Topic 2

A brief history of DeFi

Introduction

Describing the history of Decentralized Finance is like describing the history of a five-year-old. Similar to how a five-year-old experiences major milestones early on, DeFi advanced quickly since its public release. Some say that DeFi started with Bitcoin in 2009. Others believe Bitcoin enabled the start, but the actual beginning was in 2017 with MakerDAO, an Ethereum-based protocol. From there, other financial protocols were launched, and DeFi has made a parabolic ascent.

December 2017 - MakerDAO and DAI Stablecoin

MakerDAO allows users to borrow stablecoin against Ether, like taking out a loan without the bank. This Ethereum-based cryptocurrency tracks the U.S. dollar 1-to-1, so people can borrow DAI stablecoins against Ether. This marked the beginning of DeFi, where people could borrow money without going through a centralized agency. This system is open and available for anyone to use.

Hold up, what’s a “stablecoin”?
A stablecoin is exactly that; it’s a stable coin. The entire objective of a stablecoin is that it doesn’t change price. Stablecoins peg their value to an external asset. That external asset can be the U.S. dollar, gold, or other asset that’s value remains relatively stable.

Four Types of Stablecoins:

1. Fiat-backed – These are the most popular stablecoins. Fiat is just government-issued currency, so fiat-backed can be pegged to the U.S. dollar at a 1:1 ratio. Other stablecoins are linked to the British pound, euro, Chinese RMB, or the Japanese yen. An example of a Fiat-backed stablecoin is USD coin.

2. Cryptocurrency-backed – These are stablecoins pegged to a more established cryptocurrency such as Ether. MakerDAO uses a crypto-backed stablecoin that uses a smart contract to collect enough Ether to use as collateral for its DAI stablecoin. When the amount of collateral reaches a certain level in the smart contract, users can mint DAI.

3. Commodity-backed – These stablecoins are pegged to the value of commodities like precious metals, oil, or real estate. This is great for people who love investing in gold without the hassle of finding and storing it. An example is Tether gold (XAUT), a currency backed by a reserve of gold in Switzerland.

4. Algorithmic – These stablecoins use algorithms to keep the value of the coin at the same level. They automatically burn or mint new coins based on the fluctuating demand for the stablecoin. An example is the Frax stablecoin.

September 2018 – Compound Finance

Compound Finance launched another lending protocol built on Ethereum. With this, you can borrow against collateral or lend your assets to earn high interest. This system was also open for anyone to use and a smart contract was put in place to execute this. This way, an algorithm automatically executes the computer code relating to the original contract’s terms. So even if someone has bad credit or is low-income earning, they can still get a loan.

 

November 2018 – Uniswap

Uniswap is a decentralized exchange that trades tokens issued on Ethereum. This exchange pays users to form liquidity pools and receives a percentage of the fees when traders swap tokens in and out of these liquidity pools. Liquidity pools are pools of cryptocurrencies locked in a smart contract.

Uniswap is different from centralized exchanges because it’s governed by its users, and anybody can use the open-source software. It doesn’t ask users to verify their identity or restrict trades from certain locations.

Aren’t all crypto exchanges decentralized?
No, some exchanges like Coinbase are not decentralized which means they are run by a company, regulated by the government, and have to report to the government. When trading on a centrazlied exchange you arn’t actually even using a the blockchain to trade rather their internal systems. Centralized exchanges keep their systems off-chain, meaning they operate as escrows for their clients, and transactions are not recorded on the blockchain. Decentralized exchanges are run by code and the only time they are changed is if the code is changed.

 

March 2020 – Balancer

To further expand use cases for DeFi, Balancer was both a decentralized exchange and asset manager. Users can create an exchange-traded fund that keeps the ratio of the basket of tokens the same, even with price changes. Balancer DeFi operates through private, smart, and shared pools. Anyone can purchase Balancer Pool Tokens, and if the pool becomes unbalanced, traders can swap tokens. The exchange then uses the fees to give investors a return.

 

 

November 2022 – FTX crash
In November 2022, FTX, one of the largest centralized crypto exchanges, crashed for misappropriating billions of dollars of user funds through its trading platform, Alameda Research. Many FTX and other centralized exchange users started pulling their money out only for withdrawals to be halted because of the lack of liquidity. While this is unfolding, many users of decentralized exchanges remain immune to the FTX’s contagion because there’s no one behind the scenes mismanaging their money. There’s no deception because there’s no deceiver in DeFi.

To Recap

Many of DeFi’s biggest moments in history have been the creation of open source codes that make taking advantage of financial systems in Web3 more accessible. These companies created a system that is open, permissionless, and accessible to anyone with an Ethereum address and collateral. These invaluable features made the overall crypto experience unique and inclusive.

Key Terms

Blockchain

“Blockchain is a shared, immutable ledger that facilitates the process of recording transactions and tracking assets in a business network. An asset can be tangible (a house, car, cash, land) or intangible (intellectual property, patents, copyrights, branding). Virtually anything of value can be tracked and traded on a blockchain network, reducing risk and cutting costs for all involved.”

 

– IBM

NFT

“Non-fungible tokens or NFTs are cryptographic assets on blockchain with unique identification codes and metadata that distinguish them from each other. Unlike cryptocurrencies, they cannot be traded or exchanged at equivalency. This differs from fungible tokens like cryptocurrencies, which are identical to each other and, therefore, can be used as a medium for commercial transactions.”

 

– Investopedia