## It all started with Bitcoin. According to Mason Marcobello at [DeFiant](https://thedefiant.io/what-is-defi-ultimate-defi-101-guide/), “the concept and very term “DeFi” was birthed in an [August 2018 Telegram chat](https://twitter.com/injeyeo/status/1157001562457174016?ref_src=twsrc%5Etfw%7Ctwcamp%5Etweetembed%7Ctwterm%5E1157001562457174016%7Ctwgr%5E%7Ctwcon%5Es1_&ref_url=https%3A%2F%2Fthedefiant.io%2Fwhat-is-decentralized-finance%2F) between Ethereum developers and entrepreneurs”. However: >“Bitcoin in many ways was the first DeFi application. Bitcoin lets you really own and control value and send it anywhere around the world. It does this by providing a way for a large number of people to agree on a ledger of accounts without the need for a trusted intermediary." Bitcoin is open to anyone and no single person or group has the authority to change its rules. Bitcoin presents us with a choice about what we put our faith in: governmental fiat and regulated, insured intermediaries; or a public, adversarial, networked ledger that anyone can use, which processes transactions without fear or favour according to pre-established, verifiable, deterministic mathematics. Phrasing it like this reveals that it is not a straight-forward choice: it depends on your context and goals. It depends on your prior beliefs about external authority and personal responsibility. But what is most important is that **Bitcoin gives us the choice again**, and this fact cannot be overstated. DeFi builds on this choice. Like Bitcoin, the rules can't change arbitrarily and everyone has access. The key innovation is "programmable money" in a general sense, using [smart contracts](https://ethereum.org/en/glossary#smart-contract), so you can go beyond storing and sending value. >“Although Bitcoin helped pave the foundations for an open and meritocratic financial system, the limitations of its programming language, Script, prevented a range of solutions that most central financial services and products can offer to their clients such as lending, borrowing, and derivatives." ## Ethereum Bitcoin is really "network of timestamp servers" (Satoshi's [initial wording](https://bitcoin.org/bitcoin.pdf)). The fact that we can agree about the order of events in time without intermediaries is the necessary condition that makes DeFi possible. Ethereum extends the idea of networked timestamp servers in a more experimental environment. It is not just a way to send and store value via messages: it is a single, shared computer which anyone can program. Ethereum enables us not only to agree on the order of events in time, but to create those events according to generalised contracts which can express fully any kind of value we wish to communicate to and between one another. It provides both the necessary, *and* the sufficient, conditions for a different way of financing our activities, and therefore a different quality of faith in one another and the world we share. >"Ethereum launched in 2015. With a Turing-complete programming language known as [Solidity](https://soliditylang.org/) and a flexible ERC-20 contract standard that allows for compatible fungible tokens and applications, Ethereum provides developers with the freedom and flexibility to build on its protocol. In doing so, it functions as one of the first truly programmable versions of money.” **Source**: [Ethereum Foundation](https://ethereum.org/en/foundation/) ## Early days of DeFi Let's begin with a greatly simplified graphic: ![[defi-history.png]] We've already discussed Bitcoin and the launch of Ethereum. Tether - a coin that is "tethered" to the US Dollar, i.e. it is always worth $1 - is an interesting case which we can discuss together endlessly: there is a lot to explain and reflect on. It certainly does not live up to the standards by which we previously defined [[3. What Is Defi?|DeFi]]. Rather than focus on that here, we'll begin with the protocol that really made DeFi possible in terms of opening our minds to what could be done with generalised contracts and an agreed order of events: Maker. 1. **2014** - MakerDAO was brought to life by the work of many people who understood the need for a financial instrument that hedged against extreme volatility in crypto markets. That is: if we denominate the price of crypto in terms of USD (another choice we make, which is not inevitable!), then the "price" of crypto changes wildly and regularly. Therefore, we needed some way to let people hold cryptocurrencies, without being constantly exposed to the abrupt changes in the market. We needed some way to "peg" a token to the unit most people choose to measure in - i.e. USD - without that way depending on a single group of people (as it does in the case of Tether). MakerDAO made this possible with the creation of DAI. 1. The idea is simple: lock up your ETH as collateral in a contract. That contract will issue you with DAI, but is programmed to be "overcollateralized": i.e. you always have to lock up more ETH than the DAI you'll get in return. A system of oracles (run by differen people) tells that contract what the current price of ETH is in terms of USD, and you have to make sure you maintain a healthly "collateralization ratio". This is kind of like a margin call: if the price of ETH falls, you need to add more ETH to your position, if it rises, you can claim more DAI for the same amount of collateral. 2. If the price of DAI as it is traded on secondary markets rises above $1, anyone can lock ETH and create DAI at $1 in the contract, then sell it on the open market for a profit. 3. If the price of DAI falls below $1, you can buy it on the market, exchange it for ETH, and redeem your position more cheaply than you would otherwise be able to. 4. In this manner, we have a decentralized mechanism that anyone can use, the result of which is the maintenance of a "stablecoin": a digital token which tracks a unit of value that exists "outside" the specific order of events we all subscribe to "on chain". 5. We gone into such detail about it because it was really the first mechanism to illustrate the power of DeFi and what can truly be done without any central authority. 2. **2016** - EtherDelta was one of the first [decentralized exchanges (or DEXs)](https://www.notion.so/978e942399ae4cdda9db92ecaf7d8c9a). This service allowed users to exchange tokens without using centralized marketplaces or brokerages. 3. **2017** - Compound launched, enabling anyone to provide liquidity that is then used to support decentralized borrowing and lending services. 4. **2018** - Uniswap, which is an automated market maker (or AMM), launched. Similar to EtherDelta, Uniswap was a DEX. However, Uniswap helped solve the liquidity matching issues DEXs faced (i.e. matching trades to meet supply and demand in a timely manner). Uniswap introduced the concept of liquidity mining or yield farming. ## DeFi Summer It takes time for collective intelligence to evolve and begin using ideas like the ones sketched above in valuable ways. By the the summer of 2020, colloquially known as "DeFi Summer", enough people had learned how to leverage the various financial opportunities implied by the tools above that DeFi began to take off. Instead of just arbitraging DAI (selling your DAI if it was worth more than $1 on the market, buying it if it was worth less than $1), people began to take advantage of opportunities on Compound and other places like it. Moreover, they began to **compose strategies**, simply because it is possible to do so in an open and decentralized system. Rather than making single trades that earned small profits, as a community, we built tools and became better at programmaing complex series of trades, leveraging interesting new ideas like [[5. DeFi Terms|flash loans]], to both make and break increasingly high value exchanges. In addition to this came the recognition that DeFi protocols are as reliant on liquidity as their traditional counterparts. How much "cash" there is, or how "deep" the market is, contributes not only to stability and security, but attention and retention of traders. Many protocols began what became known as "yield farming" initiatives, where they would offer "Liquidity Pool" tokens in return for people "locking" trading collateral in their contracts. While the market was constantly rising, the rates offered for this kind of "Farming" were enormous. Such hype is unsustainable and interest in DeFi cooled somewhat in 2021. By this time, Ethereum had become costly to use due to the volume of transactions occurring on the network. This wasn't only due to DeFi activity, but was driven by a sudden and meteoric rise in the number of transactions associated with Non-Fungible Tokens, or NFTs. When there are more transactions competing for the same space in blocks on the networks, fees tend to rise and people are willing to pay more to have their transaction included quickly, especially if it has to do with a valuable trade. This pushed users to consider other chains and ecosystems. - **Alternative Chains or Ecosystems:** DeFi users began using alternative chains and ecosystems such as Solana, Avalanche, and Terra as these ecosystems had respectively built similar products to those in Ethereum (e.g., Uniswap) - **Ethereum Layer 2s (L2):** Ethereum seeks to address issues of scale by building different "layers", such that the higher layers process most of the data, absording expense and complexity, while benefiting from the security properties of the base layer, which moves more slowly. Such networks include Optimism, Arbitrum, StarkNet, Polygon, and others. In 2021, due to some of the problems that appeared with Liquidity Pools in a falling market, we also saw a rise in projects deploying a design referred to as Liquidity Owned Protocols. When you create a liquidity pool to power your protocol, the key metric is "Total Value Locked" or "TVL". The problem with TVL in a decentralized system is that anyone is free to remove their capital whenever a better opportunity appears elsewhere, so we saw massive chunks of "liquidity" migrating rapidaly from protocol to protocol, constantly seeking the best rates. This is traditionally known as "predatory capital" and DeFi supercharged it. Projects like OlympusDAO, and its regenerative-focused fork KlimaDAO, sought to reverse this with "Protocol Controlled Liquidity", using specific kinds of bonds and a design which offered high annual yield percentages (APYs) in the 1000s due to the fact that any holder constantly gets diluted as the protocol mints more of its own tokens to buy (and therefore own) the liquidity allocated to it. While this garnered a lot of attention, and performed well as the market was rising, it would later turn out that this method is also vulnerable to bear market cycles. ## Ongoing Cycles The crypto markets entered a bear market in 2022 spurred by the combination of: - Unfavorable market conditions for crypto and other high-risk and growth assets - Liquidy crisis and insolvency of successful projects and businesses like FTX, TerraLuna, and Celsius We await what will unfold in 2023. Authors: Danny Gattas and cryptowanderer