*https://nakamoto.com/beginners-guide-to-defi/*
Linda J. Xie, January 2020
Decentralized finance, also referred to as “DeFi” or open finance, aims to recreate traditional financial systems (such as lending, borrowing, derivatives, and exchange) with automation in place of middlemen. Once fully automated, the financial building blocks of DeFi can be composed to produce more complex capabilities. Today, the primary venue for decentralized finance is Ethereum, but in principle these ideas can be implemented on any smart contract platform.
In this beginner’s guide to decentralized finance (“DeFi”) we review the following:
- Stablecoins. A building block of decentralized finance. Unlike cryptocurrencies like Bitcoin or Ethereum that are known for their price volatility, a stablecoin is engineered to remain “stable” at exactly 1.00 units of fiat. Most stablecoins are pegged to the USD, but some are in other fiat currencies like the Chinese RMB.
- Decentralized lending. Programmatically take out a loan on the blockchain. No bank account required.
- Decentralized exchanges. Buy and sell cryptocurrencies through a blockchain, rather than a centralized exchange like Coinbase. In principle, a machine can trade on these!
- Collateralization. Provide digital assets to collateralize your decentralized loans, providing the lender some recourse in the event of default.
- Decentralized Identity. Identities are used in the context of smart contracts for things like assessing your creditworthiness for a decentralized loan.
- Composability. Snapping together DeFi functions that do different things, much like software libraries. For example, if one contract takes in crypto and generates interest, the second contract could automatically reinvest that interest.
- Risk management. High returns in DeFi are often accompanied by even higher risks. Fortunately, new tools are arising to help hedge these risks.
Let’s go through these concepts one by one.
Stablecoins
If we try recreating traditional financial products on a blockchain, we are faced with an immediate problem: price volatility. Specifically, the native cryptocurrency of the Ethereum blockchain (namely ETH) experiences large intraday swings in the USD/ETH exchange rate, sometimes moving 10% or more in a single day.