DeFi is something that everyone should be paying closer attention to. It could be that in a relatively short time the way we bank, borrow, lend, carry out financial speculation and even buy insurance could radically change. Welcome to DeFi!
While crypto may still be seen by some as “underground”, a place for enthusiasts, weirdos and tech nerds, DeFi is something that everyone should be paying closer attention to.
DeFi stands for decentralised finance. It offers a decentralized financial system that eliminates the need for traditional middle men: banks, payment providers, exchanges, and insurance… Its name came in opposition to Traditional Finance (TradFi), seen as and also called Centralised Finance (CeFi).
DeFi today is still very much in its infancy but has a very promising future, potentially providing a more financially accessible and egalitarian possibility for millions, maybe one day even billions, of people around the world. That sounds like a good thing indeed!
TradFi vs Defi
Traditional Finance is, as the name suggests, traditional financial players like commercial and investment banks and brokerage houses that can often be hundreds of years old and are involved in every aspect of finance from banking to trading and everything in between.
On the opposite of that spectrum are the young new upstarts starting a revolution by throwing hand grenades into the traditional and gentile world of TradFi. These DeFi upstarts envision a world where there are no stuffy organisations controlling access to the world of finance and where the rule book is literally set alight and unceremoniously thrown out the window. In this article we are looking at the highly innovative world of DeFi and how it contrasts and potentially threatens the cozy, closed off and highly entrenched world of traditional finance (TradFi ).
DeFi vs TradFi, a historically monumental shift
Today’s financial systems might feel antiquated when compared to the wonders of the technology-driven world we live in. The world of TradFi tries to keep up with consumer needs by building on top of an existing closed system and open finance has helped somewhat to bring TradFi into the modern age. We must however keep in mind that even open finance whilst fresh and innovative is still constrained by the rules and limitations of traditional finance. Traditional financial institutions may try and look cool and hip but in the end, they are still old-fashioned organisations that hold the keys to everyday finance for billions.
DeFi on the other hand is starting from scratch in many ways and building something totally new and free from the constraints of TradFi.
The inescapable fact is that times and consumer habits, needs and expectations have changed and now the technology exists that can facilitate the kind of monumental shift we are seeing in the crypto world. It is no different to automobiles challenging the horse and cart or online travel agencies such as Expedia or Booking.com challenging traditional travel agencies when they first arrived on the scene during the early internet boom. The first internet startups and first car drivers were seen as crazy too!
So, what is potentially in store for us?
First, do note that this is a revolution and not an evolution. The automobile wasn’t a horse that could go faster, the automobile eliminated the horse completely from the picture. In much the same way DeFi is not an evolution in TradFi but rather a true revolution, a re-start from scratch, in a sense. Of course, people’s core financial needs are still pretty much the same: earn, hold, pay, save, borrow, lend, invest, convert, trade, insure, donate. But the infrastructure to do those “basic” things is about to be re-written.
Just as in the early days of automobiles when there were plenty of accidents along the way, no speed limits, no speed cameras or speeding tickets, DeFi is currently a bit of an unregulated, free and “wild-west” of finance. It’s basically doing everything that traditional finance does, and more, without re-using a single piece of it.
DeFi explained
Decentralized Finance is the “money” arm of the crypto world. Think of it as Wall Street 2.0, where decentralised companies go public and services like lending, borrowing and derivative trading can all be accessed by anyone.
How Defi Started
In many ways, Bitcoin could be seen as the very first example of DeFi even though the term DeFi hadn’t been coined yet, if you pardon the pun! Bitcoin was and still is a decentralised monetary system independent of any government or central organisation, the very meaning of DeFi. But the only use cases were “hold” and “pay”. There was no lending, borrowing, trading or anything else natively built on the Bitcoin blockchain.
The first example of what we would today consider to be Decentralized Finance started in 2015 with Maker. It had the vision to create a decentralized financial system that would be governed by its user community and, in doing so, give borrowers more control of their assets .
It allows users to borrow Dai, the platform’s native token pegged to the US dollar. Through a set of smart contracts on the Ethereum blockchain, which govern the loan, repayment, and liquidation processes
So it lends money against collateral, like a pawn shop or a real estate mortgage dealer. That was DeFi use case #1. In 2018 Uniswap was released and allowed the exchange of any token for any token without the need for a central exchange and in 2020 AAVE made lending and borrowing decentralized. From then on it went crazy and today you can earn, hold, pay, save, borrow, lend, invest, convert, trade, insure, and donate with Decentralized Protocols; and often in ways that were not possible before.
Whereas in open finance fintech apps are interfacing with established financial institutions to provide consumers with greater ease of use, developers in the DeFi world are rewriting the rule book completely. They are not looking for ways to integrate with traditional intermediaries but rather eliminate them from the picture completely! Why connect to a bank’s back end if everyone can hold their own keys and be their own banks?
How can this be possible you might be asking, don´t we need these very solid financial establishments like banks to provide us with lending, borrowing, derivative trading facilities and so forth?
Well, it turns out that we maybe don’t. As mentioned above, the majority of DeFi applications are built on top of very sophisticated blockchain technology called Ethereum which had a market value of $212 billion as of June 2021. To put this into perspective, Barclays bank had a market cap of $42.41B on the same day in June 2021. So the market cap of Ethereum was nearly 5x that of Barclays bank! Now consider that Ethereum came into being in 2015, 6 years ago and Barclays bank came into being in 1896, some 125 years ago we can see that while Ethereum may be new it is certainly no financial lightweight when compared to the big boys in TradFi. Sure, in 2023 the price of Ethereum is not where it was then but this could potentially be seen as a mere blip when looked at in the long run, only time will tell.
There are four main tenets that all DeFi apps share
DeFi apps use a blockchain as their core ledger
All DeFi apps use blockchains for their underlying technology, a few of the most prominent blockchains used to build DeFi apps include Ethereum, Solana, Terra, and Binance Chain. The blockchain performs the central task of recording a ledger of all transactions in the form of blocks.
DeFi apps are open source and transparent by design
Being open source and transparent by nature allows a level of auditability making it possible to delve into smart contracts to see exactly what a smart contract is doing in terms of functions, user data and permissions. Lastly, the entire flow of funds is auditable, this is pretty major when compared to TradFi where everything is hidden away behind proprietary systems accessible only by people on the inside.
DeFi apps are interoperable and programmable
We often hear about “money legos” when looking at DeFi. This is a reference to their composability. Each individual DeFi app can be seen as a “Lego brick” for a specific financial service or product that can be freely combined with others. These “Lego bricks” are in a sense clicked together for each individual transaction in real-time enabling a level of speed, flexibility and innovation that would be unthinkable or even impossible in the way more closed-off and proprietary world of TradFi.
This is why innovation happens so fast: if you want to build a service that requires “swapping” tokens and “lending tokens” as fundamental building blocks and then adds some value on top (for example, a self-repaying loan like Alchemix), you don’t need to rebuild those two building blocks, you can just “plug into” Uniswap” and “AAVE”, and you only need to build the small thing that is unique to your app. In traditional finance that would take weeks of negotiations; in DeFi it takes the minutes required to connect to an API.
DeFi apps are open and accessible to all
One of the most underappreciated aspects of DeFi products is the inherent equality of accessibility: no institution or intermediary can deny service which is also known as being permissionless. If you have sufficient funds within your wallet for the transaction that you wish to carry out, you can do it irrespective of where you are from or who you are, it’s as simple as that.
Compare that to TradFi where an individual can still decide whether a person gets approved for a loan or can even open up a bank account! The DeFi world simply doesn’t care about these sorts of things. As long as you have enough coins or tokens in place to carry out the desired transaction there is nobody there to stop you. In a world where discrimination sadly still exists and where so many people around the world still do not have access to basic banking facilities let alone sophisticated financial services it´s about time!
The DeFi ecosystem now
Some examples of DeFi apps include:
- Decentralized Exchanges – also known as DEXs – such as Uniswap where trades can be executed without the DEX having to hold on to your funds to execute trades.
- Decentralized Derivatives Trading: On Synthetix for example, you can trade in commodities, something akin to derivative trading without the need to have and hold the commodities in question, instead you trade something called Synths that are synthetic assets.
- Lending: Compound is a decentralized peer to peer (P2P) lending platform where users can earn interest or borrow assets against collateral. AAVE too.
- Insurance: Nexus Mutual is a decentralized autonomous organization that provides smart contract insurance.
Risks and opportunities with DeFi
By now the opportunities of using DeFi are probably apparent: Autonomy, speed and opportunities previously unavailable.
But there are also quite a few risks still associated with Decentralized Finance that you should consider before rushing into anything. Here is an overview of the types of risks you are looking at:
1. The risk linked to the “smart contract”
The risk linked to the “smart contract” (the computer code on the blockchain) you are using (AAVE, Uniswap,…). For example, we have seen the following happen in the past:
- Oracle Attacks &/or Clever Arbitrage Execution: Manipulate the price through oracles, volumes or both, get lots of stuff for cheaper than it is, then sell it at its real value. For example: bZx, Cheese Bank, Harvest
- Contract Design: if you let them print tokens, they will. For example, PickleFinance
- Reentrancy Attack – this happens if a contract makes an external call to another untrusted contract before resolving. For example, if it transfers funds before setting its balance to zero, an attacker can beat the withdraw function to death and essentially drain the entire contract. For example: Akropolis, dForce, and Origin
- Front-end issues: bug in hosting or domain leads to attacks – not specifically DeFi, but still a problem faced by NiceHash’s. If you go to app.uniswap.org trusting that it’s Uniswap when it’s in fact an attacker, it doesn’t matter how safe the Uniswap smart contract actually is, because that’s not who you are interacting with.
2. The financial risk
As in the risk of not being repaid when needed, or at all, even if everything keeps mostly working
- While most lending platforms use (over)collateralization to reduce credit risk, over-collateralization does not completely remove credit risk – The collateral assets that back loans on DeFi platforms have a high level of variation, in liquidity & stability of price. For example, loans may be mostly backed by ETH. While ETH is pretty volatile, it is quite stable and liquid if compared to LINK. That matters when thinking about the overall risk
- Liquidity pool (Curve, Uniswap) don’t have credit risks, but they do have the “impermanent loss” one
- Liquidity: if all the money in a lending pool is lent out, you can’t withdraw, and you need to wait until some loans are repaid.
You take on a risk that you won’t be able to withdraw the assets being lent out “on demand” because all the assets are currently lent out. If you need liquidity, best to swim in big pools
- The yield is still mostly variable today. If you deposit at 11% today, it might be 2% tomorrow. 1 year low is 0.68%
- If you rely on EUROS for spending but lend out USD, there is a bit of an exchange risk too.
3. Blockchain or stablecoin risks
- If the Ethereum Virtual Machine or Parachains or, your blockchain of choice breaks or gets hacked.But at that point, we potentially have bigger problem.
- Ethereum transaction fees and congestion leads to inability to move in/out.
- This was partly the problem in March when Maker Vaults got liquidated because no one could add ETH to meet the collateral ratio because ETH was congested.
- It also happens in CeFi > try trading on Coinbase when BTC is at USD 40K or when Musk tweets “dogecoin”; or try buying AMC on Robinhood when WSB tries to pump it.
- Your stablecoin of choice proves to be worthless, gets hacked…and your unit of value = 0
4. You make a mistake
You are your own bank, so your mistakes are your mistakes: Hacked keys, hacked notepads, hacked metamask, paper wallet lost in the wash or giving your money to a fraudulent project could all see you lose your money.
Summary
Throughout human existence, there have been events that have significantly shaped society going forward including; discovering fire, the wheel, methods of communication, horses for transportation and farming, electricity, the industrial revolution, computers, the internet and most recently web3/crypto and DeFi. Yes, it’s potentially that significant!
We are still at a very early stage considering where DeFi could go in the future. Whichever way we look at it, a shift in the status quo in finance and true financial equality at a global level is needed urgently and now seems like the perfect time to throw the financial hand grenade!