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DeFi: Unpacking money legos and why we're excited about it

What you need to know about DeFi and Money Legos.

Mervyn Chng
Mervyn Chng

When you dive deep down the Decentralized Finance (DeFi) rabbit hole, many in the community are incredibly passionate about "Money Legos" - a term derived from the depths of tech memes on programmable money.

DeFi, for short, is an ecosystem of networks, products, and applications that work to improve upon traditional financial systems by replacing financial middlemen and intermediaries with automated code known as smart contracts.

There are many banking equivalent services in DeFi, including lending and borrowing opportunities, and others that enable advanced trading markets within the ecosystem. DeFi contributors mostly build on the Ethereum blockchain, an underlying infrastructure that gives smart contracts the ability to transfer value in a decentralized, immutable, and transparent manner.

Why is there a growing interest in DeFi, and why are we excited about its future over legacy financial systems? It all boils down to Money Legos.

Composability a.k.a Money Legos

Image Credits: Totle

The true value of DeFi on Ethereum stems from its key concept of composability.

That means that smart contracts from different financial applications (Money Legos) can connect and interact with each other in a variety of ways like lego blocks - with layered building flexibility that cannot exist in traditional financial markets.

These Money Legos can combine to create wholly new and innovative products and offer everyone an opportunity at higher returns over traditional financial instruments - all while empowering users with full financial control and custody of their digital assets.

Here are some of the fascinating innovations in DeFi that we love:

Lending Pools

Global lending pools like Compound and AAVE work like a marketplace that allows users to lend digital assets to others by sending funds directly into a smart contract and receiving interest from borrowers in the same lending pool.‌

At the same time, borrowers can take out a loan at an interest directly from these lending pools by providing collateral in digital assets to the smart contract. Such borrowers are typically users who own digital assets but do not wish to sell them, yet require immediate liquidity for other usage and are willing to pay higher interest rates from these loans.

This entire process of lending and borrowing via smart contracts is entirely permissionless - no need to submit applications to a centralized authority or file paperwork with multi-level approvals. It's also non-custodial, so you don't need to hand over custody of your assets to an "unknowing" third party that can be vulnerable to loss of funds through fraud or theft.

One interesting application that has me personally excited about lending pools is the idea of a No Loss Lottery.

Too good to be true?

PoolTogether pioneered the concept of a "no-loss" lottery by combining what you know of lotteries today with stablecoins and lending protocols.

Participants buy lottery tickets with stablecoin assets supplied to a Compound lending protocol to earn interest. At the end of a lottery draw, every participant gets their principal back, while one lucky winner gets to make the total interest earned in the entire pool.

So a happy no-loss win for all with zero chance of losing your capital!

Liquidity Pools

Decentralized (trading) exchanges or DEXs like Kyber Network, IDEX, and Balancer improve trading efficiency with the help of automated smart contracts. One such exchange is Uniswap, which utilizes an innovative mechanism known as "Automated Market Making (AMM)" to automate trades. AMM exchanges are unique in that it doesn't require the use of an order book to derive the price of an asset. It also allows any user to provide liquidity into the trading pool and earn a share of the exchange fees. These fees get distributed to all liquidity providers of the pool, and no centralized entity profits solely.

Image Credits: Uniswap

DEXs are innovative because they allow anyone to place trades that are entirely transparent on the blockchain, where every transaction made can be verifiable at any point in time. More importantly, AMM DEXes, such as Uniswap, allows its users to become non-custodial market-makers to earn trading fees. Users can make a return on their ERC-20 tokens and ETH without having to give up custody of their assets.

However, liquidity providers come with their own set of trade-offs and risks, which you can read more about from this article. I also recommend this guide to learn how to trade with Uniswap.

Building with Money Legos

Great builders can leverage the market's opportunities by combining different pieces of Money Legos to solve financial problems or create new products we never knew we needed.

With money legos, there's a lot to explore and to benefit on, specifically yield generating liquidity pools. They build with Money Legos into a product ideal for generating a return on stablecoin trading pairs or any asset with an expected 1:1 value in the long run.

Curve Finance

For example, Curve Finance has been gaining impressive traction in the community. Digital assets on their exchange can be supplied concurrently in both a lending pool and a liquidity pool, allowing liquidity providers to earn highly desirable returns from trading and lending fees. Note: Fees earned depend on trading and borrowing demand which do come with layered risks.

It's innovations like these that can only exist in the world of programmable money that makes us so excited to be building in this space.

Do check out the projects mentioned in this post to learn more about them. We're looking forward to bringing the value that DeFi offers for all and will be covering more amazing projects in the coming weeks.

DeFiLendingYields

Mervyn Chng

All things crypto.