Decentralized Finance, often referred to as DeFi if you’re really short on letters, is a form of finance that doesn’t rely on a central regulatory system such as banks. It has become increasingly famous throughout the 21st century, but a lot of people don’t seem to understand what exactly DeFi is.
The most famous example of DeFi so far has been the Bitcoin. A cryptocurrency which came into existence in 2009 (version 0.1) and has since skyrocketed in value, giving rise to multiple crypto-millionaires. But Bitcoin is neither the only cryptocurrency, nor the only form of DeFi out there. It’s time we dive into this new movement and find out whether this is what the future holds for us.
What is Decentralized Finance?
Ok let’s dive into it: what is DeFi? DeFi is a peer-to-peer electronic financial instrument system and refers to projects that are using cryptographic tokens and blockchains* enabling anyone to issue, transfer and own financial instruments. When reading articles talking about DeFi, any time a reference is made to financial instruments, digital assets, assets, or financial assets (or any other combination of these words), what is referred to is the token reflecting a value. In simpler language: money.
DeFi then becomes a bit easier to understand, as it is essentially just conventional financial tools built on a blockchain. The most well-known public blockchain being Ethereum. But then most people get stuck again because most people don’t know what a blockchain is.
Blockchain is a system in which a record of transactions, made in bitcoin or another cryptocurrency, is maintained across several computers that are linked in a peer-to-peer network. When we say the words “block” and “chain” in this context, we are actually talking about digital information (the “block”) stored in a public database (the “chain”). The blocks on the blockchain are made up of digital pieces of information. Specifically, they have three parts: information about transactions like the date, time, amount and vendor, information about the purchaser (your digital signature or username) and a unique identifier code for this information dubbed “hash”.
For a block to then move to the chain, the transaction must have occurred and its information needs to be verified. Who is verifying this? Rather than an overworked person, a network of computers is doing this. These networks often consist of thousands (or in the case of Bitcoin, about 5 million) computers across the globe. That network of computers rushes to check that your transaction happened in the way you said it did. They confirm the details of the purchase, including the transaction’s time, amount, and participants. From there, your info is good to go and becomes part of a larger block with other verified transactions. Lastly, this bigger block gets a “hash” of its own, and the information becomes publicly available on the chain. Tadaa!
So effectively, it’s like adding charms to a Pandora bracelet. You don’t need to have a degree to understand the logic of that, thankfully. If you need more info on blockchain, Investopedia has an entire article dedicated to it, which I recommend you read here.
We have now figured out the technology driving DeFi, but that isn’t enough. Next, we are going to look into the goals of DeFi and how you can use this yourself. It’s mainly within the latter section that we are going to dive into cryptocurrencies specifically.
What does Decentralized Finance Want?
DeFi got created with the idea of rejecting the current financial system. Especially Blockchain was created with this idea in mind, as early as 1991.
When comparing blockchain (and its cryptocurrencies) to standard currencies, the difference becomes rather clear. Currencies like the U.S. dollar are regulated and verified by a central authority, usually a bank or government. Under this type of system, a user’s data and currency are technically at the whim of their bank or government. If a bank collapses or the country is suffering an unstable government, the value of that currency may be at risk. These are the worries that led to the creation of Bitcoin.
By spreading its operations across a network of computers, blockchain allows Bitcoin and other cryptocurrencies to operate without the need for such central authority. This not only reduces risk but also eliminates many of the processing and transaction fees. It also gives those in countries with unstable currencies a more stable currency with more applications and a wider network of individuals and institutions they can do business with, both domestically and internationally.
All of this sounds great, but so far this is a plan in motion. Although global accessibility and usage is a great goal, that is all that it remains to be so far. Massive online retailers such as Amazon, eBay and any form of online grocery retailing have yet to accept this type of currency. Although a rather large change might be seen with the introduction of Facebook’s Libra. I wrote an article about Libra before, please do read it here.
What can you do with Decentralized Finance?
Now the reason we call this system decentralized seems clear, it doesn’t rely on a central authority. Cool, cool. But what does that mean for you as a consumer? Well, the main way for you to come into touch with DeFi is through cryptocurrencies, the most famous one being Bitcoin, but there are many others available. Using crypto leads to big differences in terms of issuance, trading and ownership when comparing it to “normal” money:
In “normal” financial systems, banks or governments issue currency and can use this as a means of changing the value of the currency. Often, this is used to change the exchange rate, improving export (products become cheaper to other countries) and promoting national production (imported products become more expensive). Decentralized Finance doesn’t have a single issuer of the currency, so this process is a bit different.
Crypto is mined publicly. Meaning it can be created by anyone. However, this doesn’t mean there aren’t certain standards to uphold. There are several security token issuance platforms, famous examples being Polymath and Harbor, which provide the framework, tools, and resources for issuers to launch tokenized securities (crypto) on a blockchain. They prepare their own standardized token contracts for securities that enable automated compliance and customizable trade parameters to meet regulatory requirements. Similarly, they are integrated with service providers such as broker-dealers, custodians, legal entities, and more to assist issuers in their process.
Now if you’re thinking: “cool, let’s get to mining some crypto!” Have I got some bad news for you. It requires quite a lot of computing power. To paint a picture: you wouldn’t need to switch on the heating in your house anymore, and your electricity bill would go through the roof for just mining 0.01% of a cryptocurrency. So there is that issue.
Trading and Value
Now, let’s say you’ve got some cryptocurrency (mined or bought), what now? You can exchange it (trade) and use it to buy things. Let’s drive into that.
When trading crypto, you’ll run into some issues. Markets aren’t exactly as open as the “normal” assets markets, like the Dow Jones. Exchange in DeFi, or open finance even if you will use decentralized exchange (DEX) protocols, and peer-to-peer (P2P) marketplaces. A DEX is a peer-to-peer exchange of assets, with no third-party mediating the exchange. But, these places are rather obscure, and their user interface isn’t for the fainthearted (not user-friendly at all), so trading volumes so far haven’t been very large and this is very much still in development.
Now something that has become much more popular recently is referred to as a stablecoin. Stablecoins are proposing new models for issuing tokens, auditing their reserves, and managing their price pegs. It is the latter which is very interesting for value determination. Stablecoins are just blockchain-issued tokens designed to maintain a stable peg with an outside asset — mostly the American Dollar, but it can also be pegged to gold or another asset. What an asset is pegged to depends on the protocol issuing (and creating) the coin. Now, if you want DeFi, stablecoins might seem rather counterintuitive, as they don’t seem nearly as decentralized as was initially intended. But, not all stablecoins are the same, there are actually three different categories:
- Crypto-collateralized: With this type of stablecoin the underlying asset is over-collateralized against the loaned asset based on the current collateralization ratio. So, if the ratio is 150 percent, then depositing $150 worth of underlying asset would return 100 of the loaned asset. This works effectively like an exchange rate, as determined by the protocol. One example of such a protocal is Maker Dai.
- Fiat-collateralized: These stablecoins are the most popular. These coins rely on their users trusting them by providing transparent audits that their USD reserves can back the current circulating supply of the token to maintain the price peg. They remove the advantages of a public blockchain-based cryptocurrency and add a layer of risk as companies behind these stablecoins earn revenue from the interest earned on the deposited funds (in USD) from users that they store in a bank account. As said before, their value is pegged, often at a 1:1 ratio to the USD, they are the least decentralized type of crypto.
- Non-collateralized: these stablecoins rely on changes in the supply based on an algorithm to maintain a stable peg. These are the most decentralized type of stablecoins, and closest to the initial ideal of DeFi.
Keeping these differences in mind, it is difficult to say what the value of a cryptocurrency is, as it depends on its collateral. Some depend on other assets (other cryptos, or USD, gold, etc.), others are purely supply based. This, of course, makes trading a bit more difficult, and we haven’t even gotten into exchanging crypto for actual goods or services. Something we will do in the second part of this article.
Ownership and Open Lending
Open lending protocols have probably achieved more recent attention than any other categories of DeFi. Largely due to the meteoric rise in the use of Dai and other P2P protocols like Dharma and liquidity pool designs such as Compound Finance, decentralized lending is making significant noise.
There is a reason this form of lending has become so popular: it offers numerous advantages when comparing it to traditional credit structures:
- Integration with digital asset lending/borrowing
- Collateralization of digital assets
- Instant transaction settlement and novel secured lending methods
- No credit checks, meaning broader access to people that cannot tap into traditional services
- Standardization and interoperability — can also reduce costs with automation
So it’s effectively quicker, cheaper and doesn’t exclude you from accessing it depending on your credit score. And for a lot of people, the latter is quite a relief.
Open protocol lending is entirely restricted to public blockchains, like Ethereum, and has some intriguing long-term implications for expanding financial inclusion across the globe. MakerDAO is the most prominent decentralized lending protocol, becoming so popular it had issues maintaining parity with its Dai: USD price peg. So, that’s interesting…
There are other lending services that leverage digital assets, such as BlockFi, where standard credit models like credit checks and a company processing loan requests behind the scenes are being used. So, it seems like there is always a middleway, even with DeFi.
Many DeFi applications have noticed that going the full 100 is a bit much for many, and offer hybrid digital asset/traditional financial services. BlockFi is an example of this. An alternative term that is more encompassing of the ongoing focus on financial products is open finance (rather than decentralized finance) where an ecosystem of integrated digital assets, blockchains, and open protocols are ingratiating themselves with conventional financial structures. This seems to be the next big move, as it’s become high time banks grow a pair and move into the future, or the future will come to get them.
This is it for me. This article, at least part 1, has given a more general explanation of what decentralized finance is, how it works, what it wants and how you can implement it yourself.
Normally I’m quite confident about the articles and recommendations I write and publish, but on this one I’m putting a disclaimer: I’m not an expert in this, not by a long shot. Please make sure to check out some resources yourself before diving into the world of DeFi, Blockchain and crypto, I have selected some here, from sources that I have used for this article such as Blockonomi, Investopedia, and Outlier Ventures. But please also look for resources that go beyond.
Within the second part of this article, we are going to look into what the implications are of DeFi on the current financial system, what we have seen DeFi achieve so far (and discuss its not so great reputation), and of course dive into what Behavioural Science has to say about DeFi. So stay tuned!