A Brief History of DeFi — Part 1: The Core Primitives

Hermetica
3 min readFeb 5, 2024

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The dawn of decentralized finance (DeFi) introduced DeFi 1.0, a revolutionary suite of financial primitives that transformed traditional financial operations by enabling peer-to-peer, intermediary-free transactions. This blog post explores the foundational elements of DeFi’s first generation, including decentralized exchanges, money markets, and collateralized debt positions, which together pioneered a new era of yield generation and financial autonomy in the cryptocurrency domain.

First, let’s start off by answering the fundamental questions:

What is yield?

Yield refers to the earnings generated by providing capital to another person or counterparty over a particular period. In other words, providing a service for someone else in exchange for more resources than you put in.

What is DeFi 1.0?

DeFi 1.0 was the first generation of decentralized finance (DeFi) primitives that allowed users to interact peer-to-peer. This generation produced three methods to earn a yield on cryptocurrency tokens:

  1. “Providing liquidity” to a Decentralized Exchange (DEX)
  2. Lending assets to a money market
  3. Minting stablecoins via a collateralized debt position (CDP)

Decentralized Exchanges

Decentralized exchanges (DEXs) are online platforms that enable direct peer-to-peer transactions without an intermediary or central authority to facilitate trades. The most common DEXs are automated market makers (AMMs). They operate by using smart contracts that securely lock liquidity provider coins in a pool. These coins can be bought or sold by other participants for a fee that accrues to the liquidity provider’s position.

Coins are traded on a bonding curve. Bonding curves are a mathematical concept used in DEXs to determine the price of a token based on its supply within the pool. The curve represents a relationship where the token’s price increases as the supply diminishes and decreases as the supply increases, ensuring liquidity and price stability by algorithmically adjusting the token’s price as transactions occur.

Money Markets

Money markets are online platforms that enable direct peer-to-peer lending without an intermediary or central authority to facilitate the transaction. They allow users to borrow one token by depositing another according to value ratios. These ratios are set by the contract creators and are based on how volatile and liquid a token is. If a token has poor liquidity, it will have a very high lending-to-borrow ratio because more collateral is needed to ensure the lender gets their tokens back net of slippage.

An interest rate and a borrow fee are charged to borrow assets. Token interest rates vary by borrow utilization or the % of total deposited assets borrowed; this is known as an interest rate bonding curve. The higher the utilization rate, the higher the interest rate, both set when the smart contract is created.

Asset values in money markets are determined by price oracles that average prices according to exchange volumes and other metrics. Oracles are usually trusted third-party protocols.

Collateralized Debt Positions

Collateralized debt positions (CDPs) are smart contract pools where the lender can deposit a variety of assets but mint or create only a synthetic stablecoin. This stablecoin is valued at a unit of a fiat currency, usually the US dollar. For every unit of stablecoin borrowed that amount in US dollars plus a liquidation buffer is locked in the protocol until the stablecoin debt is repaid. This process locks up a token that the market indicates has value, such as Bitcoin, and extracts some of its value in a less volatile currency like USD for use by the borrower.

Conclusion

Together these DeFi primitives enabled the first expansion of on-chain peer-to-peer markets in the summer of 2020. However, their growth was limited by their low capital efficiency compared to centralized alternatives offered by exchanges such as Coinbase and Binance. Furthermore, they did not offer the full suite of financial products available in traditional finance (TradFi) such as futures or options.

In 2021 DeFi saw its second expansion into liquid staking tokens, on-chain perpetual futures markets, and decentralized option vaults; all of which we will discuss in our next issue. Stay tuned!

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Hermetica

The first Bitcoin-backed, yield-bearing synthetic dollar protocol.