DeFi is one of the main driving forces behind the cryptocurrency revolution. This may come as a surprise to many as it has not existed for a long time. Despite not existing for long, the technology continues to pour billions into the cryptocurrency markets. Some believe that the DeFi industry could be another bubble waiting to pop. Others believe that this is far from the truth.
What is Decentralised Finance (DeFi) ?
Wall Street 2.0
DeFi is the investment and banking realm of cryptocurrencies. It is Wall Street 2.0 on the blockchain. Vitalik Buterin and early members of the Ethereum community make this possible. Using a combination of decentralised ledger technology, Vitalik and members of the Ethereum community created an ecosystem of decentralised applications (dApps) that automate processes you may normally find in traditional investment and banking sectors.
Buterin announced the Ethereum project in 2013 with a whitepaper called, “A Next Generation Smart Contract and Decentralised Application Platform”. The whitepaper detailed a platform developers could use to create dApps with smart contracts and other software development tools. Developers use Ethereum smart contracts to make dApps interact with the blockchain. This enables people to do much more with it than just making peer-to-peer financial transactions as they did with Bitcoin.
The history of DeFi defines its user experience in many ways. Thanks to the contributions of Buterin and other community members, DeFi has grown from strength to strength, with its total value locked, rising from $1 billion in June 2020 to over $79 billion in 2021. The journey to these heights is only possible because of the years of commitment made by the community. Early projects in the Ethereum ecosystem continue to significantly influence the development of the space.
Stablecoins and Collateral
MakerDAO was created a year after the announcement of Ethereum. The decentralised autonomous organisation launched on the Ethereum blockchain. MakerDAO introduced the world’s first decentralised stablecoin. Stablecoins minimise volatility and are usually pegged to a fiat currency. The creation of the DAO and stablecoin laid the foundations for the decentralised finance ecosystem. MakerDAO introduced Multi-Collateral DAI (MCD) in 2019, bringing real-world assets a step closer to the blockchain.
MCD introduced the concepts of generating collateral and yields from stablecoins. With MCD, people earn from holding a stablecoin in a special smart contract. They may also use a stablecoin as collateral for multiple types of cryptocurrencies.
How does Decentralised Finance work ?
dApps are key to unlocking the benefits of DeFi. Like normal applications, they serve as a bridge between people and organisations that interact with each other to carry out specific processes. Users in DeFi ecosystems execute different financial processes without the need for traditional financial institutions.
The main components of DeFi include:
- Settlement Layer
- Protocol Layer
- Application Layer
- Aggregation Layer
On the settlement layer, the public blockchain and its native cryptocurrency exist. In the case of Ethereum, this is its blockchain and native cryptocurrency, Ether. The protocol layer defines the software rules and standards used to govern tasks and activities. On the application layer, consumers interact with the application. The aggregation layer serves as a matchmaker, connecting applications to provide value-added services to users.
DeFi applications need smart contracts, programmed into the dApp, to interact with the blockchain. This is because smart contracts provide the infrastructure required to automate the agreed terms for interactions and processes run on decentralised finance applications. For example, smart contract code, use instructions to release collateral upon the full payment of a loan.
DeFi markets and services
One of the most sought-after services in DeFi is currency exchange. Decentralised exchanges (DEXs) enable users to buy, sell, or trade cryptocurrencies without an intermediary. Instead of an intermediary, smart contracts execute trades, process funds, and apply rules of the platform.
Decentralised money market applications match borrowers with lenders who use cryptocurrencies as collateral for loans. Smart contracts on these applications distribute interest, using the terms agreed for loans. Yield farming applications popular dApps in decentralised money markets.
Early days for DeFi
Despite growing to 2.7 million users, DeFi is still a long way from reaching the milestones needed to compete effectively against the biggest traditional institutions. Many risks are associated with the DeFi markets which stifle its growth. Nevertheless, its rate of growth and unique offerings distinguish it from even the oldest traditional financial institutions. Not only does it offer what traditional financial institutions cannot offer, it makes it possible for anyone to open the doors to the financial sector.
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Disclaimer: The views and opinions expressed by the author should not be considered as financial advice. We do not give advice on financial products.