What’s The Deal with DeFi?
What’s the Deal with DeFi?
What if you could get a loan in minutes without the need for paperwork or bank approval? What if you could issue stock for your company without having to deal with expensive legal and banking fees? What if you could earn consistent interest on your assets instead of dealing with low or negative rates?
Enter: the new frontier of Decentralized Finance.
Decentralized Finance (or DeFi) is a growing movement to recreate commonplace financial instruments, services, and products on top of decentralized infrastructure. But what does that mean?
More simply put, DeFi comprises a new class of blockchain-based service applications that leverage decentralized technologies, such as smart contracts and distributed protocols, to provide people with financial services (lending, borrowing, trading, etc.) that are quicker, cheaper, and more accessible than those from traditional finance.
DeFi is a stark departure from older financial models, wherein financial networks are run on centralized servers and large institutions are responsible for issuing credit, taking on counterparty risk, and streamlining payments. The movement is an effort to shift ownership of financial infrastructure from centralized authorities to a decentralized ecosystem run by those participating in its markets.
In powering the push toward a more open global economy, DeFi represents an important area of growth in the blockchain space — and one that has been picking up a lot of steam in recent months. At the time of writing, there are more than 100 DeFi projects in development, and the total value locked into the ecosystem stands at $817.1M, representing a ~50% increase over the last three months.
So what’s with all the recent buzz? Let’s take a look at a few key narratives.
Where is DeFi Now?
Currently, the majority of DeFi applications are built on Ethereum. This vibrant ecosystem includes projects across payments, custodial services, financial infrastructure, KYC/AML, insurance, credit and lending, asset management, and prediction markets.
One of the guiding philosophies of the DeFi space is to develop financial applications that are interoperable with each other. This means that projects are able to integrate with and benefit from other projects, creating an ecosystem of shared features and functionalities that offers developers exceptional freedom and flexibility in how they build their own applications and enhance the projects of others. In addition, this interoperability should continue to benefit the overall health of the DeFi marketplace, since different applications can be reused and recycled as building blocks for future services across the sector.
In recent months, the largest DeFi sector growth has been in Decentralized Exchanges (DEXs), which allow for the peer-to-peer trading of digital assets, and derivatives. DEX trading volume topped $2 billion in 2019, according to coingape.com, and projects such as Synthetix are building out important decentralized infrastructure for not only the trading of crypto-backed synthetic assets but also exposure to real-world currencies, commodities, stocks, and indices.
Just last week, the amount of Ethereum locked up in DeFi applications hit a new milestone of 3.1 million ETH (about $798M USD, according to decrypt.co), highlighting the recent increase in demand for such services. For a breakdown of some of the leading projects in the sector, take a look at Consensys’ list of 100+ Projects Pioneering DeFi.
Consumer crypto-backed loan providers have also gained traction with both retail and institutional customers. Popular platforms include BlockFi, Celsius, and Nexo — each of which offers a unique set of loan terms, repayment options, and interest rates. These services allow people to take out loans via collateralized positions on digital assets and to generate passive income on their holdings. Getting started takes just a few minutes and requires no need for credit reviews or background checks.
BlockFi, for example, is a crypto lending platform based in the U.S. that offers investors up to 8.6% in annual interest-earning with rates that are customized based on the size of the loan rather than being fixed (like in traditional lending). In the case of BlockFi, there is a low barrier to entry and borrowers have the flexibility to pay off the loan earlier or to refinance. By contrast, Nexo manages lending contracts via algorithms and smart contracts that are pre-set to execute based on certain inputs and functions — a noteworthy example of just how “automatable” these sorts of financial instruments and services can be.
Why Does DeFi Matter?
In Q4 of last year, Nasdaq listed a DeFi index for crypto-assets, China Merchant Bank International (CMBI) announced a partnership with blockchain network Nervos to develop DeFi applications, and countless other DeFi headlines have popped up across the blockchain landscape.
But why does it matter? In a nutshell, DeFi has the potential to significantly disrupt the traditional world of financial services. Here are just a few of the many benefits brought by using decentralized infrastructure to power common financial instruments and services:
1. Permissionless
Given their decentralized nature, DeFi applications allow for open and democratized access to a range of financial and banking services that are currently unavailable for many — to the tune of 1.7 billion people according to the World Bank. Identification checks and credit histories are often necessary to open a bank account, take out a loan, earn interest on assets, and more. This makes it exceedingly difficult for many unbanked people around the world to get access to basic financial services.
On the other hand, MakerDAO, the most popular DeFi application, allows anyone to take out a loan by simply just depositing some Ethereum into a smart contract. Users can do this in minutes and for next to nothing in fees. For the curious among us, here is a walkthrough guide for how to get started with the MakerDAO platform.
2. Access to Other Assets
In countries such as Argentina and Venezuela, which have struggled for years with runaway inflation and national currency depreciation, access to alternative forms of capital (such as digital assets and fiat currencies) is important for those who want to protect their wealth from extreme inflation and uncertain monetary policies.
Just a few months ago in Argentina, for example, capital controls imposed by the national government placed a $200 per month cap on the amount of U.S. dollars that citizens were allowed to buy (down from $10,000). DeFi applications offer an alternative, making it easier for people to buy currencies that are more stable rather than store their wealth in fiat currencies that are suffering from high inflation.
In short, we believe that DeFi will be a game-changer and will remain as one of the most popular narratives in the blockchain space. As a decentralized system that has no central authority and is open to everyone, DeFi allows users to retain control of their assets and limit exposure to the counterparty risks inherent in the centralized and trust-based model of traditional finance. The open-source protocols powering the DeFi ecosystem are globally inclusive and give people the ability to trade, use, invest, transfer, lend, and store assets in new marketplaces.
While at the time of this writing, the market cap of DeFi is relatively small, the potential for growth is significant. The 1.7 billion unbanked individuals who have not previously had access to banking, those limited by geography and still others who are restricted to participation due to circumstance, can now have access to this system of open finance — one that represents, in many ways, the philosophical end-game of the blockchain space at large.
Ultimately, the emergence of the wide array of DeFi tools and applications is powering the build-out of a whole new sector. Will the momentum continue? Time will tell, but it will be fun to watch what DeFi does in 2020. Stay tuned!
