One of the standout features of the cryptocurrency rally of the last 12 months has been DeFi applications and the cryptocurrencies that power them. But what exactly is DeFi?
DeFi, which is short for Decentralised Finance, is an ecosystem of blockchain projects with the potential to disrupt most of the financial services industry. To really understand the opportunity, it’s worth first considering the status quo in the financial services sector.
Centralised vs Decentralised Finance
Historically the financial services industry has been built around institutions that act as custodians of their client’s assets. The institution holds the assets on behalf of a client, and then makes a limited range of services available to the client.
To ensure stability within this system, financial service companies have to operate in a highly regulated environment. In addition, companies need to maintain substantial capital reserves.
The consequence – whether intended or not – of this centralised model is that barriers to entry in the financial industry are very high.
Complying with regulations is expensive, and so is maintaining capital reserves. This prevents new participants from entering the industry and results in an uncompetitive market.
A decentralised model of finance allows individuals to be custodians of their own assets, and then buy services from whomever they like. It also allows any company to provide financial services to any individual. In fact, individuals can buy, sell and trade assets and services with one another.
When finance is decentralised, the market becomes competitive. To be competitive, participants need to innovate and maximise the value they offer for the fees they charge. But participants don’t need vast amounts of capital to compete – just a better idea, product or service.
For the decentralised model to work, something needs to replace the role of regulators and institutions in ensuring that the system is trusted. This is where blockchain technology comes in.
How Blockchain Technology Enables DeFi
A blockchain is essentially a decentralised ledger that cannot be altered without consensus. Blockchain applications can be structured to facilitate the trading of assets and services in a safe and transparent way.
The second element of decentralised finance is the smart contract – a programmable contract that resides on a blockchain. While traditional contracts rely on the legal system for enforcement, smart contracts are self-executing.
DeFi projects (or platforms) use blockchains and smart contracts to enable financial services without the need for regulatory oversight or large amounts of capital. Any transaction, product or service that can be interpreted within a computer program can reside and operate on a blockchain.
DeFi Use Cases
DeFi platforms are typically built on existing blockchains like the Ethereum network or the Binance Smart Chain. However, each project has its own token, which is required to access its services.
Wallets and Exchanges
Wallets and exchanges form the foundation of the DeFi economy. A digital wallet is the DeFi equivalent of both a bank account and a trading or investment account. It gives the user full control of their digital assets. Decentralised exchanges facilitate the trading of cryptocurrencies or tokens, each of which has its own applications.
Decentralised exchanges (DEX) operate entirely on a blockchain without control from a single entity. Centralised exchanges like Coinbase are owned and controlled by companies. Centralised exchanges are still necessary when converting digital currencies to conventional currencies.
DeFi applications often require collateral to be placed in a smart contract – but most cryptocurrencies are too volatile to be used as collateral. Stablecoins are cryptocurrencies that are pegged to the value of less volatile assets.
Lending and Borrowing
Cryptocurrency users can borrow other cryptocurrencies or fiat currencies by using their crypto holdings as collateral. Typically, collateral is locked in smart contract until the loan is repaid. Lenders earn interest while their loan is secured with the borrower’s collateral.
Staking and Yield Farming
Blockchains are run by miners, or validators, who provide computing power to the network. Miners update a blockchain with new transactions and are rewarded with tokens for doing so.
DeFi applications typically run on ‘Proof of Stake’ networks which means miners must hold tokens to prove their commitment to the network. Their rewards are proportional to their stake, so they have an incentive to hold as many tokens as they can.
Yield farming is the process of lending cryptocurrency to miners to help them increase their stake. The miner then earns larger rewards which are shared with the lender.
Prediction markets offer a very efficient way to ‘bet’ on any event – be it the weather, an election, a sports event or the price of a share. But prediction markets don’t just facilitate gambling. – they can be used for insurance and hedging, and to trade traditional assets on a blockchain.
One of the biggest challenges in the crypto economy is ensuring that decentralised ledgers are updated with real-world information.
Oracles are individuals or entities who update blockchains with data from the ‘real world.’ Oracle’s stake tokens that they stand to lose if they try to manipulate the data. These oracles are essential to prediction markets and act as a bridge between the digital world and the real world.
Derivatives and Hybrid Defi Projects
The real innovation in the DeFi economy begins when different types of applications are combined. In practice, most DeFi projects include elements of several of the categories listed above.
With smart contracts, prediction markets and oracles, the types of products that can be created is only limited by imagination. Derivatives and synthetic instruments can be created to provide solutions to real-world problems in almost any industry. They can be used to manage risk, provide funding, speculate or create bridges between different platforms.
Prominent DeFi Examples
MetaMask is a popular wallet for Ethereum tokens that takes the form of a browser extension. This is convenient as most DeFi applications are accessed via a browser.
Dai (DAI) is a stablecoin managed by the MakerDAO network. Dai is collateralised with cryptocurrencies and stabilised algorithmically using smart contracts. It is regarded as the first DeFi application.
Uniswap (UNI) is a protocol used to exchange cryptocurrencies. The protocol can be incorporated in other DeFi projects to provide liquidity. The UNI coin is now the 11th most valuable cryptocurrency and the most valuable in the DeFi ecosystem.
IDEX, Bancor and Binance DEX are some of the other leading decentralised exchanges.
Compound (COMP) is a cryptocurrency and protocol that allows holders to lend and borrow Ethereum tokens. PancakeSwap (CAKE), Aave (AAVE) and yEarn (YFI) are some of the other prominent projects that enable ‘yield farming’.
Chainlink (LINK) uses oracles and smart contracts to connect blockchain applications to real-world data. The platform is powered by LINK tokens which are currently the 15th most valuable cryptocurrency, and the second most valuable in the DeFi space.
Augur is a platform that allows anyone to build a prediction market. Outcomes are reported to the system by oracles who stake and then earn Reputation tokens (REPv2).
Synthetix (SNX) is an application used to create synthetic derivatives. It can be used to trade real-world assets on the blockchain. Synthetix uses the Chainlink system of oracles to update the blockchain with real-world data.
DeFi and Emerging Markets
In developed countries, DeFi is setting out to disrupt mature and established financial sectors. But what about countries with less developed financial services sectors?
Many people living in emerging economies have never had access to a full range of conventional financial services. In many instances, people have gained access to mobile payment apps before a traditional bank account.
DeFi applications don’t require the large amounts of capital required by conventional institutions, and in many cases, they are crowdfunded. They are also global and operate across borders without needing permission from regulators.
DeFi is still largely experimental. But if the DeFi economy gains traction it’s entirely possible that it will reach communities in emerging economies before conventional services do.
The DeFi Pivot?
Most fintech companies may need to add some type of blockchain capabilities at some point, even if that only goes as far as accepting crypto payments. Others may see an opportunity to pivot and fully embrace the DeFi revolution. It’s probably too early to make these decisions now – but it’s something to consider when planning for the future.
In particular, blockchain capabilities are something to consider when recruiting talent. Developers with the hard and soft skills suited to blockchain projects may become useful, not just in the future but in planning for that future.