The 3 Elements to Jumpstart DeFi on IOTA

After these three core elements have been built on IOTA, a foundation for a new financial system will have been set and a plethora of new use cases will emerge. Let’s talk about each of the elements and why they’re essential:

1. Stablecoins

What is a stablecoin?

A stablecoin is a token that has its value pegged to some form of fiat money, usually USD. That means the price of the coin is not dependent on market movements. It remains stable and can always be redeemed for the same value as the asset it’s pegged to. One example of a stablecoin is USDC. If you have 100 USDC, then you’ll always be in control of $100. The value never fluctuates.

There are two main types of stablecoins: centralized, fiat-backed and decentralized, crypto-backed and algorithmic:

  1. Centralized, fiat-backed
    • A financial institution collects USD, puts it in a bank account, and for every dollar in the bank account they can issue an equivalent amount of that stablecoin. Every stablecoin is backed 1:1 to the dollars held in the bank account.
    • Examples: USDC, USDT (Tether), BUSD
  2. Decentralized, crypto-backed and algorithmic
    • Instead of trusting a financial institution to hold reserves, a decentralized stablecoin can use cryptocurrency as the collateral and various algorithms to maintain its peg to the dollar. There’s no need to trust a financial institution when using a truly decentralized stablecoin (this is still a work in progress).
    • Examples: DAI, RAI, sUSD

Why are stablecoins so important for a decentralized financial system?

First things first, this gives you a way to store and transfer your local currency without anybody’s permission. You can begin to think of your IOTA wallet like a checking and savings account that you control 100%.

Additionally, an important part of finance is the ability to enter and exit the volatility of the market at will. If you want to take profits or foresee a large market downturn, with stablecoins you can turn a portion of your portfolio to stable assets without using a centralized exchange. In an environment that’s open 24/7/365, with just a couple of clicks, you can sell your digital assets back to USD and wait for the next opportunity.

2. Decentralized Exchanges (DEXs)

Once stablecoins are available on the IOTA network, we’ll need a way to trade our IOTAs for those stablecoins. DEXs will be dApps built on ISCP chains and they’ll allow anybody utilizing the IOTA network to exchange tokens with each other in a trustless manner. Everything is written in code through a set of smart contracts, and everything is executed automatically once you put in your order.

There are many advantages to DEXs over CEXs, here are a few:

  • No centralized authority can stop you from making a trade.
  • All the automation, reduction of operating expenses, and utilization of IOTA’s infrastructure drives fees down and makes trading more efficient
  • Now that your assets never leave your possession, there are no longer wait times from jumping on and off CEXs.

DEXs are critical infrastructure for DeFi. Nearly every use case relies on the ability to quickly exchange assets without leaving the network.

Bonus: DEXs allow you to provide liquidity and earn passive income.

3. Lending/Borrowing

People like credit and people like interest. Borrowing and lending platforms have been at the foundation of every financial system for quite some time. The concept is very simple: Put down some collateral and in return you can borrow some cash if you promise to pay it back with some additional interest.

A good example is taking out a loan to buy a car. You don’t have $10,000, but still want a car. You go to a bank, put down the car as collateral, and the bank gives you $10,000 to buy the car. Now you own a car but are on the hook to make monthly payments to the bank until the $10,000 plus interest is paid off. The big risk here is that if the car depreciates to a value of $4,000 while the outstanding balance on the loan is $8,000, then it makes sense to default on the loan. This risk is mitigated in the real world by a credit score system. You can’t just default whenever you want because your new credit score won’t allow you to get another loan.

How does a lending and borrowing platform work on a permissionless and trustless DLT since there’s no credit score system? Through a mechanism called “overcollateralization.” To take out a $10,000 cash loan using a lending/borrowing dApp on IOTA, you’ll need to deposit something like $15,000 worth of IOTA tokens. If the price of IOTA starts to drop and the value of the IOTA tokens you deposited starts to get close to $10,000, then your IOTA tokens will be sold off to automatically pay back the loan (this is called “liquidation” and it’s all done through smart contracts).

There’s no risk from the lending/borrowing dApp side because they make sure their entire platform always has enough collateral to back all outstanding loans.

If you’re wondering why someone would participate in something like this, check out my IOTA Americas DeFi Presentation. Here’s one of my examples:

“The person who sold their IOTAs for a stablecoin would now like to at least earn some modest interest. They lend their stablecoin to the platform in return for interest payments until they withdraw (and like I said before, you’ll probably get a lot of native tokens too if you’re in early enough, which we all will be). And if you remember from the beginning, someone is always willing to borrow that money to lever themselves up. Or who knows? Maybe someone is really bullish on IOTA in the long term and wants to remain exposed to the price appreciation but sees an opportunity in the space to make some protocol revenue. They can deposit their IOTA as collateral, take out a loan in a stablecoin, swap that stablecoin for the new protocol token, and begin earning money using that protocol without ever selling their IOTA. No taxable event happened, they’re earning protocol revenue from a new project, and they’re still exposed to the price appreciation of IOTA.”

IOTA will soon have decentralized banks that can’t give anybody preferential treatment and will have safeguards written in code that make the entire system resistant to any major form of crisis that we’ve experienced in recent history.

Bonus: You can lend your tokens and make passive income.

Essential financial services like saving, earning interest, lending, borrowing, and trading are all enabled after implementing these three core elements. After this foundation has been built, things like DEX aggregators, options, futures, insurance, etc. start to pop up and the real fun begins…

Thank you to @Mammoth for reviewing and editing!

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