By Dan Eyre You may have heard about tech’s newest portmanteau in the last few months: DeFi. This is due to the meteoric rise in value of the related assets. This post will attempt to explain what DeFi is, and what the medium- to long-term impact will be. To understand DeFi we first need to break out and define its two morphemes: “decentralized” and “finance.” Admittedly, the “finance” component of DeFi is perhaps broader than a traditional definition of finance would be. There is also no formal definition for all of the activities that make up DeFi, but for the sake of simplicity we will say that the “Fi” in DeFi includes:
- Trading—the exchange of one asset for another;
- Lending & Borrowing—the borrowing or lending of an asset for interest;
- Derivatives—asset whose value is derived on the value of other asset(s);
- Prediction Markets—trading on the outcome of events; and
- Insurance—event-driven compensation in return for a premium.
While my intention is not to provide a fully developed taxonomy of the DeFi ecosystem, I believe most would agree that these are the most exciting activities in DeFi today. You may be wondering what the hype is about; I can trade and buy derivatives on Schwab, get a loan from my bank, or go to PredictIt.com (or Vegas) to participate in prediction markets. This is where the “decentralized” piece of DeFi comes in, an explanation is in order. Bitcoin was the first digitally “decentralized” asset. In the first line of the Bitcoin whitepaper Satoshi writes: “A purely peer-to-peer version of electronic cash would allow online payments to be sent directly from one party to another without going through a financial institution”. There are two points I want to call out from this sentence. The first is that we are talking about a decentralized and digital asset that does not need to go through a financial institution. In other words, I can now transact online without needing Venmo/PayPal/etc. Second, we can see the clear emphasis on cash and payments, there is no mention of yield, insurance, or trading in an equally decentralized manner. While Bitcoin invented the digital asset to be used without intermediaries, its technology starts and ends with payments (leaving aside store-of-value). Enter Ethereum. Ethereum was created to provide the decentralized benefits that Bitcoin has to broader use cases than just money. Decentralized data storage? Check. Decentralized purchases of compute power? Check. Decentralized Finance? Here we are. To answer the question “what is DeFi?” we first must see the inherent friction of traditional finance: high barriers to entry, negligible cross-anything compatibility, minimums and maximums, and silos based on jurisdiction. Now that is not to say that DeFi doesn't have friction. It does, but it's a different type of friction. Hurdles for users of DeFi can include transaction fees, unaudited or risky code, confusing UI, and a staggering degree of required technical literacy. However, the difference with DeFi is that an army of developers and product people are working day and night to reduce these barriers to entry. When was the last time there was a coalition bent on increasing access for traditional finance? The Potential of DeFi The key potential that we have with DeFi is an alternative financial system that is open to both access and innovation. For a system to be open to access, any person must have the ability to interact with the underlying network. There are no exclusions for a person regarding where they live or how much money they have. Let's look at a few examples. One of the most promising areas of DeFi lies in decentralized exchange. Traditional exchange of crypto assets takes place on centralized third-party exchanges such as Gemini, Binance, and Coinbase. These exchanges have the benefits of streamlined UIs along with onramps to and from the traditional world. But to participate in these markets, assets must reside on the exchange, exposing the assets to the potential of theft (it is worth noting that the organizations listed have excellent security programs that greatly minimize the threat of theft). Decentralized exchange allows users to trade assets in a decentralized, peer to peer manner. This allows users to maintain control of their assets, all but eliminating the possibility of theft. Users of traditional exchanges must also depend on the exchange to list assets they want, whereas in a decentralized exchange, any compatible asset with demand is viable for trading (emphasis on compatible). Lastly, access is not restricted in decentralized exchange, there is no authority permitting or preventing you from trading. This is especially valuable for people who, for whatever reason, do not have access to the same institutions that the rest of us have. This is a particularly interesting concept for the developing world and underprivileged communities in developed countries. This democratization of access is one of the most important themes of DeFi. Anyone in the entire world can access the same system in a frictionless manner. A banker in London can perform an exchange or take a collateralized loan from a 15-year-old in Nigeria. Not only is this clearly beneficial for those that live in countries that have been severely underserved by traditional financial institutions, but the greater liquidity and price discovery that will occur from a global market provides a benefit to everyone. Prediction markets are another area that greatly benefit from access to the entire globe. It must be noted, though, that by allowing anyone to participate also introduces the ability for criminals to transact too, a fact particularly scrutinized by regulators. My opinion on this is very simple: the benefits this technology will provide far outweighs the additional capabilities that criminals may have. There is also the fact that while these networks are decentralized, they are not anonymous—they are pseudonymous. This means that every transaction is transparent and visible to everyone else that is participating in the network. What this means in practice is that if a law enforcement agent spends the time tracking a particular address, they can still “get” the bad actor, far easier than if the transactions were done through traditional means. The additional transparency is another huge benefit of DeFi over traditional finance. While I cannot say that we won’t have any financial crises in DeFi, we will at least be able to closely and proactively monitor the system and implement preventative measures, as opposed to collapsing in a reactive tailspin similar to what we have seen in major financial crises of the past. Lastly, one of the most exciting things that DeFi and all decentralized networks enable is permission-less innovation. It is well known that startups innovate faster than large institutions, and anyone that has worked at a startup knows this. But the hurdles for startups in the traditional finance space are much larger than for those in any other industry. What we get because of this is a financial system that is decades behind other industries. Therefore, I am so enthusiastic about permission-less innovation. Anyone with an idea can build an application and a community without having to ask anyone for permission. The application can be audited by any party, and the building blocks of the application can be reused at will. The open auditability will drastically increase infrastructure integrity over time, and the reusable building blocks mean there will be an ever-increasing pool of capabilities that don’t need to be rebuilt every time a new solution is being developed. The sheer amount of innovation happening in DeFi is mind-boggling. Dozens of projects have appeared in the last few months and there is no sign of slowing down. Of course, as is the case with all technological revolutions, most of these projects will fail--some of them in a glorious explosion of ones and zeros. And when this happens, some people may get hurt financially, especially if they are participating in the riskier side of the ecosystem. While this is unfortunate, when the dust settles, what we will have is a financial system that is more inclusive, less bureaucratic, and better suited for our increasingly digital world. Dan Eyre is Chief Executive Officer at Blockchange.
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