TLDR: Decentralised Finance offers both an exciting innovation in financial markets, as well as an opportunity to completely re-build a financial system from the ground up. Eradicating the need for ‘centralised’ institutions in finance (banks, governments etc) enables people to become their own bank – a level of self-sovereignty we have never seen before. But to achieve this vision is fraught with risks, and governments will not just accept a decentralised financial system without a fight.
What is DeFi?
Decentralised Finance (DeFi) is the digital infrastructure that allows you to do everything you can do in the traditional financial system, but with your digital assets. If I own a share in a company in the 'real world', I can do all sorts of exciting things with it: borrow, lend, trade, short, put etc. DeFi now allows me to utilise all of these functions for my digital assets, say to lend out my bitcoin and receive interest on it.
There’s one big difference though. To carry out these functions in the traditional financial system, I need someone or something to do it on my behalf, say a bank, a stockbroker or an exchange. With DeFi, I can carry out the task using a protocol (series of smart-contracts) on the blockchain, instead of having to go through a real world entity. It is ‘decentralised’ because there is no centralised entity acting on my behalf when I need to carry out a financial task.
So DeFi = infrastructure for digital assets that you can use yourself, without the need for other humans or companies to carry out financial functions on your behalf.
With DeFi, we replace intermediaries (banks, Visa, governments etc) with smart contracts (code).
Current DeFi Use Cases – Lending
Alice has some spare cash and wants to earn interest. Bob wants to borrow some money to invest in his business. For Alice to lend directly to Bob, she has to trust that he will be able to pay it back, has legitimate collateral against the loan, and will be able to service the interest. That is too much due diligence to expect Alice to do, so instead she lends to her bank, who in turn lends to Bob. The bank then runs this lending/borrowing transaction on their behalf. So kind of her bank 😊
But oh, Alice realises that she is only receiving 8% interest, yet Bob is paying 12% interest. A 4% cut is being taken by the bank for being the trusted intermediary enabling this transaction.
Now Alice discovers the shiny new world of Decentralised Finance. Here, Alice can lend directly to Bob, via a trusted network of smart-contracts. On the other side of the transaction, Bob borrows money, depositing his digital assets as collateral (they are locked in a vault on the protocol). The 'rules' of their transaction (interest rate, collateral level, loan length etc) are written in code on the blockchain – everyone can see these rules and they can’t be disputed. As long as both sides accept the parameters, the smart contracts are executed and the transaction occurs seamlessly.
Pretty cool huh? Smart-contracts have taken the place of a bank, acting as the trusted intermediary between the two parties. The smart-contracts are just code – unlike a bank they take no spread and cannot change the rules whenever they feel like it. This means Alice can receive 10% interest instead of 8%, and Bob can pay just 10% interest instead of 12%. Everyone is happy.
Current DeFi Use Cases – Trading
Trading on DeFi is done via a Decentralised Exchange (DEX), with no central order book or balance sheet in the middle of each transaction. The exchange connects a buy or sell order with a liquidity pool which fills the trade. Trading via a decentralised exchange is generally quicker and more capital efficient (less slippage).
The Bigger Vision – Becoming Your Own Bank
Let’s be honest, the vast majority of people using DeFi today are just chasing higher financial returns. For most users decentralisation is cool and all, but not as cool as being able to generate 1000% APY (yes there are meant to be that many 0s, but lol yes obviously this is risky af).
DeFi in its current form is only about two years old. It’s no surprise then that most use cases so far just leverage smart-contract technology to create more capital efficient market places. Higher financial returns for users is the obvious place for innovation to start.
But if we zoom out, we can see a much wider potential for a decentralised financial system. DeFi offers an opportunity for financial self-sovereignty in a way that has not been possible before.
One use case I'm super interested in is the ability for everyone to become their own bank.
Crypto adoption is now growing rapidly in more volatile economies. A combination of mass inflation and war in Ukraine has led to an influx of crypto and DeFi adoption in countries most affected. People are increasingly seeing digital assets (mostly bitcoin and stable-coins) as a means of protecting their own savings in a way that hasn’t been possible before. They value the liquidity, the transferability and the ‘store of value’ nature of cryptocurrencies, protecting their savings from the decline of their economies and corruption of their governments.
Source: Chainanalysis Global Crypto Adoption Index 2021
If crypto currencies have the potential to offer people financial freedom, then DeFi is the infrastructure that allows people to interact with these assets on their own terms, not the terms of their government.
Let’s look at what this means if you live in:
Turkey, where inflation is over 60%. You have worked hard to provide for your family, but now all your savings are plummeting in value. Literally wtf. Converting your lira into stable-coins (pegged to the US dollar) protects you from your country’s spiralling inflation rate. DeFi enables you to do this without needing permission from your bank (controlled by your government) and without paying any exchange rate transaction fees.
Venezuela, where assets are regularly seized by the government because, well, they feel like it. DeFi enables you to take back control of your own finances and perform all of the functions you need to live, save and grow your wealth, regardless of the incompetence and corruption of your government.
Ukraine, where you can now flee from war, cross the border and still have all of your assets accessible and intact. Although your country’s banking system is down, you still have full control over your assets.
Russia, where sanctions have cut you off from the world. You did not want this war or ask for this war, but you are being punished for your government’s actions. Frozen out of the global banking system, now you are able to receive money from your family abroad, to help you pay the ever-increasing household bills.
Re-Imagining The Financial System
OK so clearly DeFi has value for people living in struggling economies, but how big really is the global market for DeFi?
Well it’s actually kind of endless. The entire world GDP is ‘finance’ in some way.
The full potential of DeFi is to re-build the whole financial system from first principles. Most people would agree the current financial system is sub-optimal. As with any start-up looking to disrupt an industry, the aim is to take the current model apart, challenge all assumptions inherent in the model, then build the system back up based on the needs of the users (everyone in the world) rather than the status quo.
Re-imagining the financial system from first-principles is one of the broader visions for crypto that has support across the political spectrum. Both right-wing libertarians and left-wing democratic socialists agree that the current financial system has failed people. They agree that more financial power needs to be handed to individuals, and taken away from institutions.
Government Reaction
While becoming your own bank is great for Russian citizens, it's bad for Western governments who want their sanctions on Russia to inflict maximum pain. The banking system is a weapon for governments in all times, but more acutely in times of war. This sucks if you’re on the receiving end of sanctions, but it’s great if you’re able to use sanctions to make the world a safer place.
So the picture is complex. Decentralisation can be a net positive, or can be a net negative, depending on who you ask.
As DeFi adoption grows and more real world use cases emerge (beyond just financial speculation), we will undoubtedly see more governments trying to crack down on DeFi.
But is it too late? Is the genie already out of the bottle?
A Ukrainian refugee or a Russian citizen who has begun to use a decentralised financial system is not going to run back to their old bank in a hurry. That much I know.
If you're a newbie to crypto, the world of DeFi might sound complicated, but it's actually not. It's much simpler than the world of traditional finance, and very accessible. The best way to learn is to start playing around with a DeFi protocol yourself. Alas, you’ll learn a lot more by trying it than by reading my posts.
Reach out if you're looking to play around with DeFi for the first time and I'll point you in the direction of some good resources.