of DeFi:
There is no need for automatic market making by intermediaries or clearing houses or untrustworthy exchange of one asset for another.
To provide traders, speculators and long-term holders with over-collateralized loans or the ability to “use your assets”.
Stablecoins or algorithmic assets that track the price of the underlying securities without the need to be centralized or backed by physical assets.
Understand how DeFi is made
Stablecoins are often used in DeFi because they mimic traditional fiat currencies such as the U.S. dollar. This is an important development because the history of encryption technology shows the volatility of things. Stablecoins like DAI are designed to track the value of the U.S. dollar with a small deviation even during a strong bear market, that is, even if the price of cryptocurrencies collapses like a bear market in 2018-2020.
Loan agreements are an interesting development, usually built on stablecoins. Imagine if you could lock in assets worth a million dollars and then borrow money from them in stablecoins. If you do not repay the loan when the collateral is insufficient, the agreement will automatically sell your assets.
Automated market makers form the foundation of the entire DeFi ecosystem. Otherwise, you will not be able to use the old financial system, and you need to trust your broker, clearing house or exchange. An automated market maker, or AMM for short, allows you to trade one asset for another based on the reserve of two assets in the asset pool. Price discovery is done through external arbitrageurs. Liquidity is pooled based on other people’s assets, and they can get transaction fees.
You can now access various assets in the Ethereum ecosystem without interacting with the traditional financial world. You can make money by lending assets or market makers.
For developing countries, this is a great innovation, because now they can use the full financial system of the developed world without barriers to entry.