Decentralized Finance (DeFi): It started with Bitcoin

Decentralized finance (DeFi): It started with Bitcoin

Bitcoin in many ways was the first DeFi application. Bitcoin lets you really own and control value and send it anywhere around the world. It does this by providing a way for a large number of people, who don’t trust each other, to agree on a ledger of accounts without the need for a trusted intermediary.

Bitcoin is open to anyone and no one has the authority to change its rules. Bitcoin’s rules, like its scarcity and its openness, are written into the technology. It’s not like traditional finance where governments can print money which devalues your savings and companies can shut down markets.

Ethereum builds on this. Like Bitcoin, the rules can’t change on you and everyone has access. But it also makes this digital money programmable, using smart contracts, so you can go beyond storing and sending value.

What can you do with DeFi?

Programmable money

This sounds odd… “why would I want to program my money”? However, this is more just a default feature of tokens on Ethereum. Anyone can program logic into payments. So you can get the control and security of Bitcoin mixed with the services provided by financial institutions. This lets you do things with cryptocurrencies that you can’t do with Bitcoin like lending and borrowing, scheduling payments, investing in index funds and more.

Send money around the globe quickly
As a blockchain, Ethereum is designed for sending transactions in a secure and global way. Like Bitcoin, Ethereum makes sending money around the world as easy as sending an email. Just enter your recipient’s ENS name (like bob.eth) or their account address from your wallet and your payment will go directly to them in minutes (usually). To send or receive payments, you will need a wallet.

Decentralized finance (DeFi): It started with Bitcoin

Stream money around the globe…

You can also stream money over Ethereum. This lets you pay someone their salary by the second, giving them access to their money whenever they need it. Or rent something by the second like a storage locker or electric scooter. And if you don’t want to send or stream ETH because of how much its value can change, there are alternative currencies on Ethereum: stablecoins.

Access stable currencies

Cryptocurrency volatility is a problem for lots of financial products and general spending. The DeFi community has solved this with stablecoins. Their value stays pegged to an another asset, usually a popular currency like dollars.

Coins like Dai or USDC have a value that stays within a few cents of a dollar. This makes them perfect for earning or retail. Many people in Latin America have used stablecoins as a way of protecting their savings in a time of great uncertainty with their government-issued currencies.

Borrowing

Borrowing money from decentralized providers comes in two main varieties.

  • Peer-to-peer, meaning a borrower will borrow directly from a specific lender.
  • Pool-based where lenders provide funds (liquidity) to a pool that borrowers can borrow from.
  • There are many advantages to using a decentralized lender…

    Borrowing with privacy

    Today, lending and borrowing money all revolves around the individuals involved. Banks need to know whether you’re likely to repay a loan before lending.

    Decentralized lending works without either party having to identify themselves. Instead the borrower must put up collateral that the lender will automatically receive if their loan is not repaid. Some lenders even accept NFTs as collateral. NFTs are a deed to a unique asset, like a painting. More on NFTs This allows you to borrow money without credit checks or handing over private information.

    Access to global funds

    When you use a decentralized lender you have access to funds deposited from all over the globe, not just the funds in the custody of your chosen bank or institution. This make loans more accessible and improves the interest rates.

    Tax-efficiencies

    Borrowing can give you access to the funds you need without needing to sell your ETH (a taxable event). Instead you can use ETH as collateral for a stablecoin loan. This gives you the cash-flow you need and lets you keep your ETH. Stablecoins are tokens that are much better for when you need cash as they don’t fluctuate in value like ETH. More on stablecoins

    Flash loans

    Flash loans are a more experimental form of decentralized lending that let you borrow without collateral or providing any personal information.

    They’re not widely accessible to non-technical folks right now but they hint at what might be possible to everyone in the future.

    It works on the basis that the loan is taken out and paid back within the same transaction. If it can’t be paid back, the transaction reverts as if nothing ever happened.

    The funds that are often used are held in liquidity pools (big pools of funds used for borrowing). If they are not being used at a given moment, this creates an opportunity for someone to borrow these funds, conduct business with them, and repay them in-full quite literally at the same time they’re borrowed.

    This means a lot of logic must be included in a very bespoke transaction. A simple example might be someone using a flash loan to borrow as much of an asset at one price so they can sell it on a different exchange where the price is higher.

    So in a single transaction the following happens:

  • You borrow X amount of $asset at $1.00 from exchange A
  • You sell X $asset on exchange B for $1.10
  • You pay back loan to exchange A
  • You keep the profit minus the transaction fee

    If exchange B’s supply dropped suddenly and the user wasn’t able to buy enough to cover the original loan, the transaction would simply fail.

    To be able to do the above example in the traditional finance world, you’d need an enormous amount of money. These money-making strategies are only accessible to those with existing wealth. Flash loans are an example of a future where having money is not necessarily a prerequisite for making money.

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