DeFi stands for Decentralised Finance.
After creating the basic ‘token’, the crypto-digital currency community wanted to take a part of financial transactions and decentralize them as well, which is how DeFi came to be. The biggest difficulty in decentralizing finance is not in the technology part, but in what to use to replace “credit derivatives”.
The basic BTC or Ethereum transfer is a transfer of ‘ownership’, I ‘own’ a bitcoin, I transfer it to you, then the ownership of the bitcoin becomes yours.
The nature of this transfer gives cryptocurrencies an ‘asset’ character that is highly resistant to censorship and regulation. Because the lending relationship is easy for the government to control, as long as Tom’s account is declared frozen, then the money inside the bank is actually untouchable by Tom. But unless someone uses physical means to force Tom to transfer money, if Tom has a few bitcoins, he will always have as many as he has and will not be interfered with by other external forces.
Here’s the problem: How do you play the ownership with a multiplier effect?
We look for banks to borrow money, knowing that the money in the bank is the depositor’s, and we believe that banks will not lend indiscriminately because they have reserves and are regulated by the central bank. So the bank has 1 million in hand and is able to lend out 3 millions, and we don’t worry, everything is a number anyway.
But for ownership, I have a camera, lend you can use, but you now want three cameras, said after shooting back to me five, where can I go to find out? Even if I have, I lent it to you, how can I guarantee that you can return those to me, how can I guarantee that you can afford to return those? And the anti-censorship and anti-regulation, which were previously an advantage, now become a hindrance.
And that’s what DeFi is trying to solve, to simulate on the blockchain the financial transactions we normally see, like the most basic lending and various advanced financial derivatives.
Advanced financial derivatives, from the blockchain perspective, are not complicated because they are essentially contracts, which can always be broken down into the most basic lending, collateral and ownership transfer inside a smart contract, so the core is decentralized “credit derivatives”, and after solving this problem, the rest can be left to programmers.
DeFi is currently addressing collateralization through cross-chaining and leverage through a margin system, ultimately enabling a credit derivative-like operation.
Let’s take Bitcoin and Ethereum as an example, if the name of the cross-chain is X-chain and the currency on X-chain is called X-coin.
For example, if I want to pledge bitcoins for Ethereum, I can: lock the bitcoins at a specific address, at which point a Pseudo-BTC will be generated on the X-chain representing this bitcoin pass, and then I pledge this Pseudo-BTC with a smart contract on the X-chain, generating the corresponding X-coins; then take the X-coins and buy a certain amount of Pseudo-ETH, and then release the The collateral ETH corresponding to these Pseudo-ETH is released and the transaction is finished. The whole process is done by smart contracts without human participation.
And if I don’t pay it back when it’s due, then the bitcoin I pledged is gone. The smart contract automatically executes at expiration and defaults on this bitcoin that I pledged.
This enables equal collateralization, but the beauty of finance is that you can do a lot with a little, so we need to overcollateralize. That is, you want to be able to pledge 1 bitcoin and temporarily borrow 2, or even 10 bitcoins to speculate.
Assuming there is a bank on chain X, people are fine with locking up their bitcoins and sending PseudoBTC to this bank. Now the challenge is, with the pool of money available, how does this bank come to overborrow, generate interest, and still not incur bad debt? With decentralized lending, there is zero tolerance for bad debt.
If the system is designed to prevent anyone as a traitor, then there is no room for bad debts. How can there be no bad debts? Smart contracts force the closing of positions.
The advantage of smart contracts is that everything is on the chain and can be automated on the chain. You take 1 BTC as collateral, I can lend you 10, but after lending you, if any operation of yours causes the value of the assets on the account to be less than 9.05 BTC, then sorry, the contract is automatically executed and your collateral is confiscated. This is actually the same as the margin of stocks, futures and foreign exchange, only that it is decentralized and executed on the chain.