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What Is DeFi?
Decentralized finance, or DeFi, is currently one of the most important use cases of blockchain and it stands to change how we transact money. We only need look at the implosion of Celsius to see the challenges of CeFi, or centralized finance (instruments that are managed by a centralized company or bank). First, let's understand what DeFi is. DeFi contracts are smart contracts that reside on a blockchain. They are not controlled by any central entity and as such are much less prone, if not immune, to manipulation. The two best use cases for DeFi right now are collateralized lending and collateralized borrowing. Collateralized lending is the process whereby anyone can check in collateral in the form of a crypto asset and then generate interest by lending it out (which is, by the way, what banks do with your money when you're not using it). Collateralized borrowing, conversely, consists of you borrowing funds that are secured by your collateral in the smart contract. When your collateral is deposited, it's under certain rules and conditions that are agreed, upon including how interest will be calculated, how loan‐to‐value will be calculated, and so on. The contract then works, and the software guides it. Now, back to Celsius. Celsius was a company that allowed users to check in their crypto assets and allowed collateralized lending (borrowing additional monies using crypto as collateral) and yield farming (lending assets to others and earning interest). All of this is well and good except that it was all under the control of one central entity, Celsius.
When Celsius got into financial trouble, it appears that they manipulated their own balance sheet by having their own token on it with inflated prices, which made them look more stable than they were. This is a function of management, not software. Ultimately, when the shell game could no longer hold up, the company froze everyone's assets and then, ultimately, went bankrupt. Celsius's financial problems were the result of decisions made by centralized management and resulted in billions of dollars frozen and inaccessible to their users. Conversely, while this was happening, DeFi contracts kept working. What we have here is a fundamental question: Do I trust software that is transparent and consistent? Or do I trust humans who have biases and are not always looking out for the best interest of their constituents when it conflicts with their own best interest? Personally, we're siding with software here.
The Wild West
The Economist regarded the future of crypto as a frontier where contending forces include Big Tech, “big rich countries” that have been testing their digital currencies, and software developers “building all sorts of applications” to empower DeFi.
“Finance is becoming ever less the domain of sharp‐suited bankers and credit‐card executives. Instead, a ragtag cast of characters is overseeing an explosion of innovation that seeks to cut out the incumbents altogether. From established tech firms and fintech startups on America's west coast to developers of various decentralized‐finance applications, they are jostling to reshape digital finance,” wrote finance editor Rachana Shanbhogue.1
Through smart contract platforms, developers are using blockchain technology to create DeFi platforms that allow people to lend or borrow funds, speculate on price movements on assets using derivatives, trade cryptocurrencies, insure against risks, and earn interest in savings‐like accounts. There's a freewheeling, Wild West vibe to the legions of apps presented with a trove of visual data.
“In the DeFi space, there's no central authority to report to,” Shirin Bucknam, co‐founder of Crypto Witch Club, a Brooklyn‐based online education community dedicated to blockchain and Web 3.0, told Time.com. “It's really a radical new way of doing things.”
It's radical because DeFi runs on a public blockchain that's accessible to anyone with an Internet connection, creating a truly level playing field market. On the supply side, it allows investors to create new forms of capital. Investors infuse collateral into the system through smart contracts and print a new form of stable currency called stablecoins. On the demand side, investors can take that digital money to provide the first formation of capital, which lends money back to the investors and developers who can take the funds and invest them.
Banking for the Bankless
DeFi is emerging as the vanguard of fresh financial freedom in countries where it's almost impossible for ordinary people to obtain a bank account, credit, or loans. Sixty‐nine percent of people living in Vietnam, for example, do not have access to a bank account.
Just imagine the advantage of obtaining a cryptocurrency account in a country like Zimbabwe, where inflation was 622% in 2020. In Venezuela, inflation is so severe that artisans sell handbags made from local currency – the bolivar.
DeFi opens up one of the largest new markets: people who are unbanked and not served by traditional finance. An estimated 4.5% of U.S. households (approximately 5.9 million) were “unbanked” in 2021, meaning that no one in the household had a checking or savings account at a bank or credit union. World Bank data shows that 1.9 billion people worldwide do not have access to a bank account.2
DeFi's characteristics of availability and low fees make financial services accessible to all: you only need the Internet and a computing device to access DeFi applications. These minor requirements make fintech platforms relatively easy for anyone to use – to save, borrow, and make payments. Emerging markets are among the areas that are most impacted by the world of blockchain, something we will cover in more detail in Chapter 15.
What about those with bank accounts, mortgages, and stock portfolios? Well, crypto is opening up new possibilities for them, too. Compound, for example, is an app based on the Ethereum blockchain that allows digital asset holders to borrow and lend crypto against collateral.
Let's say you bought $1,000 worth of Ethereum's currency, ether. You could add it to Compound's liquidity pool and immediately start earning compounding interest. No application required – not even a phone call. Just download the app. Compound has already amassed more than $6 billion in its liquidity pools.
DeFi delivers these products in a peer‐to‐peer format so that there are exchanges and derivative contracts, exchanges, and insurance where you can make different shares or fractionalize a given asset.
DeFi apps fall into dozens of service segments. Exchanges and loans comprise the most popular activities on DeFi by billions of dollars. Decentralized payments and insurance, for example, are much smaller in comparison – probably due to the lack of a practical application for many consumers. We believe this may change as the metaverse develops and real‐world items get involved.
DeFi assets as investments themselves provide a familiar rollercoaster ride. One investment, yearn.finance, traded at less than $1,000, ran up to $35,000, then as high as $80,000, and resides now at about $9,500 – all over two years. As with any emerging market, expect wild price gyrations but keep the long run in mind, manage your risks, and invest wisely.
DeFi and CeFi: Odd Bedfellows
While the current DeFi marketplace is a domain where you should place small bets or have a strong appetite for risk, the banking industry and consultants from Deloitte to Gartner to IBM see a huge potential for DeFi and CeFi to work in tandem. CeFi would be any big bank, lender, or other institution that provides monetary services. Think Citibank, BlackRock, Visa, and the like. Blockchain and AI expert Avivah Litan of Gartner blogged that “DeFi has the potential to transform financial services and move into the mainstream, assuming regulatory frameworks are clarified, and technology platforms mature.”
Compared to CeFi applications, DeFi lowers transaction costs and improves process efficiencies. Based on open‐source protocols, DeFi unleashes the creativity of global developers and entrepreneurs who assemble financial primitives into reusable transformational applications that are not feasible using CeFi.
“There are many shades of gray in between, where CeFi and DeFi work in tandem,” Litan said. “For example, DeFi can use assets issued by CeFi players … in which case you just have to trust the company issuing the asset used by DeFi (‘DeCeFi’). Alternatively, banks may use DeFi to offer financial services to their customers (‘CeDeFi’).”
Major players in the traditional banking world are already testing the waters and see digital asset strategies as a critical ingredient for traditional banks to gain more customers. Banks embracing digital assets are the next step in the bridge between DeFi and CeFi. “Financial institutions that can overcome outdated beliefs and leverage … approaches to prioritize digital asset strategies will be positioned for growth,” wrote Ernst & Young partner Aaron Byrne early in 2022.3 Some of the most notable of these, at least at the time of writing, include:
- The Bank of New York Mellon developed a digital custody platform for transferring, safekeeping, and issuing digital assets. “BNY Mellon is proud to be the first global bank to announce plans to provide an integrated service for digital assets,” said Roman Regelman, CEO of Asset Servicing and Head of Digital at BNY Mellon. “Growing client demand for digital assets, maturity of advanced solutions, and improving regulatory clarity present a tremendous opportunity for us to extend our current service offerings to this emerging field.”
- Wells Fargo is offering bitcoin investments to its investing clients through a partnership with DeFi human resources innovator NYDIG.
- JPMorgan Chase partnered with Singapore's DBS Group and Temasek to form a blockchain payments platform to ease cross‐border payments, trade, and currency settlements, to reimagine and accelerate value movements for payments, trade and foreign exchange settlement in a new digital era, through a newly established technology company.
- Mastercard and Gemini, a cryptocurrency platform, offer a credit card that provides real‐time crypto rewards on purchases made with bitcoin or other cryptocurrencies. Customers can benefit from any appreciation in the value of their currency holdings.
- Commerzbank, Isbank, and LBBW became the first banks to execute a commercial cross‐border transaction via Marco Polo, a blockchain‐enabled trade finance network. The partnership employs DeFi technology to enhance the efficiency and security of supply chain management and trade financing solutions. DeFi features enable the operation of the platform, with the first cross‐border transaction taking place on May 10, 2021, and involved the export of laminated special glass interlayers from Germany to Turkey.
- Binance, a leading international exchange, established a $100 million accelerator fund to support blockchain ecosystem building and better synergize DeFi and CeFi. However individual developers decide to partner or not with centralized banking, the DeFi world is generating financial solutions that work peer‐to‐peer and without intermediaries.
Decentralized finance is a natural progression of the founding ethos of Bitcoin: traditional financial institutions are too powerful, centralized, and susceptible to corruption. DeFi delivers on this proposition by building open‐source, noncustodial tools for the ecosystem. This prototype for open‐source financial services holds huge ramifications for the nature of lending and loans: no credit check, personal data, or bank account is required. Everyone can participate.
Lending, Borrowing, and Yield
Collateralized lending is the process of a lender providing funds to a borrower, which are then secured by collateral that the borrower provides to a lender. This is one of the main current use cases in DeFi, particularly since it has taken a while for banks to warm up to the concept of bitcoin and other crypto assets. Let's say Mike has five bitcoin and wants to borrow $20,000 to do some home improvements. Mike can, through a DeFi lender, borrow that $20,000 and secure the loan by pledging some of his bitcoin. If he defaults, the lender gets to keep enough of the collateral to pay back the loan; if he pays it back, he gets to keep his bitcoin. DeFi's lending services are provided in the form of smart contracts that offer collateralized loans in a permissionless environment.
Among the major platforms for DeFi lending are Ethereum blockchain protocols like Aave, Compound, and Maker. As noted by the popular Yield app, “Each one allows users to lock their funds in the platform, but smart contracts govern how they work. No third‐party can change the underlying code or contracts. Aave, Compound, and Maker are lending services with a proven track record as reliable and secure platforms with easy‐to‐use websites for executing these complex transactions.”
Another popular use of DeFi is the ability to earn interest on your funds by depositing your funds and generating interest on them, much like a CD or a savings account, except at much higher rates. Ultimately, this is just a teaser, as we'll touch more on these specific cases in Chapter 23.
Decentralized Exchanges (DEXs)
Earlier we discussed how to buy bitcoin using a centralized exchange. Centralized exchanges are common in the crypto and noncrypto world and, basically, they are clearinghouses that host buyers, host sellers, and conduct buy and sell transactions out of the common pool of both. Centralized exchanges are trading platforms that allow sophisticated kinds of buy and sell orders, derivatives, and generally a host of advanced options.
As a result of its peer‐to‐peer nature, blockchain has brought us another gateway, and that is that buyers and sellers directly trade without having to pledge their assets to a third party. Think of it like buying a car. Perhaps your heart is set on an electric sport sedan but you don't want to pay new car prices and are happy with a one‐ or two‐year‐old model. You can go to a dealer and see if they have any on their lot. If they do, then that means that they bought the car from another seller and are now selling it to you, likely at a markup. Let's say your dream chariot is there and you decide to buy. You'll pay the cost of the car, which includes dealer markup, and off you go. Suppose, however, you choose to go through a private party. By researching various trade magazines and Internet sites, sure enough, after a little looking, you see that Michelle has a two‐year‐old electric sport sedan and she's ready to sell. You buy directly from her. This is an example of a decentralized or peer‐to‐peer transaction. Decentralized exchanges (DEXs) such as Uniswap, Kyber, and Pancake Swap work much the same way. They match buyers and sellers and allow peer‐to‐peer transactions directly to and from a digital wallet without holding any assets at any time. Instead, assets interact with a set of smart contracts that manage the exchange process between two parties. These smart contracts allow for more privacy and fewer transaction costs than a centralized cryptocurrency exchange and, unlike centralized exchanges, assets are never held by the DEX, reducing costs to the user and liability to the exchange.
This changes the regulatory game as well since DEXs aren't asset custodians. Operators know that they must follow the law's letter and spirit regarding the regulatory checkpoints currently in place; however, we can expect a more mature crypto economy to include regulated centralized exchanges, regulated DEXs, and unregulated DEXs. DEXs are going to provide a world where the exchange of assets happens within smart contracts, and a savvy investor will start taking advantage of this paradigm shift.
Derivatives
Organically, new financial markets benefit by giving investors vehicles such as derivatives to hedge their bets. The DeFi marketplace includes a range of applications or companies offering digital derivatives options. The investing relationship is, of course, governed by smart contracts. Players include Synthetix, Binance, Augur, and many others. If you are in a secure position to buy derivatives, you can explore options on your favorite platform. Synthetix, for example, operates as a smart contract platform for some pretty wild plays, including Lyra, a decentralized options protocol. We wanted to include this concept for completeness, but take your time, as derivatives are not trivial and, used incorrectly, can crush a portfolio. Derivatives are an important aspect of the entire financialization process; however, they should be used by experts who know how to use them to hedge risk or speculate. They do have a place in the market.
DeFi and Governance Tokens
There is one more key element of which everyone should be aware. You see, all of this is well and good, but in this world of DeFi and DEX, of systems that have no central control or governance, the question that comes up is: Who is making the rules? Who decides what lending rates are? What loan terms are? If there's no “company” per se we need a novel way to manage the rules of decentralized systems. The answer is in governance tokens. These often‐overlooked tokens have a particular value: a say in what comes next.
In a decentralized, blockchain‐based financial system, this process of writing rules is often done through the use of on‐chain governance, which is a system that mediates how the rules that govern activity on a particular blockchain are set and revised. Early adopters using a new DeFi service can buy (or earn) governance tokens that give the holder the right to vote on how the blockchain is maintained, upgraded, and managed. One token, one vote. MKR, the token of MakerDAO, is a governance token. If you hold 5% of MKR, you have 5% of the voting rights for initiatives on that platform.
Most blockchain projects start with what's called “off‐chain governance,” which can mean anything from developers trading emails about how to change the code to founders passing notes in GitHub, the main software source code repository used for open‐sourced software projects. The people who build the currency write a founding set of rules. After this is set, many go on to establish on‐chain governance and utilize governance tokens. These tokens tend to come into play after a crypto network is established.
On‐chain governance is more formal and democratic than off‐chain, and it allows every governance token holder the right to vote on decisions and choices that will guide the particular blockchain ecosystem. Some ecosystems may vote on features to be released. The decision could be the setting of monetary policy or the reserve requirements of collateral on a loan. Or, it could be what type of consensus mechanism the blockchain uses, which affects performance, resource usage, and security for that blockchain. The on‐chain governance structure is designed to maintain transparency because everyone can see the proposals and see the computation of the results of a vote – and avoid human‐led backroom deal making.
While the primary focus of crypto investors has so far been speculation on appreciation, governance tokens will likely become more important – and valuable – as crypto investing matures. The reason is fairly simple: as the value of a crypto network increases, so too does the value of the right to govern it. Because token holders must hold the crypto asset to continue voting in that particular ecosystem's interests, investors will want to obtain and hold more tokens so they can continue participating in the governing. As long as the ecosystem makes good decisions and offers a good and competitive service, the token will likely accrue more value as time goes on.
We have something analogous in the traditional financial system. If traditional equity provides a right or claim to cash flows after all business expenses are paid, then governance tokens are somewhat analogous to equity in that they confer a right to control the direction of a crypto network and its treasury.
We're entering a new world, where more and more is being done with less and less. Part of the reason that's possible is that technology as innovation is at the heart of the economy. The world is becoming more automated and, as that trend continues, we're going to need mechanisms that manage the boundary between man and machine. DeFi's systems of on‐chain governance and the use of governance tokens look quite promising. Governance tokens give investors not just a stake but a say. As we've seen throughout history, the right to vote is a powerful thing.
Notes
- 1. https://www.businessreview.global/finance/619f863ce2b85d6c37067f43.
- 2. Global Findex Database: https://www.worldbank.org/en/publication/globalfindex/interactive-executive-summary-visualization#.
- 3. https://www.ey.com/en_us/financial-services/how-financial-firms-can-jump-start-digital-asset-strategies.