2020 has been a phenomenal year for the crypto market. Decentralized Finance or DeFi was one of the biggest trends of the crypto realm. With over 25 billion USD locked in DeFi smart contracts at the time of writing, it has witnessed a growth of more than 3500% since the beginning of 2020. It has emerged as an extensive parallel financial system that provides its users banking, investing and trading services in a decentralized and trustless environment. In the following article we will learn the rise and evolution of the DeFi ecosystem. This is the first in a series of articles to make DeFi simpler. What is DeFi? DeFi is an ecosystem of financial applications built on top of the blockchain. It provides a shift from the traditional financial system, which is managed by central authorities, arbitrators, and intermediaries. Instead of involving the banks, exchanges or brokers to provide the required trust among parties, DeFi heavily relies on cryptography, blockchain and smart contracts. DeFi applications take a decentralized approach in either storing records or governance of the platform or its functionality. These are built as decentralized applications, dApps, where users can interact with each other in a peer-to-peer network. These dApps use a series of immutable smart contracts deployed on a blockchain to automate their functionality. Popular DeFi projects provide alternatives to many traditional financial services, which include lending and borrowing of assets, decentralized exchanges, arbitrage trading, margin trading, creation of stable coins, derivatives and liquidity pools. It also facilitates many other innovative use-cases, which were not possible earlier like flash loans, synthetic assets and yield farming. Because of their composability, Defi protocols are also referred to as “Money Legos”. To extend the functionality, these applications can be easily integrated with each other like legos. People are often mixing and matching various DeFi tools in interesting patterns to create new products and services. For instance, you can deposit ether into MakerDAO, receive the stablecoin dai (DAI) and then lend it on Compound to a trader in order to earn the network’s governance token COMP. Why on Blockchain? Any traditional financial service involves multiple parties and regulatory bodies. Users have no choice but to trust these financial institutions for safe handling of their funds. DeFi applications by leveraging blockchain technology provides decentralized governance to the community. With all things crypto, a minimum amount of trust is needed. Smart contracts provide transparency in open-source DeFi protocols. There is no single point of failure as blockchain is a decentralized architecture. Removal of any 3rd party from the transactions, allows faster processing, efficient and affordable system. DeFi applications do not hold any user data. Users are custodians of their assets and have full control of their personal data. With DeFi, the investment and trading has become more accessible to any user. All they need is a blockchain address and internet connection to plug in for any service. Most traditional finance systems are biased towards the rich with a purpose to generate more and more profit, so they discourage participation from others. DeFi on the other hand rules out any prerequisites of minimum investment allowing access to everyone. Blockchain is a pseudo-anonymous system, which does not maintain any link between users’ on-chain and real-life identity. In lieu of the third party regulators to safeguard users interests, most DeFi applications are fueled by collaterals. Borrowers typically need to deposit collateral worth substantially more than the loan amount and maintain this collateral above a certain value threshold to protect the borrower. Failing this, the collateral will usually be sold to reimburse the lender if the collateral falls below a certain threshold, known as a loan-to-value (LTV) ratio. Due to the open availability of blockchain, DeFi applications provide transparent data discovery facilitating easy analysis and decision-making process for users. Popular tools and dashboards for analysis of defi activities are DeFi Pulse and Codefi Data. History and Evolution of DeFi It all started with the Maker protocol in 2014. It is a decentralized organization dedicated to bring stability to the cryptocurrency economy. In 2017, MakerDAO created and launched a token called DAI on the Ethereum blockchain. It is a stable coin pegged to the US dollar by using certain incentives. MakerDAO allows users to lock ETH or any volatile cryptocurrency in collateral and generate DAI. It provides a peer-to-contract lending platform enabling over-collateralized loans. DAI can be freely sent to others, used as payments for goods and services, or held as long term savings. It is designed to offer a value-stable asset that does not suffer from the same volatility as other digital assets. At times, despite a decrease in the market value of its collateral, DAI has maintained a close peg to $1. In addition to ether (ETH), MakerDAO allows collateral in Basic Attention Token (BAT), USD Coin … Continued
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