Is the recent DeFi hype just another ‘bubble’, or the start of a financial revolution?
If you have had any exposure to blockchain social media communities or ‘crypto-twitter’ over the past few weeks, your feed will no-doubt have been awash with #DeFi (Decentralised Finance) talk. At the time of writing, some $1.7bn in value is locked up in DeFi smart contracts and Dapps (decentralised applications).
It’s no surprise, given the recent sharp rise in value of a swathe of DeFi projects, that FOMO is beginning to set in. Investors appear to be gleefully throwing money at projects with a mere whiff of DeFi about them, whack-a-mole style, in the hope of capitalizing on the recent trend — and to date, many appear to have succeeded.
It is still early days, of course, so talk of bubbles bursting may be premature — but it’s difficult not to be cautious given the fate of many previous blockchain-based ‘flavours of the week’.
More importantly though, aside from the speculatory aspects of the DeFi market, is there real substance to this new wave of projects promising to decentralise finance?
What is DeFi?
OXBC Member and Research Advisor at ID Theory Lewis Harland describes DeFi as “not just one network or product, it is best understood more holistically. DeFi is the emerging tech stack made up of ‘lego bricks’ that gives parties the ability to pay, lend, borrow, trade, invest, invoice, govern in a trustless and transparent way and enables value to be re-routed back to the consumers. Importantly, crypto assets are at the heart of the incentive layer that ultimately ties consumers, suppliers, and distributors together.”
If successful, DeFi promises to break down barriers to finance, allowing anyone with an internet connection open access to financial instruments that would otherwise have been out of reach.
DeFi is a seemingly natural use case for blockchain technology. Its Dapps (decentralised applications) or smart contracts, mainly built on the Ethereum blockchain, harness the benefits of trustless transactions with no centralised authority, to open finance to everyone regardless of geography or social status. No forms to fill in, no bank manager to tell you you can’t have a loan.
Whilst there is also no ‘FSCS’ style guarantee on any funds invested in a DeFi project, like there would be with a UK bank for example, truly decentralised projects have open source code, making them more transparent and less vulnerable to bugs.
The interoperability, or “Financial Lego” aspect of DeFi is also incredibly significant. For example, it opens up the possibility to take code from an existing project — a decentralised exchange for example, and combine it with that of, say, a lending mechanism to create an entirely new Dapp with a completely different use case. The possibilities are almost endless.
There are of course disadvantages. Even open source projects are still vulnerable to programming errors, malicious activity and hacks.
Also, not having to deal with banks is a double-edged sword. Not having a banker to talk to makes it imperative that users do their own research about the risks of using DeFi services. For example, the liquidation processes on lending platforms such as Maker and Compound means that users can lose all of their collateral if the underlying asset falls in value — which, in volatile cryptocurrency markets, is a regular possibility.
What are the most popular applications?
The first and most obvious DeFi application is one everyone will be familiar with — payments. The plethora of new stable coins joining Tether in what is now an incredibly crowded market place has made decentralised borderless payments easier than ever — while limiting the volatility risk associated with Bitcoin, for example. Second layer solutions like the Lighting Network also combat speed and scalability issues, provided users are willing to compromise a little on decentralisation and security.
Lending and Borrowing
Permissionless lending and borrowing is a DeFi application that has real mass-appeal. It gives those unable to secure bank loans the ability to access funds using cryptocurrency as collateral.
The current ‘big fish’ in the borrowing pool, Maker DAO, allows users to borrow the stablecoin $DAI in return for depositing Ethereum as collateral. An example of the ‘financial lego’ concept in action, it is also possible using associated Dapps like Oasis, for users to collateralise other cryptocurrencies too ($BAT, $USDC or $WBTC -a ‘wrapped’ form of Bitcoin that effectively moves your BTC on to the Ethereum network.) Don’t look back in anger though, as of course there are risks. A borrower could find their collateral quickly liquidated should their underlying asset fall in value, for example.
Maker’s ambition doesn’t end loans either. According to Coinbase, there are aspirations within the decentralised autonomous organisation to be a decentralised reserve bank.
As well as loans, another major player in the DeFi market — Compound, also offers decentralised lending.
This means a user could deposit one of the accepted cryptocurrencies into the Compound protocol, for other users to borrow and receive variable interest income instantly. “Interest accrues every Ethereum block (~15 seconds), and users can withdraw their principal plus interest anytime”.
There are also Aggregators like LoanScan which track interest rates for comparison — a ‘Go Compare’ for DeFi, if you will.
DEXes: Relatively speaking, Decentralised Exchanges (DEXes) Such as 0X, IDEX and Airswap are the ‘elder statesmen’ of the DeFi landscape, having been around since the previous crypto-boom period of 2017. They allow users to trade cryptocurrency on a peer-to-peer basis with no counter party risk, directly from their own wallets. One of the more recent entrants to the DEX market, Uniswap, allows users to earn a share of the exchange fees by ‘pooling’ their assets in order to increase liquidity on the platform.
Derivatives and Asset Issuance
DeFi derivatives platforms like Synthetix allow the peer-to-contract (P2C) trading of blockchain-based derivatives — the issuing of ‘synthetic versions’ of almost anything from commodities like Gold and Silver or stocks, to traditional FOREX currencies.
The synthetic assets (Synths) are backed by Synthetix Network Tokens (SNX)which are locked into the platform’s smart contract as collateral. Because the exchange runs P2C, there are no liquidity issues and it gives unbanked or unaccredited investors, who are denied access to traditional markets, exposure to a whole new range of financial instruments.
Decentralised betting apps, like Augur, allow you to bet on the outcome of real-world events — like the U.S. presidential election. Synthetix too, offers prediction markets in the form of binary options on the predicted value of cryptocurrencies on a designated date in the future.
What does the future hold for DeFi?
If the speedy adoption of DeFi protocols among the ‘blockchain-savvy’ and speculatory investors is any indication, DeFi could well be here to stay.
For example, even though projects in the space are decentralised, many still entrust developers with ‘master keys’ in case of emergency- so are still vulnerable to a single point of failure. Though of course this practice is expected to disappear as time goes on and the code is proven to be bullet-proof enough not to need emergency human intervention.
Also, the likes of Nexus Mutual are working on insurance solutions to protect consumers in the event of smart contract or Dapp hacks.
All DeFi lending and borrowing protocols currently involve some kind of ownership of cryptocurrency. This too may be prohibitive to those wary of jumping into the space with both feet. Coinbase has an interesting take on how this may be resolved in the future:
“ More traditional unsecured borrowing and lending will need to rely on an identity system, so that borrowers can build up credit and increase their borrowing power, much like today’s SSN and FICO scores. Unlike today’s identity and credit systems however, a decentralized identity will have to be both universal and privacy-preserving.
In the future, we expect that crypto wallets will be the portal to all your digital asset activity, just like an internet browser today is your portal to the world’s news and information. Imagine a dashboard that shows you not just what assets you own, but how much you have locked up in different open finance protocols–loans, pools, and insurance contracts”.
In the short term at least, the progress of DeFi adoption continues to defy expectations.
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