The History and Development of DeFi
DeFi has grown into a giant snowball in the past few years rolling down the hill of alternative finance towards the land of traditional finance. With every move it makes, DeFi tends to answer the unanswered questions of CeFi, trying to create a fairer playing field for the average investors.
Common practices like under-collateralized loans, unfair borrowing conditions, and institutional investors only (read rich-only) investing slots are becoming a thing of the past as DeFi expands.
Although, there are still problems like liquidity pool hacks, smart contract loopholes, and good ol’ rug pulls in DeFi, having a strong cooperative community across the whole space makes it way easier to overcome these problems and safeguard investors’ funds.
In this article, we’ll have a close look at the history of DeFi and how it fits into this intricately designed world of finance.
The Beginning Days of DeFi
Before diving into where DeFi is now, it’s important to know where it all started. To have a better understanding of the speed of development the space is going through.
It all started with the birth of Ethereum, a modified version of the Bitcoin blockchain to host Dapps on top of it. It was at that moment in the history of web3 that a blockchain became more than a really advanced cashbook.
As Ethereum was introduced, ideas of creating a peer-to-peer lending system started popping out. The platform that actually laid the building blocks of DeFi was Maker or MakerDAO.
Maker DAO — The Concept of DeFi
The creator of Maker presented a platform where users can come onboard to directly lend and borrow money, eliminating the third party — banks.
However, the problem with a peer-to-peer lending/borrowing system was to find the appropriate person on the other side who is prepared to lend to you on your terms and vice versa.
Let’s say you want to borrow 30 ETH on a 5% interest for 6 months, using the P2P lending model, it’ll be a time-consuming method to match you with someone who agrees on those terms.
As a result, the user-to-contract protocol came into existence replacing the peer-to-peer model of DeFi. In short, liquidity pools came into existence.
A liquidity pool, as you know, is a pool of assets where the money you want to borrow already exists and you can just borrow it against sizeable collateral. Similarly, you can invest in the pool as a liquidity provider (LP), in return for your investment, you’ll earn interests and rewards.
We’ll go into the details of the liquidity pool as the article progresses.
Borrowing from Maker, or any other DeFi platform requires you to over-collateralize the loan to ensure that LPs don’t lose money and the pool remains healthy. In Maker, the borrower has to collateralize 150% of the borrowed amount. For every 100 ETH put in the pool, the person can borrow 66% of its total value in DAI.
[DAI is the native token for transactions in the Maker ecosystem. It’s soft pegged to the USD backed by the Maker liquidity pool. That means, the value of 1 DAI always remains close to $1.]
Being backed by a pool of multi-collateral assets makes DAI (one of) the most trusted trustless stable coin.
If the value of the collateralized assets dips lower than 150% of the borrowed amount, Maker automatically liquidates the position of the user to cover the losses and imposes a penalty to discourage such incidents from happening.
If at any point, the value of the currency fluctuates heavily, Maker encourages the borrowers to pay the principal loan amount in DAI and the accrued interest in MKR, the governance token of MakerDAO. Once the DAI gets into the pool, it gets burnt to decrease the supply.
Now coming to the DAO part of MakerDAO, Maker has a DAO in place that makes these decisions through consensus. Anyone holding the MKR token has the right to vote on issues.
These are the primary aspects of MakerDAO and DeFi as a whole, with slightly different rules and regulations.
AAVE — Flash Loans and Collateral Swap
AAVE was launched at the time of the ICO-mania of 2017–18 and is on the top 3 of DeFi platforms.
AAVE introduced a few brand new features and improved a couple of existing options in the DeFi space. The most revolutionary and groundbreaking was Flash Loans.
The concept of a Flash Loan is slightly complicated as it consists of multiple technical aspects of the Ethereum blockchain.
A Flash Loan lets a user borrow a massive amount without any collateral. But the user has to repay the amount on the same transaction within the standard Ethereum block time of 13 seconds. That’s where the name Flash Loan comes from.
Basically, you’re taking out a loan, using the money, and then returning it to the lender within a few seconds. So what exactly is happening here?
Given the special requirement of the loan, it can only be used in a few specific scenarios.
- Collateral Swap
- Self Liquidation
Arbitrage is the action of exploiting the price difference of an asset in two different exchanges to make a profit. For instance, if the price of BNB is $550.00 at exchange A and $550.50 at exchange B, buying 1 BNB from A and selling at B will result in a $0.5 profit.
If the same action gets repeated with $10 million worth of margin, the profit will be astronomically high. And that’s where a Flash Loan comes into action.
Collateral swap is another useful action that can be performed with Flash Loans. As the name says, it is used to swap collaterals inside the liquidity pool.
Say you have 100 ETH as collateral in the liquidity pool but you want to swap it with BAT tokens. In this case, you’ll have to take out a flash loan of DAI and repay your loan, then swap your ETH for BAT, and then take a put the BAT tokens in the liquidity pool to borrow DAI.
The third action that Flash Loans perform is self-liquidation. This issue arises when your collateralized asset (ETH, for example) loses value and comes close to the minimum valuation limit. At this level, you don’t want to put more of the same asset in the pool, so you take out a DAI flash loan and to repay your borrowed amount and withdraw the ETH. Once you have withdrawn, swap your ETH for DAI to repay the flash loan and keep the rest.
Compound and cTokens
Compound is another popular DeFi platform with $5 billion in total value locked. It more or less uses the same system with a few exceptions.
Compound’s most interesting revelation to the world is cTokens. cTokens are used as a token of certification to liquidity providers. Depending on your lending token, the cTokens are assigned directly at a standard exchange rate. For ETH, it will cETH, for DAI, it’ll cDAI, and the exchange rate of cTokens against the actual token depends on the market price.
The exchange rate of DAI to cDAI at the time of writing is 44.95 cDAI.
So if you lend 1000 DAI to the Compound Protocol, the protocol will transfer 44950 cDAI to your wallet. You can redeem your cTokens by withdrawing your actual tokens, or you can redeem a portion of them.
The longer you hold the cTokens, the more it appreciates in value.
Projects like Uniswap, Curve Finance, and Bancor are also performing phenomenally in this space going on an explosive trajectory.