The term DeFi, short for Decentralized Finance, was introduced in August 2018 in a Telegram chat between developers and entrepreneurs at Ethereum, including Inje Yeo from Set Protocol, Blake Henderson from 0x and Brendan Forster from Dharma. They discussed what to call the open finance application movement based on Ethereum. Other options considered were “Open Horizon”, “Lattice Network”, and “Open Financial Protocols”. Henderson said DeFi worked well since it “came out as DEFY”.
Let’s now dive into some basic characteristics of DeFi:
1. Not in custody
These distributed networks allow people to be in control of their own assets and data and to transfer value from one person to another without the need of intermediaries such as banks or other financial institutions. Users are the only ones who have the keys to their wallets and control their money. The term used to describe this feature is that DeFi applications are “out of custody”, since no intermediary has custody for your assets – you do.
These networks are global, which means that there are no limits and anyone can access them. It is like the Internet, but instead of the information being continuously and creatively transmitted globally, it happens with money. We can then say it is a sort of “valuable Internet”.
The code for these financial claims can be viewed by anyone. This is of fundamental importance because anyone can check how applications and logs are working and therefore keep track of where money is exactly.
The open source code enables developers to build on other people’s applications, accelerate innovation, turn those applications into pieces of Lego and harness each other’s value – hence the term “Legos of Money”. Therefore, if users do not like how an application works when it is being built, they can copy the code and create a new one.
DeFi protocols are based on public blockchains, like Ethereum. This blockchain, a technology at the basis of this new financial system, is usually operated by thousands of us, through computers provided with specific software that are spread around the world, making it almost impossible to censor or stop.
In addition to this basic level of decentralization, DeFi platforms can be managed by a community of users that is not centrally controlled. Users become owners of their financial applications. They can participate in important decisions, including proposing changes themselves, and benefit from their growth and success. No centralized party can unilaterally take control of the funds or change the rules of the game.
Open finance: a better term?
Most DeFi applications do not fulfill all of the functions listed above. Ironically, given the name, the decentralized aspect is the hardest to accomplish. Indeed, giving up complete control of an application makes it more difficult for developers to react quickly to problems because they cannot unilaterally make changes without reaching community consensus. This is extremely more difficult for applications that are still in the early stages of development. As a result, some control over logs is often retain by specialized teams.
Decentralization is a spectrum, and while not all DeFi applications are the most decentralized, they work to have teams gradually giving up control.
Instead of decentralization, the main characteristic that most DeFi protocols use to service the ecosystem and define these applications is that they are accessible to everyone. Users just need an internet connection and a blockchain address. For this reason, the term “Open Finance” is often used instead of DeFi.
DeFi: a short story about its introduction
It can be argued that DeFi started with Bitcoin (BTC) in 2009. BTC was indeed the first point-to-point digital money, the first financial applications developed using blockchain technology. Particularly, the turning point for financial apps that allow users to get more out of their money than sending it from point A to point B happened in December 2017 when MarkerDAO was launched.
Along with it, we can also talk of ManufacturerDAO and MakerDAO.
ManufacturerDAO is an Ethereum-based protocol that allows users to spend a 1: 1 indexed cryptocurrency against the US dollar, using digital assets as collateral. This mechanism effectively enabled anyone to borrow Dai Stablecoin against Ether (Ethereum‘s native cryptocurrency). It created a way for anyone to take out credit without relying on a centralized entity. It also created a dollar-indexed digital asset that did not depend on holding dollars in a bank such as USDC, USDT, or other stable currencies.
MakerDAO is on the other hand a loan protocol and its Dai stablecoin formed the very first building blocks for a new open and unauthorized financial system. From there, more financial protocols have been launched creating an increasingly vibrant and interconnected ecosystem. At the same time, other platforms were created: Compound Finance, launched in September 2018, which created a market for borrowers to take out secured loans and for lenders to increase the interest rates paid by those borrowers; Ö Uniswap, which from November 2018 allowed users to exchange tokens in Ethereum transparently and without permission.
Less than three years after MakerDAO launched the first Lego of Money, there are now dozens of DeFi applications out there, from basic use cases like activating credits, and transactions to crazier cases like creating synthetic assets, streaming lottery payments and games where you can always get your money back.
The wealth included in the smart contracts on these platforms soared to over $ 1 billion and quickly to $ 2, 3, and 4 billion, just this year. And more is yet to come.
With the term decentralized funding increasing in headlines and conversations, the acronym DeFi may sound like an empty term. But it is far from being just a catchphrase.
DeFi is a growing ecosystem of real and functional protocols and applications that add value to thousands of users and trade the equivalent of hundreds of millions of dollars in digital assets every day.
The foundations for a new financial system are being laid with applications that enable everything from simple transfers and payments to loans, to portfolio management and insurance.
Stay tuned for Part 2, in which we will focus on some platforms and how they work.
– Husan Ravshanov, American University of Central Asia