Decentralized finance – known also as DeFi and sometimes referred to as “open finance” – is an expression used to indicate the shift from traditional, centralized financial systems to peer-to-peer finance. This shift is enabled by decentralized technologies built on different blockchains.
From lending and borrowing platforms to stablecoins and tokens, the wide DeFi ecosystem is made of large networks of integrated protocols and financial instruments.
I have been following the space for many years now, and in this essay I will attempt to condense my research, in order to provide a primer on Decentralized Finance and its key aspects. The first section is going to explore five tenets of DeFi, while in the second one I am going to analyze ten different applications of Decentralized Finance with real-life examples. In the last and closing section of the essay I will look at how governments are reacting to this transformation and what we can expect from regulators around the world.
What is DeFi?
Effectively, DeFi is a new set of rails for “value” to be created and exchanged between different actors. This innovation has enabled various arrangements that have been tested and scaled rapidly: we will look at some those in detail in the second part of this post. For now, we should know that DeFi offers a range of novel use cases for developers, individuals, and institutions. A recent report from Chainalysis shows that large institutional transactions (ie those above US$10 million), accounted for over 60% of DeFi transactions in Q2 2021, compared to under 50% for all cryptocurrency transactions. That represents a massive uptick in institutional adoption.
Our traditional financial system is managed by a few central authorities, runs on a number of for-profit intermediaries and works on infrastructure that is centralized: essentially, there is a core set of institutions we all use, which all of our financial activities go through. This started to change about 10 years ago, in 2009, with the invention of Bitcoin: we do not need any intermediaries when a bitcoin is sent from one person to another.
DeFi works on code running on decentralized blockchain infrastructure. Smart contracts enable developers to create financial platforms (and new products) that work according to predefined algorithms and that are accessible to (and usable by) anybody in the world with a basic Internet connection. The opportunity for banking the unbanked is huge: people can participate in the financial system regardless of their wealth, their status or where they were born.
Many world-class scientists and engineers believe the decade that just started will be characterized by “disintermediation at scale”: this phenomenon that commenced a few years ago is likely to extend to new industries, including the Financial Services one.
The products, solutions and services that decentralized platforms offer are very similar to those provided by banks, except for one key difference: we don’t need human interaction to make things work in DeFi. Everything happens in a fully automated way. While it is important to understand that we are still at the very early days of DeFi and these platforms are all still relatively small compared to their centralized equivalents, nobody can ignore the speed at which the new protocols are moving.
By now, it should be clear that DeFi leverages key principles of blockchain technology with the objective of completely revolutionizing finance, so that we can conduct financial transactions without centralized intermediaries.
Smart contracts are the essential building blocks of DeFi. These are essentially contracts written in code: if the conditions programmed in the code are met, then the payout or consequences are automatically executed. This means that the contract is fulfilled without human intervention, unlike what happens in banks where, even to these days, many processes still require manual execution and are partially (or entirely) managed by humans – people like you and me.
DeFi platforms make things cheaper, faster, more transparent and infinitely scalable, without any “human bandwith” limitation.
Decentralized Finance uses inherent attributes of the blockchain to increase financial security and transparency. Let’s have a look at five tenets of DeFi:
- Immutability. Data in the blockchain cannot be altered. The consensus mechanism ensures that the originality of data is maintained. Blockchain immutability means that data auditing processes can be made more efficient and cost-effective, bringing more trust and integrity to the data.
- Transparency. A blockchain is an immutable distributed ledger that allows every single transaction to be viewed. DeFi has the potential to introduce a new era of financial transparency and rewards for the best behaviors: in a sense, transparency is by far the best regulator. DeFi protocols are all built with open source code and anyone can view, audit, build upon it.
- Programmability. Programmable smart contracts allow for reengineering and streamlining of business practices. The ability to execute transactions more complex than a direct payment is what defines the concept of “programmable money”. Many cryptoassets (including bitcoin) can handle the simplest forms of these transactions, however blockchains like Ethereum are designed to support complete customizability and increased complexity.
- “Permissionlessness”. Permissionless blockchains are open to anyone with access to Internet and an active cryptowallet. This brings trust to any user or any entity that interacts with such type of technology. Also, permissionless blockchains typically incentivize with some sort of reward the users for participating in network activities.
- Interoperability. Blockchain interoperability allows blockchain systems to communicate one another without the need of intermediaries. A composable software stack ensures that DeFi protocols and applications integrate and complement one another. DeFi developers can build on top of existing protocols, customize interfaces, and integrate third-party applications in a similar way to people that combine lego pieces to create new structures (because of this, DeFi protocols are often referred to as money legos).
Leveraging these five crucial features we just discussed, projects are emerging that address real-life problems. Let’s review ten popular applications.
What are the applications?
So far, we discussed some introductory concepts around Decentralized Finance. In this section, we are going to look at ten applications of DeFi and we are going to discuss real-world initiatives happening in the space.
In the last few years, many DeFi projects appeared in the market, each trying to focus on specific use cases. The list of real-world problems getting addressed and solved for is large and constantly changing. Here, I want to focus on ten of the most popular solutions in the DeFi space.
To clarify, the products we will discuss here are all early-stage. Despite massive efforts from the developers to ensure the security of these protocols (eg code is open source, independently audited by professional third parties with bug bounty programs issued to safeguard the security of end customers) there are clear risks associated with using these protocols. It’s important to remember that users should assume full responsibility for their usage.
Let’s start.
- Data and Analytics – Thanks to the technical architecture of the blockchain, there is a first-of-a-kind level of transparency available to services operating in the Data & Analytics space. For example, projects like ApeBoard and YieldWatch are able to track the market price of value locked in DeFi protocols. Organizations like Nansen perform analysis about the wallets that are transacting on-chain. This enables users to discover opportunities by performing accurate due diligence on cryptoventures.
- DEXs – In transactions made through Decentralized Exchanges, the typical third party entities which would normally oversee the security and transfer of assets (e.g. banks or stockbrokers) are replaced by a blockchain platform. Because users do not need to transfer their assets to the exchange, decentralized exchanges reduce the risk of theft from hacking. Decentralized exchanges are more anonymous than exchanges which implement Know-Your-Customer (KYC) processes however most DEXs these days are not fully decentralized: in most cases, servers (centralized) still host order books (among other features) but, importantly, do not hold private keys. PancakeSwap is a decentralized exchange that is similar to Ethereum’s Uniswap, but runs on Binance Smart Chain instead. Sushiswap is another example of a popular Decentralized Exchange and Trading platform.
- DeFi Lending – DeFi lending platforms provide crypto lending in a way that is trustless and without delegates. A borrower can take a loan by using a decentralized platform and the lending practice permits the lender to gain interests. DeFi has the highest lending growth rate and is the most predominant patron for locking crypto assets among all decentralized applications (DApps). DeFi Lending has some clear advantages over traditional applications: improved speed of loan procedure, higher consistency in lending process, increased transparency. As an example, Aave is a decentralized non-custodial liquidity market protocol where users can participate as depositors or borrowers. Depositors provide liquidity to the market to earn a passive income, while borrowers are able to borrow in an overcollateralized (perpetually) or undercollateralised (one-block liquidity) fashion.
- Payments – DeFi payments apps, protocols and solutions are focused on creating an open finance ecosystem that caters to the needs of retail customers and institutions, as well as the underbanked and unbanked populations. Blockchain technology is foundationally architected so that users can exchange cryptocurrencies in a secure and peer-to-peer way, without any middlemen. The first cryptocurrency, Bitcoin, allows for on-chain settlement leveraging its secure base layer without intermediaries, thanks to the Proof-of-Work consensus mechanism. This system would be inefficient and slow if it had to be leveraged for the everyday payment scenario. Layer 2 solutions, such as the popular Lightning Network, provide Bitcoin with the technology that enables fast, scalable payments at nearly zero fees.
- Alternative Savings – DeFi Alternative Savings Apps are aiming to improve and simplify onboarding experience for third-party DeFi lending protocols. They are introducing DeFi savings products to non-crypto native users and act as an alternative interface for lending protocols. A popular platform is Donut. When you save with Donut, your fiat currency is automatically converted into digital dollars (stablecoins, such as DAI) so those dollars can be put to work in decentralized markets. Those dollars are then lent at high variable interest rates through a global, decentralized pool of borrowers. Typically, highly collateralized platforms – such as Compound – are used to ensure the money is secure and covered. Through DeFi, users are able to collect variable or fixed interest in real time, 24/7, at annual rates that are up to 20x higher than the average bank account.
- Prediction Markets – Prediction markets are exchange-traded markets created to trade the outcome of events. The market prices can indicate what the crowd thinks the probability of the event is. A prominent player in the Prediction Markets DeFi sector is the Forecast Foundation, a group of developers and technology professionals that support and develop the free, open-source Augur protocol. The Augur protocol is currently the only prediction market protocol where the development team doesn’t do anything beyond writing the free open source code. The Forecast Foundation does not create markets on the Augur protocol itself, they do not perform trades, or have the ability to monitor, control, censor, or modify any actions performed on the Augur protocol.
- Stablecoins – Stablecoins initially arose because the price of cryptocurrencies is very volatile relative to some “stable” asset or basket of assets and stablecoins aim at decreasing such volatility. We have various subcategories of stablecoins: fully collateralized coins (USDC or BUSD for example), national cryptofiat (potentially Central Bank Digital Currency), natural asset collateralized tokens (like Digix where gold bars are made divisible, transferable and redeemable via their token), and non-collateralized stablecoins (the most problematic category – with tokens that rely on an algorithm generated mechanically, able to change the supply volume so as to maintain the token’s price pegged to an asset).
- Staking – Networks that are based on a Proof-of-Stake consensus mechanism use validators who create, propose, or vote on blocks added to the blockchain. From the customer point of view, Staking is similar to interest savings account in a traditional bank. In DeFi though, infrastructure service providers such as staking pools and Staking-as-a-Service providers play the role of the bank, running nodes for decentralized Proof-of-Stake protocols on behalf of investors. PancakeSwap is a very popular Staking platform based on the Binance Smart Chain with more than $10B in value locked.
- Know Your Transaction – Traditional banks and Financial Services institutions need to fulfill specific government regulations around anti-money laundering (AML), countering the financing of terrorism (CFT) and other crimes involving money. This happens via policies, procedures and technologies typically referred to as KYC (Know Your Customer). In the DeFi space, compliance analysis can go much deeper around the behavior of participating addresses rather than participant identities. As such, we talk about Know Your Transaction (KYT) automated policies that, in real time, help protect against financial crimes.
- Gaming and Lotteries – Gaming is an immersive distraction for many people: the more addictive a game is, the more time and money the gamer invests into it. DeFi offers gamers a new way of compensation through cryptotokens and other rewards. Blockchain is deeply innovating the gaming experience by incorporating proof-of-ownership of in-game assets. This could also lead to unique secondary marketplaces, where players buy and sell these in-game assets as Non-Fungible-Tokens (NFTs) in a secure and irrevocable fashion. With the rise of the metaverse, more complete and cheaper Augmented Reality and Virtual Reality technologies, the gaming industry is set to proceed in its booming trend and cryptoassets are best set to support this explosive growth. For example, Zed Run is a decentralized horse-racing game that provides gamers with the ability to trade virtual horses, which compete in races to win crypto-based prizes. On top of what just described, another way in which Gaming as an industry has been able to profit by the rise of DeFi is via automated lotteries, like the one offered by PancakeSwap and PoolTogether.
In the next section, we are going to discuss how governments have been reacting to the crypto revolution and what interventions may be desirable to regulate the space.
How are governments reacting to the rise of DeFi?
As we elaborated in the previous two sections, DeFi has the potential to provide a massive shift in the Finance world across a wide and wild range of areas, from the monetary system to gaming. While we are still in the early innings of adoption, we continue to see new financial products and services coming up regularly.
Today, the market for cryptocurrency is sitting at around $2 trillion. Crypto has certainly caught the attention of retail investors but institutions haven’t been idle either. Crypto-backed ETFs have popped up, giving people a way to invest in cryptocurrencies, without even the requirement of buying the actual coins (and storing the associated private keys).
Wholesale investors have also been holding cryptocurrency more and more. Companies are starting to have Bitcoin on their balance sheet as part of their treasury strategy with the objective to counteract negative yields on cash. Elon Musk’s Tesla and Michael Saylor’s Microstrategy are two notable public companies which hold, combined, around 150,000 Bitcoin for a current estimated value of over US$7B.
The two largest global payment networks — Visa and MasterCard — have also begun to facilitate cryptocurrency transactions, with Visa also creating a whole suite of Visa Crypto solutions to focus on Crypto cards.
The big players are getting serious. These moves suggest to the world that there are real opportunities, but also risks, with cryptoassets.
Of course, governments are now also becoming more and more interested in the cryptoworld. Different regulators around the world have approached DeFi and cryptocurrencies in general in different ways.
In Europe, DeFi services must register at the national level to be able to operate, in order to comply with European Anti Money Laundering laws. Specific countries, like Germany and Switzerland, have their own way of regulating crypto-platforms and custodians: for example, the Crypto Valley is a region in Switzerland very friendly to cryptoventures. The MiCa (Markets in Crypto Assets Regulation) is a regulatory framework developed since 2018 with the mandate of helping regulate cryptoassets and their service providers in the EU and providing a single licensing regime across all member states by 2024.
In Canada, crypto ETFs are regulated similarly to other investment funds. Cryptoexchanges are required to register with local Securities regulators. This is somewhat akin to consider cryptoassets as “securities” or a derivative instrument. The framework applied says that the actual good being exchanged in a crypto transaction is simply a “right” to own a cryptocurrency, not the cryptocurrency itself.
In Australia, the Select Committee on Australia as a Technology and Financial Centre has recently launched a round of consultation to review the policy framework around cryptocurrency and DeFi platforms. To date, the Australian regulation on cryptocurrencies is at its early stages. At the moment, Australian laws do not see cryptocurrencies as money and the Reserve Bank of Australia (RBA) is currently only experimenting with a Central Bank Digital Currency (CBDC). Crypto exchanges need to register with the Australian Transaction Reports and Analysis Centre (AUSTRAC) and, because of that, they are subject to AML policies.
In the USA, laws and regulations vary from state to state. Similarly to the Australian case, cryptoexchanges are considered money service businesses hence they must comply with AML legislation. As of now, a unique federal regulation around cryptocurrencies and DeFi businesses does not exist in the USA however, in a recent intervention, Gary Gensler, chairman of the SEC, admitted that his office will start looking into it. The initial proposals appear to be very harsh and even suspiciously close to an attempt to regulate a competitor out of business: it would be fair to say more work will need to be done on this front.
It would be desirable that governments become more involved with how this industry evolves, perhaps even more than they have been with the Internet in the last few decades.
Governments should aim at becoming “model users” of crypto and DeFi, as well as they should aspire to cause the least amount of harm possible to private enterprise.
This is a difficult task. It requires categorising cryptoassets so they can be regulated: are they securities, commodities, currencies, a combination of those, or are they something else altogether?
In the meantime, Blockchain companies are concerned about unclear regulation and its social cost.
For example, what if DeFi service providers were not held directly liable for the behavior of their users?
On one hand we want DeFi innovation to flourish, of course, but on the other hand, the issues of the first era of the Internet (violations of intellectual copyrights, privacy, and other human rights) don’t completely line up with the potential downsides of misusing crypto – such as terrorism financing and money laundering. These are possible uses that these platforms can enable at scale, possibly with worse consequences of what happens now with national currencies. Regulators must tread lightly and work tirelessly to keep up with the innovation that every new day brings: it is objectively difficult to absorb all the information and to take appropriate action.
As I stated before, my view is that governments should be starting experimenting themselves with blockchain, crypto and DeFi: they should be using these platforms. Their participation will help to shape a better, more efficient, and more inclusive financial marketplace.
Conclusive thoughts
In this post, I offered a primer on Decentralized Finance.
We reviewed what DeFi is and then we looked at ten real-world applications that have flourished in the recent years. Lastly, we read about initiatives that the various governments are undertaking in an effort to regulate this emerging space.
While projects are growing in popularity and users increase daily in the cryptospace, DeFi as a nascent technology still presents significant risks for its users.
Only time will tell if traditional financial services players will be eventually dethroned by their decentralized counterparts.