Everything You Need to Know About Decentralized Finance (DeFi)

The impact that the Ethereum blockchain has had on the blockchain and crypto industries cannot go understated. Operating as a “world computer,” Ethereum enables the use of smart contracts, which allow decentralized applications (DApps) to be built. Smart Contracts have evolved over the last few years to spawn an entirely new set of financial protocols collectively called decentralized finance (DeFi). So what is DeFi, and where does it fit within the crypto industry?

Read: Everything You Need to Know About the Ethereum Blockchain

What is DeFi?

In short, DeFi is the name given to the suite of financial tools that blockchain technology enables. These tools include lending, borrowing, and yield farming. Blockchain technology allows these tools to be utilized without needing permission from a centralized entity (i.e. banks).

Borrowing

Traditionally, if you wanted to pull out a loan, you’d have to go to a bank and apply. Banks will scrutinize your credit history and financial situation to determine if you’re eligible for the loan. If approved, the bank will then give you the terms of your loan, including the interest cost and term length.

Pulling out a loan at a bank comes with its detriments. Qualifying for a loan in the first place is uncertain, usually requiring a high enough credit score and good debt-to-income ratio. Once approved, interest rates are usually high for the average borrower. On average you can expect to pay 10%-30% in interest.

On the other hand, DeFi let’s you collateralize your crypto holdings in order to pull a loan against it. For example, if you are holding $1,000 of bitcoin, a DeFi platform will let you pull out a loan on anywhere from 25%-75% of that balance. And this is all permissionless, meaning that no background check is required. What’s more, interest rate payments on DeFi loans range from only 1%-8%.

Lending

With DeFi, you may also opt to lend your crypto and earn interest on it. Most DeFi platforms and decentralized exchanges (DEXs) have a staking mechanism or liquidity pool where you can lock your crypto into the platform and earn interest. Lending helps DeFi platforms to continue facilitating transactions through increased liquidity.

Interest earnings within DeFi are surprisingly high, ranging anywhere from 5%-400%+ in yearly earnings. Comparatively, centralized banks usually offer interest rates as high as .07% yearly on savings accounts. It’s clear why DeFi is becoming so popular.

Yield farming

Lending mechanisms on DeFi platforms have opened up the practice of yield farming, which is where crypto holders routinely seek the highest interest rates on the market to earn passive income.

Smart contracts

So how is all of this facilitated on decentralized platforms? Through the use of smart contracts, DeFi platforms are able to process transactions without the need of a middleman or centralized entity holding funds in custody and keeping track of ledgers. Instead, crypto traders lock tokens into liquidity pools and smart contracts use this liquidity to mint new tokens and facilitate transactions.

History of DeFi

It’s hard to talk about the history of DeFi without including Bitcoin as the start of it all. But although Bitcoin’s 2009 whitepaper laid the foundations for all things crypto, Ethereum is truly the project that pushed DeFi into what it is today.

For starters, Ethereum’s biggest contribution to the crypto industry was the creation of smart contracts, which are self-executing agreements that automatically facilitate transactions based on conditions met.

From smart contracts, a blockchain project called Maker was able to create a stablecoin known as DAI. And with DAI, holders of ethereum were able to collateralize their tokens in exchange for the stablecoin.

Another big innovation that Ethereum enabled were initial coin offerings (ICOs). ICOs received a lot of attention around the 2017 crypto bubble as they allowed all sorts of blockchain projects to raise funds by accepting Ethereum in exchange for the project token.

While the ICO craze led to many scams, there were a handful of great projects that survived the 2017 bubble. Most notably, in terms of DeFi, was AAVE, which is now one of the most popular DeFi platforms to-date. AAVE is an open-source DeFi protocol that allows borrowing and earning interest on collateralized tokens.

During the crypto bear market between 2018 and 2019, developers built Uniswap, which today is the top decentralized exchange (DEX). DEXs are token exchanges that are completely ran by smart contracts. They require no middleman custodian to facilitate transactions. As automated market makers (AMM), DEXs like Uniswap are crucial on-ramps into the DeFi world.

March 2020 was an unprecedented time for the entire world. The COVID-19 pandemic put the global economy to a stand-still. For crypto, COVID was a stress test for the markets as prices plummeted similar to the traditional stock market.

Fortunately, many top DeFi projects survived, including one called Compound which led to what is now called “DeFi Summer,” defined by an exponential increase in total value locked (TVL) into DeFi protocols. Compound kicked off the practice of yield farming, mentioned above.

For a more in-depth look at the history of DeFi, be sure to watch this comprehensive video below:

Popular DeFi platforms

The future of DeFi

DeFi saw huge growth in the middle of 2020 but declined a bit later in the year. Despite drops in the token value of popular DeFi projects, their usage and development continued well into 2021. Now, many are speculating a “DeFi Summer 2.0” as the Ethereum blockchain is slated to release an important upgrade in July 2021. The new upgrade, EIP-1559, is expected to help lower gas fees substantially. What’s more, mainstream adoption is steadily on the rise with the popularity of NFTs, the recent Coinbase listing, and the surge in the price of Dogecoin.

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