As we enter 2021, the term DeFi will continue to populate our news feeds. DeFi is short for Decentralized Finance, the concept based on the decentralized revolution accelerated by bitcoin. Simply put, DeFi is the result of combining traditional financial services and blockchain. Specifically, DeFi is mostly built on the Ethereum blockchain, allowing the execution of financial transactions upon contract conditions being met, or smart contracts. Following the groundbreaking whitepaper on bitcoin by Satoshi Nakamoto in 2008, people have imagined a world of open finance, free of middlemen, institutions, and intermediaries.
To understand the potential impact of DeFi, we have to remember how traditional financial services provided goods and services to customers. From loans, payments, insurance, to trading, there is a company or institution in between those who are receiving and providing the goods and services. With DeFi, it is possible to execute those very services on the Ethereum blockchain, peer-to-peer without a bank or central authority. Imagine an open financial world, where you can access financial services with just a smartphone and an internet connection. By combining technology such as the blockchain, cryptography, and internet, DeFi has the ability to fundamentally evolve the financial services industry but more importantly, transform the global economy. DeFi is one of the most important sectors within the growing crypto space.
At the moment, the main programs in which we are seeing DeFi are decentralized applications, or dapps. Dapps are designed to function as decentralized networks, run without intermediaries, be it central banks, corporations, or companies. The idea of obtaining a loan or mortgage without a bank or lender may sound futuristic or simply farfetched. But many dapps are live and running today. Before taking a look at some of the use cases of DeFi dapps, let’s understand four fundamental differences between traditional financial services and DeFi dapps.
- Permissionless: The open-source code allows for anyone to examine the details and build on top of the code. Anyone can audit and validate the code. This is opposed to closed-source, where transparency does not necessarily exist. In open-source, there is no company or gatekeeper holding the keys for access. There are no approvals or hierarchical layers. Permissionless truly allows for anyone to participate.
- Decentralized: Similar to permissionless, there is no central organization, or groups of organizations that control the ongoing governance and operations of dapps. In a bank today, the rules are determined by the company (and the regulators). The bank holds the decision to upgrade software, and all the decisions are made by management, committees, and boards within the organization. In DeFi dapps, once the rules are written on the code, contracts and transactions are then run with no (or very little) human intervention.
- Interoperable: A major blockade in today’s financial world are the headaches when two systems cannot communicate with each other. Interoperability is the ability of computer systems or software to exchange and make use of information. With DeFi, dapps are built so that they can talk to each other, cross-chain communications. In its infancy, many blockchains were developed but could not communicate with each other, reducing the value of a blockchain, namely value transfer. DeFi dapps are interoperable.
- Globality: To access today’s financial services, you may need a NAB account in Australia, Bank of America account in the US, and HSBC account in Hong Kong to transfer funds to your family living around the world. With DeFi, whether you are in Athens, Georgia or Athens, Greece, you have access to the same services given the internet and a smartphone.
With bitcoin continuing it’s impressive gains in the first month of 2021, so too does ether, the second-largest cryptocurrency by market cap. According to Coindesk, the total value locked in DeFi crossed the $22 billion mark for the first time. This represents the US dollar value equivalent of cryptocurrency liquidity locked up in DeFi projects. This metric is commonly used in the industry to track the growth of the DeFi space. Now that we understand the four fundamental characteristics of DeFi, here are some of the current use cases.
- Lending: This sector of banking is traditionally slow and arduous. Everyone has had negative experiences applying for a loan. Compound tackles this through its lending protocol. Users can lend their crypto out to other users and earn interest in the form of crypto. Now, this may sound similar to existing banking services (substitute fiat currency for cryptocurrency), but the platform utilizes blockchain smart contracts to match borrowers and lenders and automatically adjusts interest rate based on the market, or supply and demand.
- Stablecoins: With the recent OCC interpretive letters and guidance (#1170, #1172, #1174) on national banks’ ability to custody and interact with stablecoins, this sector is growing in its importance and stature. As stablecoins are designed to hold specific value and pegged to fiat currencies. Stablecoins can be fiat-collateralized, crypto-collateralized, or non-collateralized. Although cryptocurrencies are still notoriously volatile, stablecoins offer price stability. Maker’s DAI is the prime example of a stablecoin.
- Exchanges: Automated market making systems are the new trading books. Decentralized exchanges (DEXs) are unlike centralized exchanges (think Coinbase). DEXs conduct peer-to-peer transactions of digital assets on smart contracts on the blockchain without intermediaries.
According to the latest report from the World Bank, there are about 1.7 billion unbanked adults globally. These adults remain without an account at a financial institution or through a mobile money provider. Living in the US, it may be hard to imagine over a billion adults in the world without banking services. Americans can walk into a branch of Chase or Bank of America and open a checkings account, or take out a mortgage. Or simply take out their smartphones from their pockets and trade stocks in a brokerage account. Many of these unbanked adults live in developing economies such as Indonesia and India. DeFi has the potential to bring banking access to this population, a critical component of economic development.
Cryptocurrency and digital assets are transforming financial services as we speak. Although DeFi may not necessarily be in the mainstream yet, with traditional finance still dwarfing DeFi, this space is poised for a breakthrough. It will take some time for DeFi to catch up and then surpass traditional finance. New innovations come with new risks. It will be incumbent for the regulators and the innovators to work together to minimize risks, in order to reap the rewards. Hop onboard this incredibly exciting journey on decentralization, watching how code can innovate and build a financial system for everyone. This is a paradigm shift.
