Decentralized Finance for Complete Beginners

As of the time of writing, the estimated Total Locked up Value (TLV) in the DeFi market is over $22 billion, which is phenomenal, considering that the entire DeFi market was just about $300 million only two years earlier.

While some may say it’s all a speculative bubble waiting to burst, we will be looking beyond these numbers into the actual technological innovation driving these numbers. 

The rise of DeFi  

Following Bitcoin’s success as a payment system that could replace financial institutions in electronic transactions, there have been several attempts to replicate that across every system. This quest at disruption is intense in the financial market where trusted third parties are required for every transaction to be completed. 

The rise of blockchain infrastructures like EOS, Ethereum, and the recently launched Polkadot, allows anyone to replicate any traditional system which depends on a third-party, on a blockchain network using smart contracts

With a blockchain like Ethereum, anyone can model the activities of any aspect of the traditional financial market as a self-executing, decentralized smart contract. Hence, the name decentralized finance. This ability of self-execution did spark the fire of this new financial movement and technology. 

Decentralized Finance is basically reiterating an operation that constitutes the financial market on a decentralized blockchain protocol. These replications are otherwise dependent on a financial institution for its operations and liquidity. 

We are talking about placing trust in the eyes and hands of the public as well as depending on the public for liquidity/cash-flow to keep the system operational. Technically this makes that group the owners of the business.

In place of brokers and traditional order books, used in the financial market, we now have smart contracts executing trades. In place of market makers providing liquidity to complete trades, we now have pooled contributions from different participants, providing the volume to complete pending trades on an exchange. 

Think of it as a financial system for the people, by the people, and of the people. DeFi is a classic example of what a democratic financial system, independent of politicking can look like.

Top 3 DeFi solutions that are trending

We will be looking at some controversial DeFi applications with the potential of changing financial market operations that have lasted very long; some for more millennials.

Asset Lending deployed as DeFi protocol

This is where it all started, with Maker DAO — a decentralized lending protocol. Deployed on the Ethereum blockchain as a smart contract, Maker DAO, allows ETH and BAT token holders to lock up their funds as collateral on the Maker smart contract in exchange for Dai token. Dai is a stable token pegged against the USD and it is technically the legal tender of the MakerDAO community (usually called the native token.)

With the Maker lending innovation, investors could now take up loans against their ETH or BAT holdings, without selling off their holdings. This is great for cryptocurrency investors who are not ready to liquidate their ETH or BAT position but requires some liquidity to reinvest into other assets.

Following the Maker DAO success, there have been several tweaks and innovations to the lending protocol initiative. Unlike Maker, which only minted new Dai, when a collateral is locked, newer protocols like Aave allow anyone to loan out their holdings with interest. With this, debtors and creditors can now interact in a free market, where interest rates are defined by the market. 

This single innovation has sparked the whole yield farming movement. For perspective, you want to think of yield farming as smart contract lending on steroids. In fact, there are many who believe that this will be the death of traditional credit provision by banks and credit providers.

Asset exchange as DeFi protocol

Popularly called decentralized exchanges (DEX). The idea is simply to make the total creation, ownership, and exchange of cryptocurrencies completely independent of third parties. 

Conventionally, every asset exchange in the financial market, including stock exchanges and cryptocurrency exchanges like Binance and Coinbase, requires a sizable amount of cash flow in place to complete whatever order- size traders may place. The provision of liquidity (which is called market making) is traditionally done from a central source.  

Although DEX existed long before Maker and the whole DeFi movement; it was not very popular. as it was limited to one pair and it generally operated as a peer-to-peer crypto exchange that swapped assets when users were available to swap. Cryptocurrencies were not locked up beforehand.

The genius with DeFi DEXes is that these central liquidity sources are shared through a liquidity pooling protocol, which involves a crowd of users called Liquidity Providers (LPs) making volume available for a range of assets to be traded on the DEX. In exchange for staking their volume, they get to share the fees that traders pay while using this decentralized exchange.

Cryptocurrency derivatives on DeFi

In traditional financial markets, derivatives are a type of instrument that draws/get their value from the performance of an underlying asset or entity. The underlying entity or assets can be a basket of assets, stocks, bonds, commodities, and currencies.

Derivatives technically are contracts between two parties. This could be a contract which states that party A will buy so and so asset from party B at an agreed price, at a specific time. Traditionally, derivatives provide the opportunity for investors to hedge themselves in the market.

The possibilities of simulating whatever contract and instance that can be thought of using smart contract powered protocol, has paved the way for derivative instruments to help crypto investors hedge their positions from the volatility that cryptocurrencies are very prone to.

Other DeFi protocols to have in mind

Some other DeFi solutions that are disrupting some aspect of the financial markets are decentralized crypto payment gateways, which allows merchants to accept crypto payment without relying on a traditional payment gateway; asset diversification protocols, which allow traders to gain significant exposure of the crypto market without having to use a third-party brokerage service or exchange to gain that exposure; and several other great solutions.

The Future of finance with DeFi

We live in a world where over 1.7 billion lives still remain unserviced by legacy financial systems. Fortunately, technological bridges, like mobile phones have been instrumental in bridging these gaps, especially in emerging economies where the numbers are the highest.

Innovations like DeFi coupled with the borderless power of mobile banking will significantly affect that number. For this to happen, financial service institutions will need to embrace this new decentralized financial model.

Also, the possibilities of what can be simulated on smart contract infrastructures like Ethereum is endless. This is why we would continue to see new DeFi instruments and systems going forward.

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