Decentralised Finance v1.0: Ethereum’s DeFi
This is part 2 of a series on decentralised finance. Part 1 introduced the topic and I put together this explorer guide so you can interact with DeFi directly.
The current financial system is made up of central banks, banks, insurance companies, asset managers and so on. Any decentralised financial system is made up of much the same, except there are two key differences:
- Instead of “companies”, such as BlackRock or Goldman Sachs, we refer to them as “projects”.
- These “projects” are autonomous (they work without needing manual, human intervention) and decentralised (they are not controlled centrally by a board of directors or government or even employees).
“DeFi” refers to the collection of decentralised financial projects which are built on the Ethereum blockchain. There are many projects ranging from insurance to banking to payments and each one is developed by developers and entrepreneurs across the world. If you can codify and automate the work done by a financial services firm, and place this code on the Ethereum blockchain, then you can create your own DeFi project.
As of March 2020, $600m is currently invested in various DeFi projects. That’s not a lot if you compare it to BlackRock asset management which has about $7Trn invested! However, the amount of funds invested into DeFi projects increased exponentially at the end of 2019 and early 2020, thanks to the increased quality and integrity of these projects. It’s a good time to get to know DeFi. Start by looking at this chart…
Lending clearly has the biggest slice of the DeFi pie and most of this is actually held in one crucially important project called “Maker”. In fact, the Maker project accounts for over 50% of all DeFi funds invested.
Tip: To understand DeFi, you need to take the time to understand why Maker is important.
Maker is a project offering loans which are 150% collateralised (meaning that if you want to lend $10 then you will need to put up a digital asset worth at least $15 as collateral) and the loans are paid in“Dai”, which is pegged to the dollar. The proven stability offered by Dai and the system behind Maker has created a strong base for DeFi to build from.
DeFi is following a pattern of evolution similar to the early Western financial system. By taking the time to understand the origins of the modern financial system, we can understand where the future of decentralised finance will likely go, and how to anticipate its development over the coming years. Sit tight for a brief history lesson…
The origins of Central Banking
B y the 17th century, European merchants had become wealthy and had accumulated large stores of bullion. In order to keep their wealth safe, they deposited their bullion with goldsmiths who were experts at storing gold securely.
The goldsmiths developed a method of accounting to record all gold stored with them and then issued receipts to the merchants as proof of the bullion deposited with the goldsmith.
Merchants at the time had a problem when dealing in large transactions since they would need to move large volumes of physical bullion to effect any transaction. They soon realised that instead of actually moving any physical gold, they could just use their paper receipts to settle their financial transactions.
Here is the important part though: the merchants only ended up drawing on a fraction of their physical bullion. Once the goldsmiths cottoned on to this fact, they realised that they could extend their lending business by issuing notes in excess of the bullion they held on deposit. This is known as “fractional reserving”.
The goldsmiths would only “loan” gold to merchants who they believed would eventually be able to pay them back. In a sense they were issuing a receipt to a merchant for their future gold earnings.
This divorce of currency from the actual underlying asset ushered in a new era— where individuals’ and companies’ financial worth was measured based on current physical wealth and future prospects. This practice of placing a value on future prospects led to much of the financial system which protects against uncertain future events (e.g. insurance), allows us to speculate on future events (e.g. stock markets) and hedge against future uncertainty (e.g. commodity futures).
Eventually many of these goldsmiths joined forces, influenced the monarchy in order to create their own monopoly (bankers influencing politics — surprise, surprise) and over the next 50 years they rapidly coalesced and evolved into the Bank of England.
The emergence of digital assets
Today people around the world have real value stored in a digital format but they face a big problem which is eerily similar to what those 17th century merchants faced.
Problem: Digital assets are not great at facilitating transactions in the real world. They fluctuate in value wildly (imagine paying your rent in Bitcoin!) and most people would prefer to receive fiat money instead. In a way, digital assets are a bit like those inconveniently heavy chests of gold — they have value but are difficult to transact with.
That problem was solved 400 years ago for merchants and led to the eventual creation of the financial system. What would happen if similar solutions existed for digital assets? Would we see a similar evolution of a new, digital financial system?
That time may have come. The reason DeFi has flourished over the recent past, and the reason it is generating so much hype around its potential, is because its version of a goldsmith, “Maker”, seems to be working pretty damn well.
Ethereum’s fledgling central bank: Maker
Maker allows people to invest their digital assets (e.g. trade finance debt; cryptocurrency) as collateral and then receive a more useful cryptocurrency, pegged to the US dollar, as a loan. So now there is a system which allows people to transform that difficult-to-use digital asset into, effectively, US dollars (Dai). This peg has proved to be robust, retaining a near 1:1 ratio to the US dollar even at the bottom of the cryoptocurrency crisis in 2018 and right now in the midst of the Corona crash. Here is a wonderfully simple video on how it works: Ivan on Tech.
How is this different to other dollar pegs (e.g. China’s yuan currency)? The key lies in the decentralised way the peg is maintained. Maker requires you to put up collateral (150%) to receive the dollar peg and this is all handled within a clever bundle of software code (a.k.a a “smart contract”). There is no need for a company or government to manage this and so no need for trust in an entity — it is all decentralised and automated. A truly decentralised bank for a truly decentralised finance system. This construct is the backbone of a system on top of which other financial products can be built in a more interconnected, efficient and creative way than in the traditional financial system.
Currently the system has not made that leap which the medieval goldsmiths made when they gave out more notes than actual gold they had deposited with them…as I’ve said, DeFi is still just learning to walk.
What’s next?
Maker’s stated intention is to broaden the horizon of assets which qualify as collateral from digital assets to physical assets (trusted digital representations of physical assets) — which could be the bridge needed between the digital and physical realms of finance.
Centrifuge already allows SMEs to use trade finance debt as collateral and its a matter of time before all manner of assets can be used to unlock US dollar loans immediately without any intermediary required.
Based on the lessons of history can we expect a decentralised fractional reserving solution to enter the fray? Would such a thing be against the principles of the blockchain realm where ex nihilo money creation is regarded as anathema? Watch this space.
How does DeFi compare to the mainstream financial system?
Over 75% of DeFi funds are held in the lending sector. If this DeFi construct is meant to be a full-blown, digital financial system, is that lending proportion normal?
Well let’s look at the UK financial system as an example. The chart below is from the Bank of England and the blue blocks on the left represent money held with banks. You can see that they quite significantly outweigh the other financial sectors such as asset management and insurance. So while the lending piece of the DeFi pie is outsized, its in line with the principle of financial systems having most activity weighted in the banking space.
This chart is interesting because it may be a blueprint of what we can expect as DeFi matures into a full blown digital financial system. There are already many projects working on creating solutions for the right hand-side from fully decentralised insurance projects to savings solutions.
I’ll will leave you with this:
If DeFi is following the same trajectory as our current financial system only three centuries later, should we expect a decentralised fractional reserving solution to enter the fray, and what would this mean? Would it succeed in bringing DeFi closer to the mainstream financial system? Would such a thing be against the fundamental principles of the blockchain, which seeks to avoid the pitfalls of ex nihilo money creation?
In my next article I’ll delve into some interesting DeFi projects, including one where you can earn dollar interest rates at multiples higher than what you can on fiat bank accounts today.
