Decentralized finance (DeFi) was not well understood when it came into the spotlight in 2019. In 2020, it scaled fast and increased from $700 million at the beginning of 2020 to $15 billion by the end of 2020, and as of June 2022, the total value locked (TVL) reached a high of $256 billion. What explains this remarkable increase? The current financial system has left 1.7 billion people unbanked. The barriers to entry are high, the costs are high, transparency is low, and a small group of powerful elites dominates it. DeFi offers an accessible alternative to the current financial system. It explains its exponential borrowing, lending, yield farming, and insurance growth. Early results suggest that DeFi will redefine the financial system. This chapter provides an overview of DeFi, an analysis of its ecosystem, and its likely trajectory.
TopIntroduction
DeFi represents an essential step in the evolution of money. Over history, what is called “money” has had many iterations. Money has three qualities: as a medium of exchange, a unit of measurement, and a storehouse for wealth, which determines its value (Investopedia, 2022). Money has not always been in the exchangeable paper form as it exists today; some of the earliest forms of money were cowrie shells, first used as money in about 1200 BC (Britannica, 2022). Next came metal, reportedly in Babylon before 2000 B.C., and Turkey's first standardized and certified coins emerged in the 7th century (Saggs, 2022). Since then, there have been multiple innovations in money. The next iteration was paper money, invented in China during the reign of Emperor Zhenzong between 997 and 1022. (Britannica, 2022). Paper money spread to other parts of the world by the late 18th and early 19th centuries, and it was in the form of promissory notes to pay specified amounts of gold or silver. In 1821 the Gold Standard was introduced in the United Kingdom. This linked the standard currency unit to the value of a fixed quantity of gold (Britannica, 2022). Countries such as the United States of America, France, and Germany adopted the gold standard, but by the 1970s, it was no longer tied to currency (Britannica, 2022). The next iteration of money was the emergence of the credit card. In 1950, Diners Club introduced the first universal credit card; in 1959, American Express debuted a plastic card (Britannica, 2022).
Bitcoin was the next major innovation in the history of money when the first Bitcoin was mined in 2009, and technology gave the world the potential for digital scarcity. Verification, digital signatures, and cryptography create identity, ownership, and the ability to be traded, which set Bitcoin apart from older mediums of exchange, such as copyable paper currency. The next innovation in virtual assets was the Ethereum public blockchain outlined in the Ethereum Whitepaper (Buterin, V., 2015). Ethereum established the ability to create and issue tokens seamlessly, similar to creating a currency. Initial Coin Offerings (ICO) offer a token. They are conceptually similar to Initial Public Offerings in that ICOs offer ownership stakes as opposed to IPOs as “shares,” and these ownership stakes are in the form of tokens. They can be risky and speculative, but the investors hope that the subject blockchain protocol or cryptocurrency will grow in popularity, and such popularity will translate to an increase in the value of the underlying token. The smart contract function of Ethereum laid the groundwork for Decentralized Finance (DeFi), which is envisioned as an open-source alternative to the current financial system which allows people to develop decentralized products which mirror the traditional finance system in a decentralized manner. There are many criticisms of the global financial system, which relies on expensive intermediaries. It takes days and costs money to settle a stock transaction to transfer money from a bank account to anyone. Retailers pay for every customer's credit card transaction.