What is DeFi? Decentralized Finance — Everything You Need to Know
One area in cryptomorphic that has attracted much attention is DeFi or decentralized finance. This refers to financial services that use intelligent contracts, which are automated and enforceable agreements that do not need intermediaries like a bank or lawyer and use online blockchain technology.
Between September 2017 and the time I write this article, the total amount blocked in DeFi contracts exploded from $2.1 million to $8.54 billion. Since the beginning of August alone it has increased $4.5 billion.
This generated a massive increase in the value (market capitalization) of all tradable tokens used for intelligent DeFi contracts. Numerous tokens have increased in value three or four times in a year — and some considerably more. For example, the Synthetix network token increased more than 20 times and Aave almost 200 times. So if you had bought $1,000 Aave tokens in August 2019, they would now be worth almost $200,000.
DeFi, mostly built on blockchain ethereum, is the next step in the revolution in disruptive financial technology that began 11 years ago with bitcoin. One area where these decentralized applications (dApps) have taken off is the trade of cryptomoedas in decentralized brokers/exchanges (dexs), such as Uniswap. They are entirely peer-to-peer, with no company or other institution providing the platform.
Other DeFi services now in use allow you:
- Borrow and lend cryptomoedas to earn interest using platforms like Compound or Aave;
- Bet on the results of various events using Augur;
- Create and exchange derivatives of real world assets such as coins or precious metals in Synthetix;
- Participate in a Lossless Lottery at PoolTogether, where everyone gets their money back and one lucky participant earns all interest accrued in a shared pot;
- Buy cryptomains known as stablecoins, which are tied to the value of a specific coin or commodity. For example, DAI and USDC are both indexed to the US dollar.
DeFi is sometimes known as “Lego money” because you can stack dApps to maximize your returns. For example, you can buy a stablecoin like the DAI and then lend it on Compound to earn interest, all using your smartphone.
While many of today’s applications are niche, future applications can have a big impact on everyday life. For example, you could probably buy a plot of land or a house on a DeFi platform under a mortgage contract for which you pay the price over a few years.
The shares would be placed in token form in a blockchain ledger as collateral and, in case you do not pay your refunds, the shares would be automatically transferred to the creditor. As no lawyer or bank would be required, it could cheapen the whole process of buying and selling houses.
Why all this madness?
In the first place, regulators were late and DeFi managed to flourish in this vacuum. For example, in traditional unsecured lending, there is a legal requirement that lenders and borrowers know each other’s identity and that the lender evaluate the debtor’s ability to repay the debt. In DeFi, there are no such requirements. Instead, everything revolves around mutual trust and the preservation of privacy.
Regulators are having to weigh the delicate balance between stifling innovation and not protecting society from risks like individuals who put their money in an unregulated space, or banks and other financial institutions potentially unable to make a living as intermediaries. But it seems wiser to embrace change — and that seems to be happening. In July, the U.S. Securities and Exchange Commission (SEC) made a major change to adopt the DeFi by approving an ethereum-based fund, the Ark, for the first time.
This is welcome and important, since one of the greatest challenges for financial innovation is the hostile environment created by archaic regulations written for a bygone era. This has caused some DeFi projects to fail — including major ones such as Basis, based in New Jersey, which returned $133 million to investors in 2018 when it concluded it could not function within SEC rules.
A second reason for the increase in DeFi is that the big players are getting involved. Many large financial institutions are beginning to accept DeFi and seek ways to participate. For example, 75 of the world’s largest banks are testing blockchain technology to accelerate payments as part of the Interbank Information Network, led by JP Morgan, ANZ and Royal Bank of Canada.
The third is the effect of COVID-19. The pandemic has further reduced global interest rates. Some jurisdictions, such as the euro zone, are now in negative territory and others, such as the United States and the United Kingdom, may follow.
In this climate, DeFi potentially offers much higher returns for savers than commercial institutions: Compound, for example, has offered an annualized interest rate of 6.75% for those who save with Stablecoin Tether. You not only gain interest, but also receive compensation tokens, which is an added attraction. With two-thirds of people without a bank account in possession of a smartphone, DeFi also has the potential to open financing for them.
A final important reason for the increase in people who put money into DeFi tokens is to avoid being left out of their explosive growth. Many tokens are worth nothing or almost nothing in practical terms, so we are getting a lot of irrational exuberance.
But like it or not, we are moving towards a new financial system, more liberalized and decentralized than before. The central question is how best to guide its development with brakes and counterweights that minimize risks and distribute potential benefits as widely as possible. That is the challenge for the coming years.
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