Understanding Decentralized Finance: A Strange World

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The lifeblood of finance is reliability and liquidity. Financial institutions must constantly imprint the trust that their customers’ deposits are safely managed. This trust is the foundation of reliability. If a customer wants to withdraw money deposited in a bank, the financial institution must be able to return it at any time. That is, liquidity must be abundant. Reliability increases when liquidity is abundant.

Decentralized finance and fintech: From developing countries perspective

Conventional Finance

Looking back, there are not a few banks that have disappeared into the back road of history. In 2008, Lehman Brothers, the world’s fourth-largest investment bank, went bankrupt. The Guinness Book of World Records recorded this bankruptcy as the largest bankruptcy in history. Paradoxically, the more important a bank is, the less likely it is to go bankrupt. The so-called too big to fail adage applies. Fearing that the global economic order would collapse in one blow if left bankrupt, there are numerous large banks that saved their lives with bailout loans. Historically, financial markets have always been volatile and not very safe.

The moment customers lose their faith that they can immediately get their money back when they want to withdraw the money they trusted, the bank faces an uncontrollable bank run. There are times when bank balances are not enough because banks lend out most of the deposited deposits for interest income. Therefore, banks desperately rushed to avoid bankruptcy every time a deposit withdrawal occurred, and passed countless dangerous hurdles. The trust of large financial institutions was built that way.

To give customers a firm belief that they are safe, banks obtain government licenses. Even if a bank goes bankrupt, Korea’s Deposit Insurance Corporation preserves deposits up to 50 million won per customer. Commercial banks across the country must prepare a capital of at least 100 billion won to obtain a license from the government. Local banks need at least 20 billion won. Internet-only banks must raise 25 billion won in capital. In order to obtain a government license, all other very demanding requirements must be satisfied.

Decentralized finance: a new world for everything on finance related

New Era, New World for Finance

However, young people without a license from the government and no experience at all publish a white paper, and in an instant, hundreds of billions of won in assets are accumulated to conduct financial business. Several new decentralized financial services appear every day, and some disappear. Even though assets can fly away, there are people who entrust ‘Bitcoin’ or ‘Ethereum’ to decentralized financial institutions. In the eyes of conservatives, these things, which are infinitely strange, happen all the time.

For example, in 2018, a decentralized finance platform called ‘Uniswap’ emerged, but as of January 16, 2021, the customer’s deposited assets (TVL) reached a whopping $3.1 billion. There is a very important factor that makes depositing large amounts of assets on a decentralized finance platform that may collapse at any moment. It is a firm belief that there will be no loss of principal even if you entrust valuable assets. That’s why people boldly deposit ‘Bitcoin’ or ‘Ethereum’ on the ‘Uniswap’ platform.

Let’s take another example. It is fashionable to freeze the underlying assets entrusted by customers and instead have smart contracts mint alternative assets. When a customer entrusts ‘Bitcoin’ or ‘BTC’, which are underlying assets, a service that creates ‘wBTC’, an alternative asset, has emerged. Minted ‘wBTC’ is used for decentralized financial services on the ‘Ethereum’ platform. When the alternative asset is returned, the alternative asset is immediately incinerated by the smart contract, and the customer gets the underlying asset back. So, the customer’s underlying assets are safely managed. You don’t have to worry about taking it off.

Of course, there is no way for customers to entrust their ‘Bitcoin’ to a decentralized finance platform for no reason. To attract customers’ assets, the decentralized finance protocol pays interest to customers. It is a platform that started without a single penny of capital, so it is not in a position to pay interest in cash. So digital assets that seem useless in some ways are paid as interest. For example, ‘Uniswap’ pays interest with a digital coin called ‘Uni’ that it minted itself. This coin may be just a number with no value whatsoever. By the way, ‘Uni’ is trading at $ 15.40 as of January 30, 2021. Getting ‘uni’ as interest can be much better than depositing it in the bank.

Decentralized Finance, Smart Contracts, and Blockchain

Even if you hold ‘Bitcoin’ for a long time, you will not earn a penny of interest. However, if you entrust it to a decentralized finance platform, you will earn interest. If the value of ‘Uni’ is zero, the interest received after entrusting ‘Bitcoin’ is also zero, so it is no different from the customer just locking up ‘Bitcoin’. However, if the value of ‘UNI’ is not zero, it is a pleasure for customers to receive a proper interest rate. Therefore, depositing ‘Bitcoin’ in a decentralized finance platform is a profitable business, not a break, because the principal is guaranteed and interest can be received.

From 2020, clever young people have jumped into the field of yield farming, where they entrust ‘Bitcoin’ and receive interest. There were also projects with interest rates of hundreds of percent, so it was not easy to avoid yield farming. As a result, yield farming gained the trust of customers, and as billions of dollars of assets were accumulated on the decentralized finance platform, liquidity became abundant. In this way, the conditions for creating a decentralized finance bank in a matter of days were created.

Decentralized finance is growing in size

Decentralized finance, which will be deployed in earnest in the future, is approaching as a new paradigm that has not been experienced in traditional finance before. An unsecured, risk-free, ultra-short-term loan, such as a flash loan, is a new service model that is only possible in decentralized finance. There are many services such as flash loans in decentralized finance. Decentralized finance is leading us to a new and wonderful world that is too young to dismiss it as futility.

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