Decentralised Finance — why DEFI is a thing
Decentralised Finance (DEFI) has seen an explosion of interest from developers and all sorts of crypto holders. Much of this interest has been generated by the genius viral marketing of crypto where everything in crypto looks like a get rich quick scheme. This interest has also generated copious articles all over the internet exploring DEFI.
Articles on the subject generally fall into two camps: overly technical, or overly simplistic and narrow. What is missing is a simple answer to the following: “why does DEFI exist?”.
What is needed is a short description of:
- what problem DEFI solves
- who has this problem
- what innovation DEFI represents over the traditional solution
In this article I will cover all of this. A single article cannot be expected to discuss every type of DEFI. So I will restrict this one to discussing only the problem of international exchange with large orders, this is traditionally solved with a “market maker”. DEFI just allows us to do this in a decentralised way.
What problem DEFI solves — and who has this problem
We can begin with the biggest question: decentralised liquidity provision is a solution, but to what? Ignore the “decentralised” bit, why does liquidity need to be provided?
Imagine you are a huge importer of phosphorus operating in Australia. Generally you expect to pay and be paid in Australian Dollars. The main supplier of your phosphorus operates in Morocco.
Likewise, your supplier expects to pay and be paid in Moroccan Dirham. When you order phosphorus, first you sell Australian Dollars (AUD), and buy Moroccan Dirham (DH).
So far so simple — just find a seller of DH who wants AUD. You also need to hope that if you find a seller of DH that they will buy all your AUD for a reasonable price. This gets more difficult the larger the amount of DH you need.
Therein lies the rub. It would be nice if there were people who existed who bought and sold any amount (within reason) of any currency at reasonable prices. They could make money by the difference between the buy and sell price, and commissions. These people exist of course, banks often fulfill this role. There are also other non-bank institutions who do this. In general, we call these institutions “Market Makers” because they, quite literally, make the market.
These “Market Makers” need a supply of lots of different currencies. They need “liquidity”. If they are a bank this liquidity comes from other banks, central banks, and bond holders. For non-bank Market Makers the liquidity comes from banks, depositors, or other financial institutions who lend to the Market Maker. This currency is not supplied gratuitously, liquidity providers are rewarded with interest.
That, in a nutshell, is the traditional solution to the problem of international exchange with large orders. It works and has worked for a few centuries.
This begs the question: why do we need another solution if the current one works so well? What is the innovation that decentralising this system actually offers.
What is the innovation DEFI offers over the traditional solution?
The key to understanding the answer is looking at who gets to supply liquidity to the “Market Makers”. And so, who gets the (lucrative) interest in return. The average person (at least in most western countries) can usually expect to buy a bank bond with little hassle, and earn a paltry return.
Greater returns are offered by other “Market Makers” provided that the liquidity supplier lend a sufficient amount. For average people this amount is far out of reach and so this investment product is only available to the rich.
The key to the current system is humans trusting humans. Traditionally, we establish trust using contracts, standards, and legal enforcement. The idea is to make cheating more expensive than cooperating. Such a system implies large fixed costs which must be covered with fees at each level. This structure naturally tends to favour those with more.
The ethos of crypto is all about democratising finance. We want to get as many people access to as many investment products as we can. That is what DEFI does. Any person who owns an amount of crypto tokens can lend their tokens to a “Market Maker” and be rewarded with interest. Depending which token you choose to lend, the amount lent can be vanishingly small and the transaction fees minimal. The reason it can be made available to all is because instead of lending to an intuition or a person, you lend your tokens to a “smart contract”. This is a needlessly technical term, instead think of it as a machine. It takes instructions and follows a specific routine and spits out outputs.
The key to this new system (DEFI) is humans trusting machines, and machines trusting machines. When we establish trust between machines we need only be assured that the machines will follow the same routine and spit out the specified outputs. This system of trust does not imply an ever expanding hierarchy of fixed costs. In this sort of system fees can be minimal. This makes DEFI more accessible.
