DeFi: what it is and why it matters
There has been a lot of noise, scepticism, confusion and hype around decentralised finance, known as DeFi, an ecosystem of blockchain-enabled products and services that replace traditional financial intermediaries with freely available, autonomous and transparent software.
Although it’s still early days for Defi (only a couple of years old), the associated economy is already large and reaching astronomical proportions. The underlying infrastructure for Defi was about $1.5 trillion in transaction volume last quarter. This can be equated to 50% of Visa’s payment volume.
Decentralised financial markets lend billions of dollars each month, and individuals and businesses use platforms such as Uniswap to trade at about 30% the size of Coinbase.
As there is a lot of interest in this trend from entrepreneurs, corporate leaders, politicians and organisations large and small, we aim to explain the features and benefits of DeFi.
Let’s first consider what has made it all possible?
What are DeFi and where did they come from?
DeFi is based on three major waves of blockchain innovation over the past decade, each of which began with deep scepticism, but over time DeFi has been accepted as an inevitable phenomenon.
The first era was defined by Bitcoin (invented in 2009), which gave us a distributed ledger or blockchain designed to facilitate the peer-to-peer transfer of non-sovereign digital assets.
The second wave was defined by Ethereum, which was based on the same basic, distributed and censor-resistant architecture: however, unlike Bitcoin, Ethereum’s own programming language (Solidity) can be used to create any imaginable application, turning it into a globally accessible supercomputer.
The third wave was the initial coin offering boom (ICO) in 2017, when a number of projects were funded, some of which began to deliver on their promise of a decentralised financial ecosystem.
DeFi is the fourth wave based on a combination of these innovations.
With DeFi, anyone in the world can borrow, lend, send or trade blockchain-based assets using easily downloadable wallets, without the need for a bank or broker. If they wish, users can explore even more advanced financial activities — leveraged trading, structured products, synthetic assets, insurance underwriting, market making — while always retaining full control of their assets.
DeFi’s protocols meet key criteria (notably prohibition of access and transparency) reflecting the values of Ethereum, the decentralised open-source software platform that forms the infrastructure for most decentralised applications.
“Permission-free” are the addresses to both end users and developers: DeFi applications can serve anyone in the world who has an Internet connection, regardless of ethnicity, gender, age, wealth or political affiliation. In addition, any set of developers can use these platforms with confidence, knowing that no central authority has the ability to revoke access in the future.
“Transparency” refers to the inherently controlled nature of DeFi platforms: since the software is always source code or open source, the whole of the underlying code is constantly available for inspection and all associated capital is open for audit. All transactions are recorded on the blockchain, making it easy to review specific transactions or build a business by examining the data for investment (or even research) purposes.
What are the features and benefits of DeFi?
DeFi’s two fundamental qualities — no permissions and transparency — translate into several powerful use cases.
“Reduce barriers to entry, reduce switching costs, provide optionality”
The unlimited nature of Ethereum-based applications — with the ability to freely and seamlessly “fork out” (or copy and adapt) codebases — reduces barriers to entry for entrepreneurs to zero.
End-users are the primary beneficiaries of this innovative environment: because all applications use the same database (Ethereum blockchain), the movement of capital between platforms is trivial. This forces projects to compete ruthlessly for royalties and user experience.
A relevant example here is the rise of ‘exchange aggregator’ applications: using publicly available API interfaces, these aggregators connect to multiple liquidity platforms, distributing orders between platforms to provide end users with the best possible exchange rate.
In just a few months, such aggregators have accelerated DeFi’s progress towards best execution — a standard that required formal regulation to bring early electronic markets closer together.
Compare DeFi’s competitive markets to consumer banking as it exists today, where opening and closing accounts can take three days. Or compare DeFi to the brokerage business, where transferring securities between different platforms takes up to six working days and requires many phone calls. Combined with other onerous conditions, these are ‘switching costs’ that prevent consumers from running their business elsewhere, even with the acceptance of the ‘pain’ of poor service. Indeed, to the detriment of retail consumers, traditional finance is moving in a diametrically opposed direction, with bank rates falling by 3.6% a year since 1990, limiting consumer choice.
Transparent accounting, careful risk assessment
The auditable nature of DeFi’s capital reserves allows for careful risk assessment and management. For decentralised money markets and credit facilities — repo (Repurchase Agreement) platforms that allow users to enter into peer-to-peer variable-date secured lending arrangements — users can verify both the quality of the portfolio and the degree of leverage in the system at any given time.
Compare this with the opaque nature of the current financial system. Only after the global financial crisis of 2007–2008 did analysts and regulators begin to realise that the loan-to-deposit ratio in the US had reached 3.5… twice as high as in the second largest highly leveraged banking system, Russia.
Aligns incentives, solves the principal-agent problem
The use of trusted programmable escrow accounts (commonly known as “smart contracts”) allows DeFi protocols to leverage the means of legal protections at the protocol level.
For example, in the MakerDAO (decentralised credit organisation) system, the holders of MKR tokens receive the interest paid by the borrowers. However, in the event of insolvency or default, they serve as the main support: MKRs are automatically issued and sold on the market to cover losses. This software creates very strict accountability, forcing MKR holders to set reasonable parameters for collateral security and liquidation risk. The alternative — free risk management techniques — exposes MKR holders to the risk of dilution.
Compare this to traditional finance, where shareholders lose out directly when management makes mistakes. The collapse of Archegos provides an example: although several senior Credit Suisse executives left the bank, they were not personally held accountable for the losses. However, with DeFi, direct accountability will lead to better risk management.
Modern infrastructure, enhanced market efficiency, reliability
Ideally, capital should be as transparent as information in the internet age. In particular, settlement should be instantaneous, transaction costs should be minimal and services should be available 24/7/365: 24 hours a day, 7 days a week, 365 days a year. It is simply not productive for our global financial system to operate only from 9am to 5pm, excluding weekends and public holidays.
There is clearly a latent demand for a modernised settlement infrastructure, as evidenced by Ethereum’s transaction volume of $1.5 trillion last quarter, up from $31 billion in Q1 2019. We’ve also recently seen the types of market disruption that can arise from the lack of instant settlement: Robinhood was forced to briefly suspend purchase orders for GameStop due to difficulties meeting capital requirements, itself a by-product of T+2 settlement (an industry standard in which transactions typically take two days).
Efficient markets also require a robust infrastructure. The distributed nature of blockchains gives them incredible resilience: in the six years since Ethereum was launched, the network (and, by extension, the applications built on it) boasts 100% uptime. The same cannot be said for centralised counterparts. Even when they are centralised, established and/or regulated, these centralised organisations — be they exchanges or payment networks — can exhibit unreliability, especially during periods of high volatility.
The consequences for consumers are very real. Take the example of users of brokerage services who later logged in and found their balances quickly dwindling.
Global access, single markets
By their very nature, international markets have access to a larger pool of liquidity, which significantly reduces transaction costs for all market participants.
Today, decentralised exchanges can offer better exchange rates for certain assets than isolated centralised exchanges or service providers. On stock markets instruments such as American Depositary Receipts (ADRs) serve to provide access to foreign exchanges, but often suffer from low liquidity.
When markets become globally accessible, it can also lead to an increase in financial rights. At present, developing countries are often excluded from access to financial services because of the high cost of organising local transactions compared to demand, lack of infrastructure and much more. But decentralised financial services — proprietary online services with zero marginal cost to users — can serve marginalised demographics by providing access to services such as insurance, international payments, dollar savings accounts and credit.
A by-product of creating financial services based on a transparent shared database is that all related transaction data is made publicly available in real time. For example, revenues received by liquidity providers in the Uniswap protocol can be tracked in monthly detail. Investors can use this data to decide how to allocate capital, enabling better pricing and resource allocation, while regulators can monitor transaction data in real time to identify unfair user activity.
This is a significant departure from traditional capital markets, where investors remain in the dark until firms release their quarterly earnings reports. The state of the private markets is even more dire, with companies often inventing their own accounting metrics, if they choose to publish metrics at all. It is hard to imagine investors making rational decisions when they have to work with outdated data!
Regulators also struggle in the current system, waiting for years for irregularities to be discovered and by then it is often too late to correct them; Greensill Capital and Wirecard provide evidence of recent case studies.
Eliminating counterparty/credit risk, reducing compliance overheads
By definition, DeFi platforms are ‘self-sustaining’: users never outsource the storage of their assets to a centralised operator. While this may initially scare some people, the self-sufficient nature of DeFi serves to eliminate counterparty and credit risk — the risk associated with a party to a financial transaction defaulting on its obligations under a transaction or loan.
Analysts estimate that more than $7 billion worth of cryptocurrencies have been lost through centralised exchanges since 2011, whether through hacks or operators purposely absconding with user funds. DeFi is a paradigm shift from ‘don’t be dishonest’ to ‘you can’t be dishonest’.
Self-storage is equally beneficial to operators who can relinquish unnecessary liability and compliance overhead: FinCEN’s cryptocurrency guidelines, for example, require companies that store user funds to purchase transfer licenses, which is typically a complicated process, while those who interact with self-storage wallets can operate without one.