What is DeFi
DeFi is short for “decentralised finance”, an umbrella term for a variety of financial applications in cryptocurrency or blockchain geared towards disrupting and replacing financial intermediaries such as banks. Users instead have the ability to transfer, trade, invest and transact peer to peer using decentralised money that can be programmed for automated activities through ‘smart contract’ functionality. Since January 2020, DeFi has grown exponentially from a Total Value Locked of approximately $0.7 billion to nearly $60 billion at the time of writing
Infrastructure, components, and general concepts
Most DeFi applications or DApps are currently built on top of the Ethereum blockchain, the world’s second-largest cryptocurrency platform. Cardano and Polkadot are two other fast-developing currencies with smart contract capabilities mooted to play an increasingly important infrastructure role, particularly across unbanked markets due to high Ethereum gas fees (The cost of computing energy required to process and validate transactions on the network). Proponents of alternative smart contract technologies such as Cardano argue its adoption can reduce costs, increase speed and help scale since its programming language Plutus is more accessible for developers. Moreover, its code builder initiative named Marlow is set to enable users with no previous technical knowledge to build their own smart contacts.
A critical component of any financial system is of course money, and whilst Bitcoin is decentralised, it can be volatile and has very limited programmable functionality. Stable coins counter this problem and are tied to an asset outside of cryptocurrency. DAI for example is pegged to the USD and backed by crypto collateral that can be viewed publicly on the Ethereum blockchain. As DAI is over collateralised, even if the Ethereum price becomes extremely volatile the value of the locked Ethereum backing the DAI in circulation will most likely remain at 100 percent, and thus a good form of money for DeFi services.
DeFi services are also designed to work in conjunction, or snapped together with each other making it possible to mix and match services to create new opportunities, a term called “Money Lego’s”. DeFi more generally is projected to increase transparency, reduce fees, improve user experience and counter financial discrimination.
Decentralised money markets
DApps such as Aave allow individuals to take on a role once exclusively occupied by institutions such as banks through their borrowing and lending protocol. Lenders on Aave typically receive an APY of 10 percent+ with loans distributed through its in-house algorithms and obtained from a pool instead of being individually matched to a lender. The interest rate charged is dependent on the “utilisation rate” of the assets in a pool. If nearly all assets in a pool are used, the interest rate is high to entice liquidity providers to deposit more capital. If nearly no assets in a pool are used, the interest rate charged is low to entice borrowing.
Other DApps such as Compound offer similar services and also allow users to borrow against their own crypto deposits. The concept of “Money Legos” in operation can be seen when considering the work of Yearn Finance. It connects with Aave and Compound protocols and searches for the best yields, maximizing profit switching opportunities and automatically invests these for liquidity providers.
Synthetix is another disruptor in the money market space. It enables the trading of derivatives on assets such as stocks, currencies and commodities. Accessible globally, and therefore exposure to markets that could otherwise be restricted, the platform brings non-blockchain-based asset exposure to the crypto ecosystem. This means Synthetix users do not need to trust a particular institution or person to manage the crypto assets, but instead only trust that the code will execute as written.
All these cryptocurrencies are increasingly being bought off de-centralised exchanges, a prominent example is Uniswap, composed of smart contracts that hold liquidity reserves and function according to defined pricing mechanisms.
Potential to outperform traditional finance?
According to The World Bank, 1.7 billion adults do not have access to banking services. DeFi is well-positioned to reach this untapped market; It is permissionless and accessible from anywhere globally with a smartphone. DeFi provides a viable option for rural inhabitants who may also be excluded from traditional finance, or find it to be uneconomic. It can also offer speed and scale, exemplified by the growth in its Total Value Locked since January 2020.
Simply opening a new bank account in certain countries can take weeks, with other administrative processes such as passport applications taking even longer. Moreover, nearly 50 million Americans do not have credit scores despite potentially being creditworthy due to traditional lending criteria’s not considering nuances such as the gig economy. Coupled with this, according to the Institute of Finance, global household debt alone amounts to $48 trillion as of 2019. If DeFi covers just 0.1 percent of this debt, its Total Value Locked would skyrocket.
—Shiv Morjaria is a derivatives lawyer for an investment bank and tech entrepreneur. The views expressed are personal