Web3 technologies have the potential to change the world. This article will introduce you to some of the basic concepts underlying this exciting new evolution.
The evolution of DeFi has been fast and it’s still happening. As a matter of fact the DeFi ecosystem has risen rapidly, attracting investors who require access to a broad range of financial services and instruments without the third-party intermediation of the past. And along with DeFi, we have seen the growth of DAOs, which now interface with DeFi, providing huge opportunities for forward-thinking individuals to borrow, lend, save or invest.
As ever, DYOR (doing your own research) is key. However, we hope that this article will introduce you to some of the basic concepts underlying this exciting new evolution.
What is DeFi?
DeFi is an abbreviation of Decentralized Finance. The term encompasses decentralized exchanges (DEXs), along with derivatives, options, loans, predictions markets, insurance contracts and any other type of financial product that can be encoded in a smart contract.
DeFi protocols are permissionless, which means that participants do not need to pass any accredited investor criteria or seek approval from any third party. On the other side of this, there is no institution or third party to guarantee that your money is safe. Open-source smart contracts mean that investors can do their own research instead of trusting someone else’s promises.
The most popular DEX is Uniswap, while Compound and Aave are the best-known lending platforms. Most protocols rely on stablecoin issuance, which is where MakerDAO is important.
The majority of smart contracts within the ecosystem run on Ethereum. However, due to the high price of gas fees, protocol developers are starting to look at other options, such as Layer 2 networks (Polygon) or other blockchains (Solana, Fantom, Avalanche).
The popularity of DeFi has soared, and there is now more than $250bn locked in various DeFi protocols.
People often contrast this sector with CeFi – Centralized Finance, which represents traditional financial products and services offered by banks, brokerages, exchanges, insurers and other institutions.
History of DeFi
As with every development in the Web3 space, people will always argue about who invented DeFi, and when. In some ways, the creation of Bitcoin in 2009 is the very beginning of an entirely decentralized worldwide payment system, although Ethereum’s smart contracts (main net released in July 2015) provide the technology that makes our modern DeFi landscape what it is.
The MakerDAO developers deployed the smart contracts for their DAI stablecoin in 2017. This means users can lock up cryptocurrency via a smart contract in exchange for DAI, which is pegged to the value of the US dollar. These collateralized debt positions (CDPs) are popular because investors can effectively borrow dollars to invest elsewhere without sacrificing any potential price rises of their Ethereum or other cryptoassets.
What is a DAO?
DAO stands for Decentralized Autonomous Organization. One of the most difficult things about getting people to work together for a common goal is ensuring that their interests are aligned and that one person does not act in a way that is damaging to the other people in the group.
In a pre-digital age, when people lived in small villages and everyone knew each other, incentives such as family reputation were often (but not always) guarded against bad actors. Once business became more global and people migrated to live in cities where anonymity was possible, lawyers and banks intermediated the informal agreements that had enabled people to cooperate in earlier times.
A DAO removes the need for intermediaries such as lawyers by replacing complicated multi-party agreements with a smart contract: a piece of computer code that defines the rules, incentives and outcomes that govern the group. The smart contract automates actions such as making and receiving payments and entry to the group.
The first DAO was created in 2016, as a kind of venture capital fund to enable anyone in the world to contribute ETH and vote on which projects they wanted to fund. However, the bad publicity that followed a notorious hack meant that subsequent DAOs were slow to get off the ground.
This has changed in the last year, as groups of investors have got together to create DAOs to purchase assets collectively. The ConstitutionDAO was formed in order to bid for an original copy of the Constitution of the USA. The bid failed, but the publicity around the failed attempt hit the mainstream headlines around the world.
Why are DAOs important and what can they do?
DAOs are an increasingly important part of the decentralized ecosystem because they enable people to group together for any common purpose, safe in the knowledge that any funds they contribute are not under the control of a single person.
In a CeFi world, investment funds that pool resources from multiple individuals have great purchasing power, and enable retail investors to gain access to a wider range of assets than they would otherwise have. The down side of this is that while governments heavily regulate the activities of fund managers, the legacy financial system is still based around the idea of trusting a single person or a single company. Stories about people like Bernie Madoff, the fraudster who lost $64bn of his clients’ money, are unfortunately common.
Additionally, many governments have laws that mean individual retail investors cannot access some of the highest-returning investment schemes. This gatekeeping concentrates wealth in the hands of those who are already rich.
Because a DAOs is permissionless and decentralized, anyone can contribute their funds to its smart contract and gain benefit from pooling their resources to invest in assets that would otherwise have been out of reach, whether this is a rare Dolce & Gabbana digital wearable (Red DAO) or an antique copy of the American Constitution.
What is the future of DeFi and DAOs?
According to DeepDao, DAOs now have more than 1.7 million members. Some of these members may also be other DAOs, or corporations, so the number of individuals who invest in these vehicles could be even larger. The sector is expanding rapidly, with more than 350 thousand members added in the last month alone.
Tools such as Aragon and GnosisSafe provide software that can be used for people to create their own DAOs, but in the meantime, existing organizations continue to attract new members.
The burgeoning NFT scene has also sped up this growth. Many artworks and collectibles are now so expensive that individual buyers cannot afford them: DAOs like Flamingo or Pleasr allow people to participate by contributing smaller amounts.
NFTs that are fractionalized in this way can also be used as collateral within the DeFi system, creating a whole new economic flywheel to power up the sector even more.
DAOs will doubtless continue to be a growing element of DeFi, as well as having many other uses in community-building and governance.
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