Defi, A Trillion-Dollar Tsunami About to Flood the Markets
When I first heard about Defi a few years ago, I admit it was pretty challenging to imagine how such an innovation could exist in a world controlled by powerful financial institutions, whether public or private.
Defi is still a pretty unknown term for most people, including many experts of the “traditional” financial market, especially those unable to recognize how disruptive blockchain technology is. So, let’s dive into the most promising financial instrument of our time.
Simply put, Decentralized Finance, better known as Defi, is a set of financial services provided through applications that do not rely on a central entity to control it.
Let’s think about how a bank works to clarify what differentiates a central entity, which provides the basis of a traditional financial system, from an application based on Defi protocols.
Banks offer a range of financial services such as loans, savings, stock investing, fund management, etc. For each of these services, the bank acts intermediating any transaction. And we are so used to this model that it seems natural to have an entity controlling all our steps, under the pretext of providing us with security, comfort, and who knows, a good income through the best investments, without us having to worry about anything at all.
With the advent of blockchain technology and the rise of the cryptocurrency market, banks now face competition from Defi. With Defi, all the goods and services offered by financial institutions like a bank or an insurance company, to cite a few examples, are now available in a decentralized manner. The software, and of course, the code, is the only intermediary between borrowers and sellers. Everything revolves around smart contracts.
What are smart contracts, and how do they work?
Whenever we need to borrow some money, we usually go to the bank and ask the account manager for a loan. Suppose the amount is not so high and you are a trustable customer. In this case, there is probably already a pre-approved credit line from the bank that allows you to do everything automatically through a banking application.
This is only possible because when you open a bank account, you sign a contract, usually written in small print, and both parties — you and the bank — commit to honor the agreement it contains. A new contract must be signed for any other situation beyond this initial contract, such as a credit to buy a property, for example.
Many people who do not have access to banking services resort to friends, family, and loan sharks when in need of money, although the latter is the least advisable. In these situations, the contract signed is verbal, and the morale penalties can be much more damaging than the high bank fees.
Unlike the cases presented above, smart contracts eliminate the need for documentation, the presence of intermediaries, and trust between the parties. You interact directly through a decentralized platform, and all the necessary relation is written in software code. The code contains all the essential contractual information that allows anyone to conduct transactions without both parties knowing each other. Smart contracts are the backbone of Defi.
On a decentralized platform managed by smart contracts, it is possible to trade cryptocurrencies, lend “money” and apply for loans, transact data, trade works of art (digital or otherwise), obtain real estate financing, etc. The possibilities seem endless and have experienced exponential growth in recent years.
The Defi Tsunami
In February 2017, when decentralized investment platforms came to life, the total amount invested in the segment was no more than a “measly” $50 million, as presented below in Goingecko’s chart.
From 2020 onwards, Defi gained recognition and a watchful eye from institutions and business people. A real tsunami flooded the Dapps, and the market was irrigated with billions of dollars. Data from Coingecko indicates that the current Defi market capitalization is around $130 billion, implying an astonishing growth of 259,900% in just over five years.
Today, more and more players are using Defi platforms to diversify their investments and ride a wave that is far from having reached its peak. And this is still a market in its early stages. In the coming years, trillions of dollars will further raise the tide of this unexplored ocean. The swell is yet to come.
Defi Challenges and Opportunities
Despite high expectations for the industry, diving headfirst into unknown waters can be too risky for novices or even for experienced financial professionals who have not yet set foot on Defi’s turbulent seas.
In a recent report, the consulting firm Immunefi pointed to a loss of more than $10 billion in Defi protocols in 2021 alone. The most common causes are code flaws, scams, and other malicious activities. To circumvent these problems, you must beware of miraculous promises and rely only on initiatives audited and certified by companies specializing in detecting fraud.
Truly Defi initiatives are managed by DAOs — Decentralized Autonomous Organizations, while others are Defi in name only. DAOs are executed via smart contracts. Unlike corporate governance bodies, where a board of directors decides the entity’s steps, the system users vote through tokens in a transparent and democratic way.
Defi in name only is a situation where a central body controls the governance and the funds. And this is no exception. Once an entity has such powerful control, like a traditional bank, it can ensure that its interests are served at the expense of the community. Thus, governance systems must be equally decentralized and verifiable.
The lack of regulation is another “problem” that plagues Defi projects. But to meet regulatory standards, the premise of decentralization would lose its essence since Defi applications would need to conform to the rules of a centralizing entity. How should the smart contract resolve an issue in case the community (the governance token holders) votes against the regulator’s interest? At first sight, there is no easy answer to face this situation.
I could devote an entire article or even a book to explore Defi’s risks, and it still wouldn’t be enough: Liquidity loss, Price slippage, Impermanent loss, Centralization, Security, and Usability are just a few of them. It is also true that many of these risks are present in traditional finance, and this should not be the determining factor in whether or not to invest in this emerging market, but quite the opposite.
Frank Knight, the distinguished founding economist of the Chicago School and professor of no fewer than three Nobel Prize winners, used to argue that the challengers of conventional approaches were the drivers of entrepreneurship and those who seized profit opportunities.
Who wouldn’t want to be free of fees and commissions paid to a myriad of intermediaries in the traditional financial system? Or exercising more control over one’s financial life, avoiding excessive supervision by centralizing bodies, combined with the possibility of investing in emerging markets that will completely transform the current economic and social models?
Over the next few weeks, I will take a deeper dive into the murky waters of Defi’s unknown ocean as I look forward to the Tsunami ahead. I invite you to come along with me.
Twitter: @GandaraMarcio
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