An Introduction To Decentralized Finance

Hi There! I am thinking of starting this new section on decentralized finance or DeFi — starting from basics. A lot is happening in the DeFi space today, and understanding the fundamentals will help appreciate these developments better. So, as I embark on this journey of finding out what DeFi is really about, I plan to write short articles breaking down the concepts of DeFi in simple words.

To begin with, let us see what DeFi is all about, a brief history of how DeFi came into existence, and why it is so important.

A Brief History of Money

Evolution of Money. Image Source: Coinmama

Remember the “good old” barter system that flourished ages back? I needed goats, and you needed rice. I could give my ten bushels of rice to you and take your two goats, and both of us went home happily. Soon came metal coins and paper notes. And with them came a central figure — a financial institution. This arrangement created the necessity to trust a central authority with your wealth. Also, one had to jump several hoops, suffer delays, and pay hefty commissions to access one’s own money.

In the past, several attempts were made to find new ways that give people reprieve from the numerous problems that today’s outdated finance structure creates while also providing the security and assurance that many find when their money is in a bank. The first widely adopted of such ideas was “Blockchain.” It was popularized by an alternate currency called “Bitcoin.”

Bitcoin was the first successful attempt, where people could pay for anything, including a pizza, with digital coins that are not controlled by banks or governments. This newly found freedom spurred discussions about how we can do more with Blockchain, perhaps do everything for which we need a bank today — borrow, lend, deposits — but of course without a bank. And that is how decentralized finance or DeFi was born.

What is Decentralized Finance?

DeFi refers to a basket of financial applications built on Blockchain and does not involve traditional institutions such as banks. Think of lending or borrowing, saving, insuring your assets, or even stock market functions such as spot trading, margin trading, derivatives trading — but all these without going to a bank or relying on a stock exchange. It aims to create an open ecosystem for finance similar to what the internet is today for access to information. DeFi allows everyone to seamlessly access money regardless of where they are or who they are. 

Furthermore, privacy is a cornerstone of DeFi. People who use DeFi applications are not asked to share their personal information. They don’t need a username or a password. And the users are the only ones holding the information, such as private keys that give them access to their monie. 

Yet another nuance of DeFi is its open source code base. Anyone can get the source code of these applications, review and fork them into new apps. It makes the DeFi space very competitive as the developers are forced to build the best possible product.

Today, the total market cap of decentralized finance is over $130 billion. There are scores of DeFi applications in the market, including Aave, MakerDAO, Compound, and Uniswap. Traditionally DeFi applications were built on Ethereum Blockchain. But now, they also run on other platforms such as Binance Smart Chain, Avalanche, etc.

How Did DeFi Come Into Existence?

Image Source: Inje Yeo of Set Protocol Twitter

The first time people could do much more with their money than send it from point a to b was when MakerDAO launched in December 2017. Users could use Ether cryptocurrency as collateral and borrow MakerDAO’s Dai stablecoin. Dai is pegged 1-to-1 to the value of the US dollar. More on MakerDAO in future posts.

The term DeFi was coined in August 2018. In a conversation on a Telegram channel, Inje Yeo of Set Protocol suggested DeFi, along with other names such as Open Horizon, Lattice Network, and Open Financial Protocols. Blake Henderson of 0x put his seal of approval on DeFi since he felt the word sounds like “DEFY.”

Where is DeFi Today?

Though the future looks bright for decentralized finance, it is not there quite yet today. Not all applications running on decentralized platforms are fully decentralized. Several of them are centrally controlled to some degree, especially those in the early stages. Most apps conform to “Open” finance rather than “Decentralized” finance since they allow anyone to join. But similar to the growth of the internet, DeFi will in the near future mature and become fully decentralized, ushering a new chapter in the world’s economic history. 

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