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The idea of blockchain was first introduced in 1991 by Stuart Haber and Scott Stornetta. It was not until 2008 that the first blockchain was conceptualized by Nakamoto Satoshi and created Bitcoin. Since then, numerous projects emerged hoping to revolutionize the blockchain space.
However, it was not until 2015 when a genius called Vitalik Buterin created Ethereum and made a pivotal change. Ethereum implements a nearly Turing-complete language that allows programming on the blockchain, known as smart contracts, which brought new varieties and possibilities.
Smart contracts allowed projects and individuals to issue tokens and raise funds, known as ICO and STO. Raising funds through cryptocurrencies was the major reason that skyrocketed the crypto market cap up to 815 billion USD in 2018.
Yet, due to tightening regulations from governments around the world, the market cap has dropped as much as 85% since. The next pivotal moment occurred with the emergence of DeFi that brought new hopes to the blockchain space.
What is DeFi?
DeFi, short for decentralized finance, aims to recreate traditional banking services without centralized entities – savings, loans, trading, insurance and more.
The goal is to have an open alternative that is accessible to anyone in the world with an internet connection.
However, it is more appropriate to call it “distributed finance” or “open finance” as most of the current DeFi products and services are a combination of centralization and decentralization.
DeFi – The second breakthrough in the blockchain history
The first breakthrough is widely attributed to Bitcoin, which combines various degrees of cryptography, consensus mechanisms, peer-to-peer networks, and incentive mechanisms.
Bitcoin has become a store of value and enabled value transfer without the participation of third parties.
DeFi can be regarded as the second breakthrough. Although it has not been as disruptive Bitcoin, DeFi has already begun to take shape and showed its potential.
Why is DeFi the second breakthrough?
To understand DeFi, you must first understand why it exists.
DeFi exists because it can meet the financial needs of some people, and these financial needs cannot be met by traditional finance.
DeFi’s goal is to build a transparent financial system that is open to everyone, without permission, and without relying on third-party institutions to complete financial needs. Examples include lending, trading, payments, and derivatives.
DeFi is open finance that utilizing the infrastructure of the blockchain. With blockchain, one can verify every transaction that takes place on it, which also brings transparency.
DeFi is different
The creation of currency was a spontaneous process and inevitable during human evolution. Originally, humans exchanged goods for goods, known as barter. However, bartering was inefficient as it was difficult to find two people who happened to have matching items.
It was difficult to reach a deal for a fisherman who needed shoes and a shoemaker who needed grain. Even if the demand matches, it was hard to determine the number of fish in exchange for a pair of shoes.
Therefore, the demand for money emerged. People needed a currency system to exchange between different items. This currency became a medium of exchange and also a store value.
There have been different kinds of currency throughout human history, from shells, precious metals, gold, to fiat currencies as we know it in today’s world.
With fiat comes intermediary institutions such as commercial banks, investment banks, stockbrokers, pooled investment funds, and stock exchanges.
These intermediaries have improved market efficiency and achieved better resource allocation. But at the same time, the existence of intermediary institutions has also arisen issues like opacity which often leads to excessive debt or superinflation.
In the current intermediary-dominated financial structure, the economic crisis seems inevitable, and history has been repeating itself.
The core value of the blockchain is transparency and distribution, which serves as the best medium to change the current status quo of the financial structure. That’s why DeFi exists.
DeFi is like traditional finance
DeFi, like traditional finance, allows everyone to put their money into different assets according to their needs. Through a variety of different assets, contracts and agreements, new projects can be assembled to provide users with new products and services. For example,
Compound is a loan market based on Ethereum. Within Compound, users can borrow ETH, MakerDAO’s Dai, or USDC which is fully backed by the US dollar. Users can also lend Dai to Compound, in which users receive cDai tokens in return. cDai represents the user’s Dai and the interest accrued therefrom.
cDai itself is also a token, which means cDai can be circulated in the market, and the holder can earn a profit. For instance, users can trade cDai with ETH and hold cDai through Dex such as Uniswap and earn interest in cDai token.
In addition, it can be used by other smart contracts. For example, MakerDAO mortgages ETH or BAT to generate Dai tokens and putting Dai into Compound to generate cDai, then cDai can be exchanged with other tokens on Uniswap.
DeFi is a parallel world of traditional finance
Traditional finance has earned the trust of many people through intermediaries and their services. It can meet the needs of a large number of people in the real world but to all.
There are people who want to control their own finance. To serve these people, DeFi is building a world parallel to traditional finance.
For example, Compound, Dharma, Maker, etc. are providing lending services for cryptocurrency assets, which can be thought of the encrypted version of traditional banks. projects like Uniswap, Kyber, and Bancor provide asset exchange services, similar to the Nasdaq, NYSE and other exchanges in the traditional financial world.
DeFi is not just a parallel world of traditional finance
DeFi is not only mimicking traditional finance in the crypto world, but it also presents new features. It offers instant exchange through the fund pool, which may take traditional intermediaries 3 to 5 days to clear. DeFi’s interest rate can also be adjusted in real-time without the grace period in traditional borrowing.
User’s borrowing income is reflected by its tokens, and if a user purchases the tokens, they can essentially enjoy the borrowing income of the tokens, which is equivalent to tokenizing the creditor’s rights and realizing circulation.
DeFi greatly accelerated the liquidity of assets. its permissionless and transparent characteristics are beyond the reach of traditional finance.
When participating in a DeFi service, the user is interacting with a series of smart contracts on the blockchain.
People can take advantage of its transparent and license-free features, such as the best price transaction through the aggregation of DEX; the best is achieved through the aggregation of loan agreements Interest income.
From the lending perspective, current borrowing needs require over-collateralization in order to borrow. Since all borrowing and clearing processes are enforced by agreement, there is no need to worry about default and no third party involvement is required.
At the same time, as the intermediary is omitted, the lender can obtain higher income and the borrower can obtain better interest rates.
The convergence of DeFi and traditional finance
At present, not everyone has the ability and willingness to learn and manage crypto assets. A more likely scenario is the integration of DeFi and traditional finance.
Traditional finance can use the characteristics of DeFi to achieve liquidity, and DeFi can use the assets and compliance of traditional finance to achieve scale expansion.
USDC is an example of a combination of DeFi and traditional finance. USDC inputs the currency of the traditional world into DeFi to form a stablecoin and then uses DeFi’s features such as license-free, fast circulation, and transparency to play its role.
Traditional financial demand has its historical inertia. From today’s perspective, DeFi is difficult to expand without the participation of traditional finance. Although this is not what many idealists and geeks would like to see, in the real world, DeFi can play a role to help traditional finance to achieve a faster flow of assets through the blockchain.
DeFi as 100% decentralized finance
Anyone with crypto assets can participate in DeFi. These are usually done through on-chain operations, without the need for third-party participation, and users have a great degree of participation freedom, convenience, and speed.
However, any DeFi service holds a certain degree of centralization. For example, Dai is not 100% decentralized. Its security requires the governance of MKR token holders and the need to prevent attacks on its oracles, which all need to be centralized to a certain degree to maintain safety.
This will become more apparent as real-world assets circulate on DeFi. For instance, if you buy 100% of the tokens of a house. The house involves many legal rights and obligations in the real world so you can not automatically obtain all the rights and interests only through the token transfer, which requires the implementation of traditional law and processes.
At present, through DeFi, people can realize loans, transactions, payments, and futures, but for most ordinary users who have no experience using crypto wallets, it has certain thresholds. It requires users to have some ability and experience in managing assets.
However, as more and more DeFi projects streamline their operations and become easier to use, once people use DeFi products, the difficulty of using them will gradually decrease. Once the habits are formed, more and more people will enter the field of DeFi.