DeFi 101 - A Comprehensive Guide to the World of Decentralized Finance (Part 1/2)

2021/06/02 11:53:26

The Times 03/Jan/2009 Chancellor on the brink of second bailout for banks.

Satoshi Nakamoto launched the Bitcoin network by including this headline from The Times Magazine in the genesis block, giving a strong message to the central banks responsible for the 2008 financial crisis.

Since the inception of Bitcoin, blockchain technology has disrupted 'fiat currency' and gave us an alternative medium of exchange to transfer value in a decentralized and trustless manner.

However, this peer-to-peer 'currency' alone cannot disrupt the global financial system. There needs to be a set of financial primitives that will help rebuild the traditional financial services industry from the ground up.

DeFi, or Decentralized Finance, is an ecosystem of financial applications built on top of blockchain technology using financial primitives as the building blocks, such as credit (lending & borrowing), payments, derivatives, and exchanges for trading assets.

Sounds a little complicated? Don't worry. This detailed guide will go through DeFi and its ecosystem, from the history to financial primitives, top-performing protocols, and future outlooks.

What is DeFi? A Brief History & Why it’s Important

Decentralized finance is an ecosystem of blockchain-based applications that brings all kinds of services from the traditional finance industry to the decentralized world, all while ensuring equal and open access.

If we go back in time, the 'currency' had taken many shapes and forms, but the most dominant use-case of currency was to buy goods and services. As the size of the economies grew, we saw the emergence of different financial instruments to cater to the needs of a growing economy.

One of the earliest financial instruments we saw was credit, i.e., lending money to the people and businesses at a pre-specified interest rate. Soon after, we saw several business model innovations that gave rise to the banks and different financial institutions offering different services.

The biggest problem with these financial service providers is centralization and lack of trust. Throughout history, we witnessed many financial crises and hyperinflation events affecting billions of people around the globe.

The second biggest problem is lack of access. You will be surprised to hear that 1.7 billion adults in the world are still unbanked; they don't have access to even the most basic financial instruments such as a savings account or the ability to take out a loan.

Blockchain technology took the currency out of the control of central banks and governments, and DeFi is doing the same with traditional finance, giving everyone open access to financial instruments.

Now with DeFi products, you can take out a loan in less than 3 minutes, open up a savings account almost instantly, send payments across the world at lightning speeds, and invest in your favorite company through tokenized securities no matter where you are in the world.

Smart Contracts - The DeFi Powerhouse

DeFi applications live on blockchain networks, powered by Smart Contracts that are programs stored on a blockchain. You can think of Smart Contract as a program representing a set of digital agreements. The program executes once it meets certain predefined conditions, e.g., release a loan to a specified address once the collateral amount is sufficient.

Ethereum blockchain introduced Smart Contracts with its Ethereum Virtual Machine (EVM), a quasi–Turing-complete state machine. EVM is a computation engine for Ethereum that compiles and runs smart contracts.

Developers write code for smart contracts in programming languages that can compile into EVM, such as Solidity and Vyper. Solidity is by far the most popular programming language for coding smart contracts on the Ethereum blockchain.

Ethereum gained a lot of momentum and became the second-largest cryptocurrency after Bitcoin due to the flexibility it offered through EVM and smart contracts. However, Ethereum isn't the only smart contract platform out there. Many other blockchain protocols, commonly called 'Ethereum alternatives,' support smart contracts.

Some of the most popular smart contract platforms are Cardano, Polkadot, TRON, EOS, Solana, Cosmos, etc. These platforms are very distinct and offer a completely new design approach and architecture to solve different problems, such as scalability, interoperability, and transaction throughput.

Even though some smart contract platforms are way better in terms of technology, nothing comes close to Ethereum when we look at the numbers. Due to the network effect and first-movers advantage, Ethereum has gained a strong foothold in terms of adoption.

According to a leading analytics provider, State of the DApps, there are 6.28k smart contracts deployed on many different platforms. However, 4.76k of those smart contracts are on Ethereum, which is an astonishing 75.7% market share. If we talk about DeFi applications alone, DeFiPrime states that there are 232 DeFi projects so far, and 215 of those projects are on Ethereum.

Source: Defiprime.com

So DeFi applications are essentially just smart contracts that live on the supported smart contract platforms. Ethereum holds the largest share of this market, so the most popular DeFi applications are on Ethereum.

Wrapping Up

So this is it for the first part of the Defi 101 series. Decentralized Finance is here to stay, and it will change the way people consume and interact with financial products. Defi brings more inclusivity, openness, transparency, and censorship-resistance to the centralized world of finance.

In the second and final part of the Defi 101 series, we will discuss the basic building blocks of Defi, known as 'financial primitives' or 'money legos'. If you want to learn more about Defi and the overall cryptocurrency space, head over to KuCoin where you can find tons of knowledge resources to help you understand the crypto space.