Diving deeper into DeFi. An overview of the landscape.
There are many opinions on what exactly decentralised finance is, and I leave it up to the reader to research further on the subject to make their own conclusions. The aim of this article is to give an overview of its origins and how it drew over $100 billion dollars of investment.
Origins
Back in the early 2010s, as cryptocurrencies began to attract more and more investment, there became a growing need for ways to manage these new types of assets. Exchanges that allowed people to trade bitcoin started to appear, with the most famous, Mt Gox, handing over 70% of all bitcoin transactions in 2014 [1]. Its subsequent downfall due to inadequate management, security, and accusations of fraud shook many people’s faith in cryptocurrencies, with those who still believed in the underlying concept searching for an alternative.
Fortunately, due to the perfect storm of timing, technological development, and some clever thinking, the foundations of DeFi were laid with the announcement of Ethereum. Ethereum introduced the concept of “smart contracts” (programs) that could be used to build applications (dApps) that interacted with the underlying blockchain itself. All kinds of new innovations quickly began to spring up, including “Play 2 Earn” gaming, NFTs, and tokens. Early models of decentralized exchange systems also began to be released, but as they were less efficient and less accessible than the existing centralised exchanges like Binance, they received a muted reaction [2]. Still, there was no denying that the prospect of anonymous trading of crypto assets using your own private wallet had captured the minds of many new cryptocurrency enthusiasts.
The Rise
DeFi started to take shape with the arrival and explosive growth of Uniswap, a decentralised exchange that implemented an innovative new system to allow trading of any two assets without having to rely on a traditional order book. Known as an “Automatic Market Maker” or AMM, users could deposit two assets, such as ETH and Bitcoin, which were used by traders on the platform. In exchange for lending out their assets (aka, providing liquidity), users would receive a percentage of the trading fees. It was an exchange where anyone had access, anyone could earn interest rates on their crypto assets and anyone could be a market maker. It spurred a huge increase in ERC-20 token trading, cryptocurrency trading and inspired developing projects to continue pushing forward.
During the same period, other innovations began to surface, one of the most impactful being “oracles”. Oracles are programs that monitor and report real-world information to blockchains and narrow the gap between the potential of DeFi applications and traditional financial instruments. Stablecoins were also released, allowing people to dip in and out of their trading positions based on USD-based value without having to go through the expensive and time-consuming process of “off-ramping” (converting crypto to fiat).
Finally, lending protocols were built to allow users to provide cryptocurrency collateral to borrow other coins, keeping a hold of their assets while they used borrowed coins to invest in upcoming projects. It was an explosion of activity, caused by an interest in a brand-new sector that mixed technology and finance, with elements of gaming, futurism, and digital art.
Present Landscape
DeFi is still moving quickly, with the idea of interoperability becoming an important factor for many projects now. dApps are now striving to work together, to move value to where it’s needed, which is then rewarded with larger rates.
The graph below may help put in perspective how complicated the space has become.
I’ve explained many of the lower layer concepts in my previous articles explaining blockchain and cryptocurrencies.
Blockchain basics part 1.
Blockchain basics part 2.
Blockchain basics part 3.
Recent developments in DeFi include the growing popularity of “Yield Aggregators” at the Aggregator layer. In particular, Yearn Finance has gained recognition for providing its users with high-interest rates by automatically calculating where their funds should be sent across a variety of platforms, through a set of complicated strategies and risk assessments [3]. This can take the form of providing liquidity for DeFi applications like Curve.fi in order to receive governance tokens to further increase their influence. One danger of these emerging collectives is that monopolies may arise as they get more and more favorable rates over their competition. This has already started to happen; more details can be found here.
What’s next?
DeFi isn’t going anywhere. It provides us with services that cater to all levels of risk, promises higher rates than banks, and, perhaps most importantly, has given rise to a sense of community as cryptocurrencies continue to see appreciation amidst the unforgiving world of traditional finance.
[1] https://en.wikipedia.org/wiki/Mt._Gox
[2] https://blog.idex.io/all-posts/history-of-dexs-phase-1
[3] https://medium.com/uclcbt/yield-aggregators-in-defi-2fd483412322
