Demystifying DeFi

Decentralized finance – DeFi for short – stands for the ecosystem of financial products built on blockchain platforms. Exchanges, protocols, stablecoins, apps, derivatives, tokens, etc… are all part of the DeFi ecosystem. It’s a broad definition, but still a fairly small market. Ethereum is by far the most popular blockchain platform for DeFi products, but, at the time of writing, only $1.57 billion is locked in DeFi contracts. That’s approximately 6% of Ethereum’s $26 billion market cap.

Nonetheless, DeFi is a hot button issue in the crypto community these days. Over the last few months, DeFi has seen hyperbolic growth, a gut-wrenching crash (thanks COVID-19), and some more hyperbolic growth. It’s all been very exciting, but let’s take a step back and better understand why DeFi is a thing in the first place and what the future of DeFi could look like.

Why DeFi?

In order to understand why developers are spending their time working on DeFi products, we need to understand what’s wrong with the traditional financial system. The traditional system is slow, expensive, and not inclusive. A millennial like me, born on the waves of the Internet, scratches his eyes out at how long it takes to send money from one bank account to the other or at the skyscraper fees PayPal charges you whenever you touch their platform.

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On top of that, you don’t even control the money you’ve trusted the traditional financial system with. Most of the time, the custodians of your money will take care of it okay. But sometimes, they won’t. Consider the 2008-9 Belgian financial crisis, where two of the country’s largest banks (Fortis and Dexia) nearly went bankrupt. The government had to split up Fortis, sell off one part to France’s BNP Paribas, dismantle the Dexia group, and nationalize Dexia Bank Belgium.

Would you be comfortable having your life’s savings in either of these banks while all this was going on? They could’ve gone under, and while the government insured your funds up to 100,000 EUR, anything over that amount you might as well have lost. 

And that’s Belgium. By most measures a good country. Think about the Lehman Brothers’ collapse in 2008, the restrictive monetary policies in Azerbaijan, and the hyperinflation in Venezuela. Giving your money to an institution introduces an element of risk that we don’t think about often enough.

Here’s how DeFi tries to improve on the traditional financial system:

It’s Decentralized… Kinda

One of the most important features of blockchain technology is that it’s decentralized. A blockchain database runs on many different nodes in the network and there’s no single entity that has a disproportionate amount of control over that network. This means that you don’t have to trust a particular node for the veracity of information in the database. The network is trustless.

Most DeFi products are powered by smart contracts that run on Ethereum, which means that you don’t need to trust a particular institution to take care of your money. You trust the code. Additionally, you and only you have access to the private key of the wallet that’s linked to your cryptocurrency assets. No one can do anything with your money without your explicit permission.

However, the above doesn’t mean everything about DeFi is decentralized. DeFi is a bit of a misnomer, because most DeFi products are centralized in one way or the other. Consider this: who creates the smart contracts of a particular DeFi product? In the vast majority of cases, it’s a single company.

A certain degree of centralization is inevitable at the initial stages of a product. A centralized entity is much faster at creating and improving a product, because it’s much faster to get to an agreement about what needs to be done to move forward. The more decentralized a product gets, the harder it gets to quickly build new features, because more people/nodes/entities need to come to an agreement.

That’s why DeFi products sit on a scale between being very centralized and fairly decentralized. So far, no DeFi product is entirely decentralized. There’s always an element of the product that a company has control over. That’s not necessarily a bad thing. You just have to consider which elements of a product you want decentralized.

Most people are entirely okay giving away all control, and that’s why a company like Coinbase exists. There’s nothing decentralized about Coinbase. Even their wallet is custodial, meaning that they have control over your wallet and can shut it down if they’d want to. Again, that’s not necessarily bad. You just have to decide what you’re comfortable with.

Sidenote: Coinbase is not a DeFi product, because Coinbase does not run on a blockchain platform like Ethereum or NEAR. Instead, it almost blasphemously stores its customers’ funds on AWS.

The only thing that DeFi products have in common with each other is that they’re built on a blockchain platform and that they’re non-custodial. You hold the keys to your crypto. Apart from that, DeFi products will vary widely in how centralized or decentralized they are.

It’s More Inclusive

This is one of the most interesting aspects of DeFi to me. It’s so much easier to participate in the DeFi ecosystem than it is when compared to traditional finance. Once you get past the barriers of buying cryptocurrencies and installing a wallet like MetaMask, you can borrow money, earn interest, and trade in no time with very little effort. 

Most DeFi products have no KYC requirements, don’t care where you live, and don’t look up credit scores to determine how “worthy” you are of credit. Of course, this doesn’t mean it’s a free-for-all. 

For example, DeFi loans are overcollateralized. If you want to lend money, you have to put in more money first. If you want to lend $1,000 of a particular token, a DeFi product will ask you to deposit $1,500 in cryptocurrencies. Still useful, if you want quick access to a particular token, but you need the initial funds first.

It’s different if you want to supply money. DeFi products and their corresponding tokens often provide high rates of interest to those willing to supply their money. LoanScan is an excellent website to see how much interest you can earn on particular tokens supplied to certain DeFi products.

These interest rates often beat traditional interest rates out of the park by a long shot. Just be wary of skyscraper interest rates. Firstly, these are almost always dynamic and can change dramatically in a single day. Secondly, the value of the underlying token is also subject to high volatility. Who cares if you earn 47% APY on a token if its value drops from $1 to $0.02 in a few days.

With the opportunity to earn money comes the danger of losing money. If you think you can earn money jumping from DeFi product to product trying to get the best interest rates (I’m looking at you, yield farmers), you’ll likely burn your fingers. Don’t fall for the “How to Get 158.59% APY on X Exchange” tweetstorms or articles. Consider yourself warned.

It’s Creative

The DeFi space is new and many developers are building interesting products. For example, AirSwap Trader lets you create a smart contract that serves as an escrow service for over-the-counter trades. This eliminates the leap of faith you’d otherwise need waiting for the other person to execute their part of the deal. No expensive third-party intermediary fees either. It’s perfect to settle the handshake deals you strike with other individuals.

Another example is TokenSets, which has products called “Robo Sets” that trade cryptocurrencies automatically based on trading indicators such as Moving Averages (MA). You buy the robot set token and they do the trading behind the scenes.

Another cool product is Uniswap, currently the most popular DEX in the DeFi space. I can see why. Uniswap makes it ridiculously easy to swap your cryptocurrencies for some of the more esoteric DeFi tokens. Connect your wallet and you’re ready to go. Boom, simple.

As a final example, I want to talk about smart contract insurance. In their Ethereum Q1 2020 DeFi report, Alethio Analytics predicted that insurance for DeFi products will grow rapidly in 2020. DeFi products are built by people and people make mistakes. While you don’t need to trust a middleman, a bug in a smart contract might still lead to you permanently losing your money.

DeFi insurance like Nexus Mutual or Opyn claim to protect you against smart contract failure. When you lose money to a smart contract bug, they’ll refund you the money you lost. However, at this point in time, DeFi insurance is so new that it’s pretty much untested. Whether you’re fully protected in all scenarios through either of those providers (or newer players on the market) remains to be seen.

But that’s inevitable in a new market like this. DeFi is new, people are excited, and there are lots of interesting ideas floating around. It’s what makes Ethereum the most valuable player in the cryptocurrency market. Bitcoin, at this point purely a store of value, pales in comparison. Sorry, Bitcoin maximalists.

The Future of DeFi

DeFi is the Wild West of crypto. When lending protocol Compound released its eponymous token on the 19th of June, its value skyrocketed from $0 to over $300 in less than two days. It became the biggest DeFi product (as measured in USD) in an instant. Many people were alarmed, fearful that DeFi would turn into another bubble similar to the ICO bubble of 2017.

There are definitely some bubble aspects to DeFi. People are quite likely to lose a significant bit of money because they invested in products with security flaws, were overleveraged when the market moved against them, tried to sell through illiquid exchanges, etc. 

But, once the dust settles and it’ll be clearer which products offer sustainable solutions, we’ll have an industry that challenges traditional finance and looks to be much more decentralized, more inclusive, and more creative. That, in my opinion, is something to look forward to.