in Decentralized Finance (DeFi)
What is DeFi?
Decentralized finance, or DeFi (also called open finance), is a blanket term for financial services like borrowing, lending, and trading built using decentralized infrastructure, such as public blockchains and smart contracts.
In 2019, it has quickly emerged as Ethereum’s next big use case after ICOs in 2017 (ICOs, also known as initial coin offerings, are when blockchain projects sell crypto tokens to raise funds for their projects’ development).
By using decentralized technology like smart contracts, which you can think of as self-executing contracts made of computer code, DeFi allows for the elimination of middlemen.
- Imagine near-instantaneous loans without the need of bank approval or paperwork.
- Imagine earning real interest on your assets, instead of suffering from low, no, or even negative interest rates.
- Imagine being able to issue stock for your company without having to deal with bankers and lawyers who charge exorbitant fees.
All this and more is the promise of DeFi.
DeFi vs. Fintech
Upon first glance, DeFi might sound similar to “Financial technology”, or Fintech for short, which also aims to use technology in order to improve financial services. However, the key difference between DeFi and Fintech is that Fintech merely builds upon traditional financial infrastructure, instead of using something new like blockchain technology.
An example of a popular Fintech service would be Transferwise, an international payments service. Although Transferwise charges lower fees than most banks and currency exchange companies, it still uses bank accounts and other legacy financial infrastructure.
The difference with Transferwise is that instead of moving money across borders and via other middlemen (like banks), Transferwise has bank accounts in different countries.
So, for example, when you send USD to someone in the European Union, Transferwise takes your dollars and then takes money from its EU bank account to give to your recipient. This allows them to charge lower fees and process transactions faster.
However, you still have to trust Transferwise to approve and clear the transaction. Moreover, you still have to get permission to send your money abroad. In most cases, you need to provide identification documents and might not be able to send money to the recipient if they are located in a blacklisted country.
Now contrast this with the DeFi product, Dai, an Ethereum-based stablecoin that’s designed to mirror the value of the US dollar in order to protect against the volatile swings that cryptocurrencies can be known for.
With Dai, you do not have to trust a Fintech company or bank to approve and settle your transaction. Instead, Ethereum miners validate new Ethereum-based transactions, including those of Dai, and add them to the blockchain.
These miners will process your transaction as long as it includes a small fee averaging around a few cents in USD. This also happens in around less than 20 seconds, instead of in days, as with traditional financial infrastructure.
Not to mention you can send Dai to anyone with a wallet that supports Dai, even if they live in countries blocked off from the legacy financial system.
So besides eliminating middlemen, which drives down costs and transaction times, what are the other benefits of DeFi?
Permissionless (anyone can participate)
“Permissionless finance” is more than just a buzzword. DeFi enables people who otherwise don’t have access to financial services to take part in the global economy.
According to the World Bank, 1.7 billion people, which is a little more than 1 out of 5 people IN THE WORLD, are unbanked, which means that they don’t have access to a bank or mobile money (e.g. M-Pesa) account.
Although there are various reasons for this, one is that many unbanked individuals do not have things others take for granted like identification documents and credit scores.
ID and credit are often necessary to open a bank account and do things, such as take out a loan. After all, the bank or financial institution has to mitigate risk by making sure that their clients are trustworthy and able to meet financial requirements.
On the other hand, MakerDAO, the most popular DeFi Dapp (decentralized app), allows anyone to take out a loan, as long as they have some Ethereum (ETH) to use as collateral.
All you have to do is deposit ETH to Maker’s smart contract, which opens a Collateralized Debt Position (CDP), and you’ll be given some DAI. Just make sure that your collateralization ratio, which you can check on the Maker CDP portal, stays above 150% by depositing more ETH or returning some DAI. And once you’re done, pay back the DAI you took out plus a small amount of interest and you’ll get your ETH back.
The best part? You can create a CDP in minutes and for next to nothing in fees.
Access to other forms of capital
In a decentralized finance world, you don’t have to accept the forms of capital that centralized authorities like your government push down your throat.
For example, Argentina, a country that has struggled for decades with runaway inflation and depreciation of their currency, again imposed capital controls on its citizens to protect the Argentine peso from further drops in value.
Argentinian citizens are only able to buy $200 in USD per month (down from $10,000). This is tragic, as many Argentinians will buy dollars and other, more stable currencies like the Euro instead of storing their wealth in Argentine pesos.
DeFi gives people like those in Argentina an alternative. For example, they could store their wealth in DAI, which is meant to mirror the value of the USD.
Dai provides a potentially better alternative to the Argentine peso since Dai is always overcollateralized with ETH (and soon other forms of collateral). That stands in stark contrast to the Argentine peso and other fiat (government-issued) currencies, which operate on a fractional reserve basis.
Fractional reserve is when the outdated system of banks loan out more money than they actually have in deposits, essentially creating money out of thin air. This can lead to the banks failing in the case of a “bank run”, when a lot of the bank’s customers try to withdraw their deposits all at once. This happened during the Great Depression in 1930’s America.
Earn money...on your money
In addition to just maintaining a stable value for your money, DeFi allows you to put that money to work. For example, DeFi Dapps like Compound and Dharma let you deposit assets like DAI and USDC, which are then lent out to borrowers.
Another way to think of Dapps like Compound and Dharma is as high-interest “savings accounts”. Therefore, people like those in Argentina can not only protect their wealth against inflationary forces, but grow it, too.
And it’s not just people living in countries with runaway inflation that can benefit. Many people in advanced economies, such as those of North America, Western Europe, and East Asia would also benefit by earning higher interest rates on their holdings.
As of writing, Compound and Dharma offer interest rates of around 4% on DAI and USDC deposits. This blows away old system savings accounts, which in America pay an average of 0.09% interest, according to the FDIC.
You’re in control of your finances
It’s good to note that with DeFi Dapps like Compound, Dharma, and MakerDAO, you remain in control of your finances. While it’s true that you deposit your crypto in Compound, Dharma, and MakerDAO, there’s no one on the other side that you’re trusting with your money other than lines of code in the form of a smart contract, which automatically pays you interest.
No bureaucrat can suddenly ban you from one of the Dapps, freeze your account, take your money, and so on. The code is law and it does not discriminate. All are treated as equals by the code.
You might not think that’s a big deal if you’re from a developed country. But Cyprus, a wealthy country that’s part of the European Union, thought that, too. In 2013, Cyprus' citizens had anywhere from 6.75 to 10 percent of their bank deposits seized to bail out the banks, who created the problem in the first place (sound familiar?).
This control over one’s finances could also be useful for political dissidents (think Wikileaks), who governments and other enemies try to shut down by cutting off access to money and finance.
Easy to create your own DeFi products/services
It’s not just users of DeFi that benefit. Many builders of innovative financial products are moving towards DeFi to build the next generation of finance.
One of the main benefits of DeFi is that most of the protocols, like Ethereum, are open source, which means anyone can access and use them for their own projects.
Theoretically, anyone with access to the Internet and a device they can code on could create the next big DeFi Dapp. Therefore, DeFi isn’t just decentralized finance for its users but its creators, too.
In DeFi, important information is easily available, which lets you shop around easily for the best DeFi services and know if something is about to go terribly wrong, such as if a protocol like Maker is dangerously under collateralized.
When you try to get a loan in the old financial system, you have to go from lender to lender in order to compare interest rates and fees and make sure there aren’t any hidden fees.
Whereas with DeFi, information about lending protocols like Compound is easily available and transparent.
You also don’t have to trust that something like MakerDAO has sufficient collateral reserves and won’t collapse, resulting in the loss of your ETH (or other collateral). You can just go and look at the code or Maker’s Platform Data.
Compare that to the Cyprus example, where no one except for bank bureaucrats with access to the accounting systems could know that Cyprus was on the brink of collapse. Such a lack of transparency reduces accountability and the motivation to perform one’s duties responsibly.
As the saying in the blockchain community goes, “don’t trust, verify.”
Although cryptocurrencies like Bitcoin are already borderless, DeFi builds upon that premise with the addition of financial services like borrowing.
Imagine borrowing money from MakerDAO or Compound in order to pay a supplier for your business who’s located in another country.
Instead of the complicated, high-fee, long wait time route you’d take with antiquated financial solutions, you could simply deposit ETH or some other crypto asset into the MakerDAO or Compound smart contract, receive a crypto asset loan, and pay your supplier within the hour (or faster).
This alone has the potential to revolutionize business around the world by speeding up and lowering the cost of global trade flows.
Another interesting way to leverage the borderless nature of DeFi is by enabling margin trading to those who may not otherwise have access through traditional means. By depositing ETH into Maker, you could receive DAI and buy even more ETH (or another asset).
This is a very interesting “byproduct” of the Maker protocol, since this form of margin trading is completely decentralized and doesn’t involve borrowing money from a broker or exchange.
Although DeFi has only really taken off in 2019, there are a ton of different DeFi projects out there.
Lending and Borrowing
DeFi lending and borrowing platforms like Maker and Compound are by far the most popular kinds of DeFi projects. As we’ve mentioned, these platforms allow anyone to lend or borrow as long as they have the appropriate crypto assets to loan out or use as collateral.
Another interesting use for these kinds of DeFi platforms is arbitrage, or taking advantage of price differences in different markets. In this case, that price difference would be the difference between the fee to borrow Dai from Maker and the interest you gain from lending out Dai in Compound.
If the borrowing rate is less than the lending rate, you could technically deposit ETH in Maker, receive Dai, lend out Dai on Compound, receive interest, and collect the difference as profit (or even reinvest it elsewhere).
Decentralized Exchanges (DEXes)
Decentralized exchanges, or DEXes, attempt to emulate centralized exchange services in a decentralized manner. Instead of trusting an exchange to hold onto your money and execute your trades, DEXes do away with managing user funds themselves through a series of elaborate smart contracts.
With DEXes, users retain control of their assets and there is no intermediary, such as a centralized exchange company, as the smart contracts automatically match up buyers and sellers.
dYdX is an example of a DEX that’s quickly gained in popularity, with the value locked in its smart contracts going from nothing to around $30 million in less than a year. dYdX offers various features like margin trading, borrowing, and lending.
However, while DEXes have definitely gained traction, they still have a long way to go as most trading in the crypto world still takes place on centralized exchanges, which generally offer better transaction speeds and user interfaces.
Decentralized marketplaces like OpenSea are another type of DeFi project that takes the age-old concept of the marketplace where people can exchange goods and services, and builds it using decentralized architecture.
On OpenSea, you can buy and sell crypto collectibles, also known as NFTs or non-fungible tokens, like rare, blockchain-based trading cards. All the buying and selling is done through Ethereum-based smart contracts. This means that no central authority, not even OpenSea, ever has control over your items, which stands in stark contrast to platforms like Amazon, which sits between buyers and sellers and can dictate the rules of the marketplace.
In a sense, open marketplaces like OpenSea bring back the idea of traditional markets and true peer-to-peer commerce.
Prediction markets are popular financial tools that can be used for, you guessed it, predicting events like election outcomes.
Decentralized prediction markets have some benefits over their centralized cousins, including censorship resistance. For example, betting on sports events in jurisdictions where that isn’t allowed can be made possible with DeFi prediction markets.
Censorship resistance also means that anyone can start a prediction, without approval from any central authority, such as a prediction market’s administrative team.
However, the dark side of this is that users of decentralized prediction markets can create “dead pools”, or prediction markets that bet when someone will die, which could incentivize the assassination of individuals if an assassin were to place a bet on the market and assassinate the individual on the predicted date of his death.
Aside from betting and nefarious use cases like assassination markets, prediction markets can also be used to:
- Forecast the weather (Pennsylvania State University found prediction markets to be just as accurate in predicting the weather as professional weather forecasting services)
- Protect against financial or real world risks (e.g. you think the passage of Brexit will negatively impact the UK economy and buy shares of Brexit passing to balance out the downside)
An example of a popular decentralized prediction market is Augur, which was one of the first ICOs back in 2015.
Issuance platforms decentralize things like the issuance or creation of securities, which would normally require middlemen like investment bankers.
The DeFi equivalent of the securities market is the security token market. Security token issuance platforms like Polymath provide solutions for issuers to create, issue, and manage digitized securities.
Issuance platforms can make orders of magnitude easier (and cheaper) for companies to raise funding by eliminating middlemen like investment bankers and lawyers. It can also open up investment to a much broader pool of investors (basically the entire world, depending on who the offering is open to). Whereas traditional security offerings are limited to investors who have a trading account with the exchange where a security gets listed (e.g. the New York Stock Exchange).
Asset management, which is huge in the legacy financial system (Fidelity Investments, one of the largest asset managers in the world, has $2.46 trillion in assets under management alone), is another space that DeFi aims to disrupt.
Although DeFi asset management is nowhere near as big as that of traditional finance, there are projects like Melon that offer decentralized asset management solutions. Melon users can both manage their wealth and that of others in the form of ETH and ERC20 tokens.
Not only is asset management in Melon decentralized, but management of the Melon Protocol is, too, as the protocol is run by the community and not an elite board of directors.
Another investment-related DeFi Dapp is Set Protocol, which lets you create “Sets”, or ERC20 tokens that represent some mixture of underlying assets.
This is similar to the traditional finance idea of exchange-traded funds (ETFs), which are investment funds you can invest in that represent a mixture of underlying assets like a basket of stocks.
For example, a popular ETF is the SPY ETF, which owns shares of large companies like Apple and seeks to replicate the performance of the S&P 500 stock market index, a stock market index that measures the stock performance of 500 of the largest American companies and can be seen as representing the overall US stock market.
Decentralized Autonomous Organizations (DAOs)
DAOs, or decentralized autonomous organizations, are another type of DeFi project.
The classic example of a DAO is The DAO, which was a sort of decentralized venture capital fund.
The DAO, and other forms of DAOs allow people to create organizations with rules and transactions that are recorded on the blockchain. Instead of management running organizations, the rules of the organization would be hard coded into and automatically carried out by a smart contract. For example, a rule like “set aside 10% of profits each month for company reserves” would automatically execute once the conditions, such as profits coming in, were met.
Another example of a DAO is MakerDAO, the DAO responsible for maintaining the Maker protocol and its lending of Dai. MKR token holders participate in the MakerDAO, whose main job is to make sure that Dai retains its value of $1. They vote on things like how much collateral has to be held in each Maker CDP (collateralization ratio).
Their votes and the collateralization ratio are then written into the blockchain with the rule for the collateralization automatically being carried out. That is, if a CDP’s collateralization ratio dips below what MakerDAO decided on, the CDP is automatically liquidated and the ETH inside is sold off to cover the amount of Dai that was initially created when the CDP was opened.
Arwen is an example of a DeFi project that leverages decentralized technology to provide escrow services for its users.
With Arwen, traders can trade on centralized exchanges without actually depositing funds on the exchange itself. This is important since centralized exchanges carry risks of getting hacked and losing their users’ money.
Arwen enables this with blockchain-based escrow that hold onto your coins while your trades are done via off-blockchain atomic swaps, which use smart contracts to perform decentralized exchanges of cryptocurrency.
However, unlike traditional escrow accounts, such as that of a broker, Arwen doesn’t actually hold onto any user funds itself. The blockchain itself acts as an “escrow”, which eliminates counterparty risk.
DeFi Downsides and Risks
Though DeFi does provide a number of advantages over traditional finance products and services, as with anything, there are downsides and risks to consider.
Smart contracts getting hacked
Although you don’t have to trust a human when it comes to DeFi-based smart contracts, you still have to trust the smart contract code which was written by a human (at least for now!)
Smart contracts are normally open-source, allowing others to review them. Indeed, in the case of Maker, their smart contracts have been reviewed by security research firms multiple times. While that does give users of the Maker protocol more peace of mind, there’s still a small risk that security researchers may have missed something that could result in something catastrophic happening.
Such was the case with the aforementioned The DAO. At the time, The DAO was the biggest crowdfunding campaign ever, raising $120 million in cryptocurrency.
However, hackers were soon able to exploit a vulnerability in The DAO, which allowed them to steal about a third of The DAO’s funds, worth about $70 million at the time.
With DeFi growing in popularity, hacking attempts could be something to worry about. Maker alone has 1.8 million ETH, or 1.66% of all ETH, locked in its smart contract, which makes it nothing short of a humongous honeypot for malicious actors.
Data feed centralization
Blockchains don’t have any way to access off-chain data, which severely limits their utility. To counter this, blockchains use oracles, which provide access to data like price feeds, in a blockchain-compatible format. This allows smart contracts to take in information from the outside world and trigger changes and events based on that information.
For example, insurance smart contracts could immediately make payments for flight delays once the smart contract receives information about the delay from an oracle.
However, a problem arises if an oracle provides the wrong information, whether intentionally (malicious tampering) or unintentionally (technical error). And the more centralized the oracle(s), the bigger this problem becomes.
Synthetix, a DeFi synthetic asset issuance platform, experienced this firsthand, when a Synthetix oracle submitted false data. A trading bot quickly picked up on this, and the owner of the bot benefitted from trades with profits of $1 billion in less than 1 hour.
Luckily, however, the company behind Synthetix and the bot owner were able to come to a compromise, as the bot owner wasn’t able to cash out anyway because there wasn’t enough collateral in the system to cover his profits.
The company ended up paying the bot owner a “bug bounty” for (unintentionally) alerting the company of this bug, and the bot owner returned his fraudulently earned synthetic assets.
Nevertheless, there was a huge lesson there and other DeFi projects have taken note of the risk inherent in oracle or data feed centralization. Projects like Maker and Compound are actively trying to build their own oracle. Moreover, decentralized oracle projects like Chainlink are working on solutions to avoid this problem as well.
Capital inefficiency of DeFi loans
DeFi loans are great for reasons that we’ve discussed like being permissionless (anyone can take out a DeFi loan as long as they have crypto assets to put up as collateral).
Yet, they’re capital inefficient compared to traditional finance loans since the loan amount you get relative to your collateral isn’t as favorable as the amount you’d get with a traditional loan.
A person is not truly free unless they have financial liberty. DeFi proposes solutions to give economic power back to the people by creating a financial system that is accessible, efficient, and transparent. It is an exciting development for the blockchain space that brings real, useful financial services like borrowing, lending, asset issuance, prediction markets, and more to anyone, anywhere.
DeFi could be the birth of a global financial revolution.
This content is for informational purposes only and is not investment advice. You should consult a qualified licensed advisor before engaging in any transaction.