On November 14th, 2019, the decentralized finance (DeFi) startup Compound Finance raised $25 million in a series A funding round led by the a16z crypto fund. This fundraising is not unusual, but rather confirms a trend that has been going on for the past year-plus. In September 2018, Maker sold $15 million worth of MKR tokens to investors, including a16z. In October 2019, Indian DeFi startup InstaDapp raised $2.4 million from institutional investors. The DeFi segment is capturing more and more investor interest, and DeFi companies are proposing revolutionary services that could be massively adopted in the near future. If you’re looking for a use case that could transform the entire blockchain industry, chances are pretty high that this is it.
For context, decentralized finance, or DeFi, is the development of financial services and tools with the use of decentralized ledger technology (DLT). DLT is especially useful for increasing transparency, removing middlemen, improving transaction performance and, in general, just being more inclusive than traditional financial products based on centralized technology. These DeFi startups did not formulate these services in a vacuum, but are rather building on top of an existing suite of blockchain and token-based protocols that developers have been focused on for the past few years.
When people unironically use the word BUIDL, it is these protocol stacks or protocol suites, depending on who makes them and how you use them, that they are talking about. DeFi is based on these protocols that the blockchain community has been creating, despite the price swings in the market, and the interfaces and products that are just now beginning to come to the market are nothing short of amazing. DeFi is an essential part of blockchain, but more importantly DeFi is part of a global movement that only looks to get stronger over time. According to defipulse.com, which has become the Coinmarketcap-equivalent info site for this particular niche in the blockchain world, only one-third of 1% of the assets that comprise the global crypto market cap are currently staked into DeFi smart contracts and platforms. The potential growth in the DeFi industry is astounding.
From Centralized to Decentralized finance
Centralization has always been a key issue in the financial industry. A few organizations, institutions and key players retain control and capture massive wealth creation. Over time, this situation widens inequalities and excludes a significant part of the world population from the existing financial system. Approximately 1.7 billion people were unbanked in 2017. Moreover, the current system has proven incapable of lowering transaction fees, speeding up transactions, or making those transactions more transparent. Many people lack trust in these centralized institutions. Distrust levels seem to get bigger by the day all over the world. America’s subprime crisis brought this question to the fore. A few years later, the Greek crisis, which is still ongoing, made people question the appropriateness of the global financial system. Continuing Venezuelan hyperinflation has led the Venezuelan people to largely forsake their existing national financial system for a more decentralized one based on bitcoin. On November 18, 2019, Iranian people even set fire to Iran’s central bank during a protest against centralized authorities. In fact, there are so many similar conflagrations all over the world, that they are too numerous to mention here. There has never been a better time to increase awareness about DeFi opportunities.
Decentralized finance appears to be a paradigm shift. And it’s just beginning. Because 3.9 billion people have access to the internet (63.4% from their phone), the internet is increasingly available to all parts of the globe and to all levels of society. Because Big Tech like Facebook Pay, Apple Pay, WeChat Pay, and Alipay increases access to financial services without customers having first to initiate a relationship with a bank, it seems that current barriers to those services (such as location, minimum money requirements, smartphone, etc.) are being removed. DeFi is the next step. It provides a solution against government censorship, like monetary manipulation and hyperinflation, as well as future potential corporate censorship as Big Tech inevitably takes market share away from TBTF (“too big to fail”) banks.
Decentralized financial services will eventually compete with traditional finance.
Several solutions are proposed to address the lack of access to financial services. To name but a few, tokenized assets, decentralized lending platforms and decentralized exchanges. Crypto startups, such as Set Protocol, are proposing to give people more and more alternatives to invest their money easily in diversified baskets of tokenized assets. Because these assets have been tokenized, many intermediaries are removed. Thus, it will be much easier to invest in stocks, real estate, or even tokenized Legos in the future! Moreover, services like Set allow people to invest small amounts of money, which leads to increased financial literacy and awareness. Increased exposure to the wonderful magic offered by compounding investment returns is a plus any way you can get it.
Other companies such as Celsius, ETHLend or Maker offer crypto loans that are much easier to obtain than traditional loans, which opens opportunities to people who otherwise would not be able to borrow. These are different from P2P platforms that allow one to borrow money from another user, paying interest during a predetermined period. With these decentralized platforms, one simply borrows against the collateral of their own assets. These loans can be denominated in large and liquid cryptocurrencies such as Ethereum. But also, if you’re worried about cryptocurrency volatility, they can be denominated in a stablecoin such as DAI.
Finally, decentralized exchanges (dex for short) propose to ease asset transactions without relying on centralized exchanges, which have shown a propensity to lose their own assets and typically charge fairly high fees not unlike traditional financial institutions. People are free to trade their assets, buy new ones and even use financial tools such as futures and options on some of these exchanges.
Assets offered on these decentralized platforms can even be “synthetic assets.” These innovative crypto tokens are not backed by the actual underlying assets but their price moves in tandem with the pricing of those assets thanks to oracles that convert real-time data streams into on-chain data that can interact with the smart contracts that govern the synthetic assets. The most popular oracle providers is by far ChainLink, but there are others such as Band Protocol. Synthetic assets are offered by Synthetix, which offers a variety of “Synths” (the most popular of which are sUSD and sETH) and “Inverse Synths” (iUSD, iETH) that provide the essential ability to short the synthetic asset without having to find a buyer in the open market. These assets are backed by the value of their SNX collateral token, which is the centerpiece of their primary Mintr interface.
Challenges Faced by DeFi
Solutions proposed by DeFi startups are promising. However, there are challenges that must be addressed. Regulations are obviously one of the biggest. DeFi has to comply with current regulations and new laws should be thoughtfully created to protect users from potential abuses. Financial literacy is another challenge that needs to be addressed, since 1/3 of the global population is unable to understand basic financial concepts, much less complex DeFi ones!
We’ll dive deeper into the DeFi world in our future articles!