Decentralized Finance (DeFi) on Ethereum: The Future of Finance?

Decentralized finance, or “DeFi” for short, has taken over the world of cryptocurrencies and blockchains. However, its recent resurgence masks its roots in the bubble era of 2017. While everyone and their dog were doing an “Initial Coin Offering” or ICO, few companies saw the potential of blockchain much beyond a quick profit. Price. These pioneers envisioned a world in which financial applications – from commerce to savings to banking and insurance – would be possible simply on the blockchain without intermediaries.

To understand the potential of this revolution, imagine if you had access to a savings account that yields 10% per year in USD but without a bank and practically without risk of funds. Imagine that you can negotiate crop insurance with a Ghanaian farmer sitting in his office in Tokyo. Imagine being able to be a market maker and earn fees as a percentage that any Citadel would want. It sounds too good to be true? It is not. This future is already here.

DeFi building blocks

There are some basic components of DeFi that you need to know before moving on:

  • Automated market creation or exchange of one asset for another without trust and without an intermediary or clearing house.

  • Loans with excess collateral or “put your assets to use” for long-term traders, speculators and holders.

  • Stablecoins or algorithmic assets that track the price of an underlying without being centralized or backed by physical assets.

Understanding how DeFi is made

Stablecoins are frequently used in DeFi because they mimic traditional fiat currencies like the USD. This is an important breakthrough because the history of cryptocurrencies shows how volatile things are. Stablecoins like DAI are designed to track the value of the USD with minor deviations even during strong bear markets, that is, even if the price of cryptocurrencies is falling like the 2018-2020 bear market.

Lending protocols are an interesting development that is generally based on stablecoins. Imagine if you could lock in your million dollar assets and then borrow against them in stablecoins. The protocol will automatically sell your assets if you fail to repay the loan when your collateral is no longer sufficient.

Automated Market Makers form the foundation of the entire DeFi ecosystem. Without this, you are stuck in the legacy financial system where you need to trust your broker or clearing house or an exchange. Automated Market Makers or AMMs for short allow you to trade one asset for another based on a reserve of both assets in their pools. Price discovery occurs through outside arbitrageurs. Liquidity is grouped based on other people’s assets and they get access to trading fees.

Now you can get exposure to a wide 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 by being a market maker.

For the developing world, this is an amazing innovation because they now have access to the full suite of financial systems in the developed world without barriers to entry.

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