While crypto may still be seen by some as “underground”, a place for enthusiasts and tech nerds, 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 the world of DeFi!
DeFi stands for decentralised finance. It offers a decentralised financial system that eliminates the need for traditional middlemen: banks, payment providers, exchanges, insurance etc
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 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 cosy 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 drag 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 and their way of doing things.
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 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 during the early internet boom.
So, what does DeFi potentially have 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 completely!
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.
Decentralised 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 essence 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 Decentralised Finance started in 2015 with Maker.
Maker had a vision to create a decentralised financial system that would be governed by its user community and, in doing so, give borrowers more control of their assets.
Maker allows users to borrow Dai, the platform’s native token which is pegged to the US dollar.
This is one via a set of smart contracts on the Ethereum blockchain, which govern the loan, repayment, and liquidation processes
So Maker 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 another token without the need for a central exchange and in 2020 AAVE made lending and borrowing decentralised.
From then on things went crazy and today you can earn, hold, pay, save, borrow, lend, invest, convert, trade, insure, and donate with Decentralised Protocols.
Whereas in open finance fintech apps are interfacing with established financial institutions to provide consumers with a 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 $225 billion as of 2nd August 2023.
To put this into perspective, Barclays Bank had a market cap of $31 billion on the same day.
So the market cap of Ethereum was nearly 7x that of Barclays Bank!
Considering that Ethereum came into being in 2015 and Barclays Bank was founded way back in 1896, Ethereum is certainly no financial lightweight when compared to the big boys in TradFi.
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, 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 could take months 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 does not 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 clearly about time!
The DeFi ecosystem now
Some examples of DeFi apps include:
- Decentralised 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.
- Decentralised 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 decentralised peer-to-peer (P2P) lending platform where users can earn interest or borrow assets against collateral. AAVE too.
- Insurance – Nexus Mutual is a decentralised autonomous organisation 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 Decentralised 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 a “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, and then sell it at its real value.
Example: bZx, Cheese Bank, Harvest
- Contract Design: if you let them print tokens, they will.
- Reentrancy Attack – 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.
Example: Akropolis, dForce, and Origin
- Front-end issues: bugs in hosting or domain leads to attacks – not specifically DeFi, but still a problem faced by NiceHash. 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-collateralisation to reduce credit risk, over-collateralisation 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.
- 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.
- 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 a bigger problem.
- Ethereum transaction fees and congestion leads to the inability to move in/out.
- 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, metamask hacks, paper wallets lost in the wash or giving your money to a fraudulent project could all see you lose your money.
As wikipedia says, “Inexperienced investors are at particular risk of losing money using DeFi platforms due to the sophistication required to interact with such platforms and the lack of an intermediary with a customer-support department.”
Throughout human existence there have been events that have significantly shaped our societies, discovering fire, the wheel, horses for farming & transportation, the industrial revolution, the internet and most recently web3/crypto and DeFi.
While DeFi may still be the new kid on the block, this kid isn’t messing around!
Whichever way we look at it, a shift in the status quo in finance and financial equality is urgently needed at a global level and now seems like the perfect time to throw that proverbial hand grenade!