DeFi Whitepaper #1: An introduction to the potential and reality of Decentralized Finance (DeFi)
“DeFi is really eating the world of finance,” Jesse Powell, Founder and CEO, Krake
The emergence of blockchains and distributed ledger technologies has created a new degree of ownership, moving beyond the read-and-write world of Web2, to the evolution of the internet, Web3.
The subsequent explosion of new primitives from Web3, through Tokens and NFTs, has begun to disrupt many large established industries, including the largest, the USD 22.5T Global Financial Services Industry.
Decentralized Finance, otherwise known as DeFi, is a financial system built for the internet age. In contrast to the highly opaque, closely controlled, traditional financial system (TradFi), DeFi and decentralized blockchains are open, transparent, and give the individual user control over their own assets in ways not possible before.
DeFi does not rely on traditional centralized financial intermediaries or institutions for the execution of financial services. The only requirements for participants to freely access payment and financial solutions offered by DeFi platforms — are that they have internet access and a cryptocurrency wallet.
“The DeFi revolution is here to stay. It offers the promise of a bankless world, where you don’t need permission to save or invest your money. Like any nascent technology, there will be times when it gets overhyped, but DeFi is real and it’s already working in the wild. This is just the beginning.”
— Tyler Winklevoss
Over 7M users have participated in DeFi, and as of the second week of January 2023, there are currently USD 74B equivalent worth of tokens operating in DeFi now, being used to; borrow, lend, invest, securitise, and insure amongst many other functions.
While cryptocurrency meltdowns dominated the news in 2022, DeFi survived and did well. This was due to excessive lending of large sums of capital to risky counter-parties who make risky opaque transactions, which was a prevalent factor among businesses that failed dramatically.
Participants of DeFi do not have to trust banks, asset managers and insurers with their assets, as Blockchains are public, with transactions and wallets visible, thus blockchains enforce accountability and traceability of every transaction from every wallet on the chain.
In this article we will explain:
- the vast opportunity of DeFi,
- the path of evolution it has taken,
- the building blocks it requires,
- as well as recent prominent examples of why DeFi and transparency are so important and differentiated to the systems before.
Evolution of Fintech to DeFi
Standing at USD 22.5T, and responsible for 24% of world GDP, the financial services industry is massive!
Yet the relationship between innovation and highly regulated industries, such as financial services is complex. There have been many innovations, but despite these, much of the industry still struggles to convert these into its core business offering.
For example:
- Electronic signatures have yet to be fully embraced, despite being in existence for over 20 years
- Cross border transactions such as those over the SWIFT Network can take 1–4 days for the money to arrive
- There still exist today open-outcry pits of the Chicago Board of Trade despite the vast majority of Trading being electronic
- US listed equities and other securities take same day plus an additional 2 extra days to be delivered, in what’s known as t+2
The reasons for this slow adoption in finance are multiple:
- Creating and maintaining financial services is very costly in terms of time and resources
- Modifying the infrastructure of a live platform is risky, particularly with new technologies
- Traditional banking databases have difficulty communicating with each other and are even written in different languages
- It is challenging to understand regulatory implications of new technologies, with variations in financial regulations across different countries limiting wider adoption
With the wave of Web2, and increased usage of mobile telephones and greater dissemination of information spawned 2 major improvements:
The rise of “Super Apps” on mobile brings in additional user-data to build a bigger picture of a customer to offer additional services too, which includes the likes of Revolut, Klarna, AliPay, Kakao, and WeLab (an AngelHub portfolio company)
Cost pressures on Active finance managers and wealth Managers with layering of fees has moved tens of millions of users into low cost ETF’s and Automatic “RoboAdvisors” who use technology to generate optimal low cost portfolios for its users.
Fintech has challenged traditional financial institutions, stealing market share, and forcing many to adapt or even launch internal Fintech companies or NeoBanks such as Marcus by Goldman Sachs or Mox by Standard Chartered.
However whilst Fintech has made huge improvements to the overall user experience, by making financial products far more accessible, it is often still built on the same legacy infrastructure and financial plumbing. DeFi is different altogether.
DeFi is different altogether.
DeFi will do to banks what the Internet did to newspapers
- Nemil Dalal, Product at Coinbase
Built on a completely different technology stack with complete transparency of all past transactions, DeFi does not have the same barriers as FinTech to overcome. But has a different offering with decentralization and democratic access at the core.
One of the key advantages of blockchain technology, on which DeFi is built, is its permissionless nature. This means that anyone can participate in a blockchain network without the need to have permission from a centralized intermediary.
This permissionless nature of blockchain technology allows for greater accessibility and inclusivity in the financial system. The use of blockchain also provides transparency in transactions and can potentially give more autonomy to users over their financial data. In particular, DeFi offers an alternative solution to serve the underbanked population who may have limited access to traditional financial services.
The Wider Opportunity — Underbanked and Cost Advantages
According to data by the World Bank, the Traditional Financial System has either failed to supply or undersupplied over 24% of the world’s population.
Globally there are 1.7 billion individuals without bank accounts, yet from these, 1.1 billion own a mobile phone. In many places, private companies have stepped into this void, establishing regional monopolies in mobile payments systems like M-Pesa (made by Telecoms behemoth Vodafone), serving over 50 million monthly active users across Africa.
However, as services like M-Pesa and other mobile payments providers have near-monopolistic power over the people they supply, they are able to pass on high-costs that the service imposes on its users whilst offering limited services.
Thus a huge potential from DeFi comes from the ability to successfully service these underbanked, yet technologically connected users. All that is needed is a phone and an internet connection. DeFi is democratic across users, offering the same service at the same costs regardless of geographic location.
DeFi also has a huge cost advantage attaining to the technological stack on which it is built, allowing a more scalable, open solution.
This was reflected by The IMF in its April 2022 ‘Global Financial Stability Report’, which showed that DeFi has the lowest marginal costs and higher cost-efficiency compared with incumbents across both advanced and emerging market economies. This is a reflection of the leanness of DeFi operations as bank tellers, loan officers and settlement analysts are replaced by lines of code.
One clear example about the cost advantage and accessibility potential of DeFi comes from the example of remittances:
Traditional remittance services often rely on a complex network of banks, payment processors, and foreign exchange providers, each of which can take a cut of the transaction, sometimes as much as 7% of the initial amount, with the proceeds taking hours or days to arrive if done by a bank transfer. Furthermore rates are often subject to change to compensate for any big market fluctuations.
DeFi and Blockchain technology can enable users to swap one token to another (for example a token pegged to a US Dollar to a token pegged to a Thai Baht) on a decentralized exchange and then sent on to a different wallet. There would be costs involved, around 0.2% trading fee on the decentralized exchange and then gas fees of maybe USD 0.01 if the transaction was done on a low cost blockchain with the proceeds arriving in the second wallet in under a minute.
It is important to note that DeFi is not risk free however, these additional risks impose a higher funding cost on capital than traditional financial institutions. The increased risks of hacks and exploits, a lack of access to central bank liquidity support, and legal uncertainties all weigh heavily.
The Requirements; Smart Contracts and dApps
Smart contracts are digital agreements that are automatically executed when certain conditions are met. They are sometimes compared to vending machines in that one inserts a coin and a product comes out, thus the vending machine contains an implicit contract to exchange one item (USD 1 coin) for another (1 Snickers Bar).
In DeFi applications, smart contracts are combined and incorporated into dApps (Decentralised applications) that are used to facilitate complex transactions and functions. From the user’s perspective, interacting with a dApp, is similar to using a vending machine: the user inputs a token into the protocol and the software performs a specific function, such as borrowing funds or exchanging tokens.
Smart contracts offer several benefits, such as trust, transparency, and the ability to store and manage crypto assets.
DeFi, CeFI and TradFi
Just because an entity deals with crypto currencies, does not make it a part of DeFi. Most cryptocurrency exchanges; Binance, Coinbase, Kraken and previously FTX were centralized institutions otherwise known as CeFi.
Within the exchanges tokens were moved around between clients on a centralized blockchain, depending on their on-exchange activity. In contrast to DeFi, CeFi clients do not actually have possession of the tokens they have on an exchange, these are held in large centralized wallets held by the exchange.
DeFi is broadly distinguished from traditional financial or TradFi in the following key aspects:
- No intermediary involvement;
- Greater accessibility;
- Non-custodial nature; and
- Open and transparent systems
DEFI is the Solution
2022 was a sobering year for the digital asset industry.
May
- TerraForma Labs a crypto protocol including the Luna ecosystem crashed bringing down the UST stablecoin as a result of poor mechanism design and alleged suspect internal transfers
June
- Celsius, a crypto lending company froze withdrawals after being unable to process withdrawal requests as a result of alleged poor risk taking from the CEO using client assets
- BlockFi (a lending pool) and Voyager (a brokerage firm) and other crypto lending platforms also followed suit in being unable to honor withdrawals of client assets needing bailouts.
- 3 Arrows Capital, one of the largest crypto hedge funds imploded having overleveraged itself after promising the same collateral to multiple different lenders and taking excessive risk
November
- FTX, then the second largest crypto exchange, collapsed in part after commingling funds with an internal hedge fund, Alameda Research.
However one of the learnings from this period was that all the points of failures in each of these entities was centralized control (CeFi) and obscure off-chain activity.
Furthermore, whilst these incidents all had crypto currency at their heart they also had clear traditional finance equivalents; FTX has been compared to Enron the early 2000’s accounting fraud, 3 Arrows Capital to Bill Huang’s Archegos Capital blow up in 2021, TerraForm Labs to Bernard Madoff’s Ponzi Scheme, and the failures of BlockFi and Voyager to the likes of Lehman Brother, Fannie May and Freddie Mac in 2008.
Bank to the Future
DeFi has shown its robustness throughout 2022, withstanding intense periods of volatility and scrutiny. The decentralized nature of DeFi protocols offers an open, transparent, and public way of storing and utilizing tokens. It provides a trustless way of conducting finance, which has historically been plagued by bad actors and fraud.
There are some very positive signs, Decentralized Exchanges are now putting through more transactional volume than their Centralized Equivalents, and big banks like JP Morgan and Societe Generale are publicly interacting with DeFi more and more. So the signs are present that DeFi is here to stay and will have an important role to play in the next wave of crypto adoption and web3 development.
It is worth noting that DeFi still faces significant risks such as hacks, exploits, and regulatory challenges, which continue to act as a headwind against adoption. Nevertheless, the events of 2022 have reinforced the use case for the DeFi ecosystem, as the need for a more robust, open, permissionless, and transparent system has never been higher.
Sources:
https://grayscale.com/wp-content/uploads/2022/12/DeFi-Report-12-8-22-update.pdf
