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Decentralized Finance, or “Defi,” has swept the cryptocurrency and blockchain worlds. However, its recent revival obscures its origins in the 2017 bubble period. While everybody and their dog were making an “Initial Coin Offering,” or ICO, few businesses saw blockchain’s potential beyond a fast price increase. These forerunners imagined a world in which financial applications such as trading, investments, banking, and insurance could all be made directly on the blockchain without the need for any middlemen.
Consider what would happen if you had access to a savings account that paid 10% a year in USD, but you didn’t have to go to a bank, and there was virtually no chance of losing your money. Imagine being able to exchange crop insurance with a farmer in Ghana from the comfort of your Tokyo office. Imagine working as a market maker and earning a percentage-based fee that every Citadel will desire. Sounds too good to be accurate. That isn’t the case. This is already the case.
DeFi’s building blocks
Before we go any further, there are a few simple Defi building blocks that you should be aware of:
Without using an intermediary or clearinghouse, automated market making or exchanging one asset for another is possible.
Traders, speculators, and long-term investors profit from overcollateralized lending or the ability to “put your money to work.”
- Stablecoins are algorithmic assets that monitor an underlying asset’s price without being backed by physical assets or centralized.
Understanding the Development of Defi
Stablecoins are common in Defi because they closely resemble conventional fiat currencies like the US dollar. This is important because the experience of cryptocurrency demonstrates how unpredictable things can be. Stablecoins like DAI are designed to follow the US dollar’s value with slight fluctuations even during heavy bear markets, such as the bear market from 2018 to 2020.
Lending protocols, which are typically developed on top of stablecoins, are a fascinating creation. Imagine being able to lock up a million dollars worth of assets and then borrow against them in stablecoins. If you don’t repay the loan when your collateral is no longer available, the protocol would automatically sell your properties.
The entire Defi ecosystem is built on the backs of automated market makers. You’re stuck with the legacy financial system if you don’t have this, where you have to trust your broker, clearinghouse, or exchange. AMMs, or automated market makers, allow you to swap one asset for another using a reserve of both investments in their pools. External arbitrageurs are used to finding the best price. They have access to trading fees because liquidity is pooled based on other people’s money.
You can now invest in a wide range of assets within the Ethereum ecosystem without ever dealing with conventional financial institutions. Lending assets or working as a market maker are two ways to make money.
This is a fantastic innovation for the developing world because it now gives them access to the entire suite of financial structures used in the developed world with no entry barriers.