A Marketer’s Guide to the DeFi Movement
What is decentralized finance, how does it work, and what does it means for finance service brands
By now, everyone who works in the finance industry has at least heard of the term “decentralized finance,” often abbreviated to simply “DeFi.” For some, it may sound interchangeable with blockchain-related concepts such as cryptocurrencies, NFTs, DAOs; to a certain degree, that’s not wrong, as those concepts are the key manifestations of DeFi, which is more of a guiding principle to reorganize the way we handle money and other financial assets.
Finance has long been a centralized operation, as it is a business built on trust. We trust banks to hold our money and assets, which enables banks to offer loans and credits to businesses and people that need them. Nations issue their own currencies through either a central bank or government-controlled financial institution, and trust in the fiat currency is intrinsically tied to the authority backed by the state apparatus. Tax is also a centralized operation, in which local and national governments collect taxes and spend the money collected based on centralized budget plans. In short, the modern finance system is built on a centralized principle.
But, what if there is another way of doing things? What if, instead of placing our money and trust in centralized financial institutions, there is a new way to guarantee trust and facilitate transactions? That is at the crux of the value proposition behind the growing movement to decentralize the financial system.
Defining “DeFi” & How It Works
DeFi, short for decentralized finance, is an umbrella term for the emerging class of blockchain-based applications aimed at, as its name suggests, decentralizing the existing financial system by offering peer-to-peer alternatives for conventional financial services and institutions. DeFi promises an open and global financial system made for the internet era, providing an alternative to decades-old infrastructure and processes made for a pre-digital age.
To understand how DeFi works requires some basic knowledge on how blockchain works. As I wrote in this Blockchain 101 guide for media owners back in 2017:
A blockchain is an open, real-time database or ledger that maintains a continuously growing list of data or transaction records. In other words, think of a special live spreadsheet that everyone in the network can edit and verify. When a new transaction happens, it is instantly pushed to all participants in the distributed network (known as “nodes”) for documentation and verification. Once a new “block,” aka a group of new transactions, is created and cryptographically linked to the previous block, it becomes immutable and irreversible, barring a consensus agreement across the distributed network.
As the genesis of cryptocurrency, bitcoin is a good example of this decentralized principle. There’s no central authority that administers the issuing or circulation of bitcoin; instead, every bitcoin transaction is encrypted and logged on its dedicated blockchain, which was released as an open-source software in 2019, and new bitcoins are created as rewards for the “nodes” that beat others to encrypt a new block of transactions. There is no central server, as the bitcoin network is peer-to-peer, and there is no single administrator, as the ledger is maintained by a network of equally privileged users.
This is distinctly different from the centralized model in which our financial system currently operates. Instead of the type of centralized ledgers that banks and financial institutions use to log and verify each transaction, blockchain aims to eliminate the need for a central authority to verify the data input or validate the transactions, which is achieved by combining the openness of a peer-to-peer (P2P) network with the cryptography that ensures privacy and transparency. In other words, rather than generating trust through the authority of the state and financial institutions, blockchain is designed to distribute trust and back it up with algorithm-driven encryptions.
Besides bitcoin, which enjoys a first-mover advantage as the best-known cryptocurrency, most existing DeFi products are being built on Ethereum, the second-largest blockchain after the one that bitcoin runs on. For example, most NFTs, a breakout use case of blockchain in recent years, are created and traded on decentralized applications (aka “dapps”) that run on Ethereum. Each NFT is created to represent a particular piece of digital asset and verified by the network. When people sell and buy NFTs, their unique identifier gets encrypted into the token to denote ownership, which is then encrypted and distributed throughout the entire network. (Check out this marketer’s guide to NFTs if you need a refresher.)
Another key feature of Ethereum is the support for smart contact. Although DeFi kicked off with bitcoin, the idea of a decentralized finance system was spurred by applying blockchain’s distributed network to create new lending and investing dapps. Smart contracts allow payments or other agreed-upon actions to be automatically authorized and carried out once the predetermined conditions have been met, without any intermediary’s involvement or time loss. They consist of computer programs or transaction protocols which are stored on blockchains and enable new products that allow for decentralized borrowing, lending, and investing, often without collateral or real-life identities.
For example, decentralized exchanges (DEX) are online trading services based on smart contracts that enable users to trade crypto-tokens without intermediaries. Another unique investment product in DeFi is the so-called “no-loss” lottery hosted by dapps like PoolTogether. As its name suggests, it combines traditional lottery systems and crypto staking, allowing participants to pool their crypto-tokens for a chance to win a significant prize, which is made up of accumulated “staking fees,” and any participant can withdraw their full original deposit even if they don’t win.
Besides cryptocurrency-based DeFi products, decentralized autonomous organizations, aka DAOs, also stand out as a new way to create and manage financial products. By leveraging smart contracts encoded on blockchains to manage organizations instead of transactions, DAOs present a new way for communities to make decisions, fund projects, and share value on the blockchain. The power of decision-making is distributed to each participating individual who has invested their crypto assets in the DAO, and those individual stakeholders get to vote on what they want an organization to do.
Today, most DAOs are decentralized investment groups. DAOs like the interest rate protocol Compound and liquidity protocol Aave allow crypto-owners earn profits on billions of dollars worth of pooled assets and share financial rewards and governance within their communities. Flamingo DAO is an NFT-focused DAO that aims to explore investment opportunities for ownable, blockchain-based assets. In addition, startups like DAO Haus are building non-code tools for any creator, community or individual to start their own DAO.
Traditionally, financial institutions act as guarantors of transactions to eliminate human errors or frauds and reinforce the terms of transactions. But with smart contracts, blockchains like ethereum can theoretically replace the role of financial institutions. This forms an important component of the budding DeFi movement, which aims to eliminate the friction and efficiencies in the existing financial systems.
The Pros and Cons of DeFi
Since the debut of Ethereum in July 2015, DeFi has been quickly attracting developers and investors, growing from a fringe trend into a mainstream movement in a relatively short period of time. As the DeFi movement grows, it is getting easier and easier to onboard regular consumers and reach more people. PayPal and its subsidiary Venmo have both integrated crypto-trading into their flagship apps as they push educational content and offer free bitcoins as sign-up rewards to entice more users to look into crypto investment. Payment company Square created a new business unit dedicated to DeFi, while also adding crypto trading features to its P2P payment app Cash.
At a time when public trust in government and institutions are in decline, DeFi offers an alternative model that aims to digitize trust and decentralize institutional power. But the elimination of intermediaries, and with them, centralized control, is a double-edged sword. Every defining characteristic of DeFi stems from the decentralized model it is built on, and each underlines both its strengths and downsides.
First, the fact that DeFi runs on a distributed network without a central authority allows for open permissionless accessibility, meaning that anyone with an internet connection can access it and sign up to use any dapp they want to use and utilize in whatever DeFi product they want, without needing a bank or financial institution to give permission and sign off on things like loans and investments. As a result, DeFi enables a faster and easier verification process in lending and borrowing applications. This is theoretically great for democratizing access to financial services, especially for a significant portion of the global population that is still unbanked or under-banked.
To further enhance accessibility, there are many noteworthy efforts to improve the interface layer of blockchain apps and make them more user-friendly. For example, crypto wallets like Rainbow and MetaMask both enable users to easily access their Ethereum wallet through a browser extension or mobile app, thus serving as a gateway to other dapps on Ethereum. There is also WalletConnect, a web3 open protocol for connecting apps to mobile wallets with QR code scanning or deep linking, which further enhances the ease of use and broadens the type of dapps that regular users can access without understanding the underlying technical mechanism of blockchain.
On the flip side, because there is no central authority to oversee and verify the legitimacy of each DeFi product, the world of crypto-trading and NFTs has been overflowing with scams and frauds. According to FTC data, nearly 7,000 people have collectively reported more than $80 million of scams in the past 12 months alone.To be clear, scams and frauds exist in DeFi not because the blockchain technology is vulnerable to hacks or technical exploitations; on the contrary, the cryptographic encryption it uses makes them quite secure. (Although some DeFi projects did get hacked because of developer incompetence, which causes coding mistakes that hackers can abuse.)
Instead, the scammers and fraudsters in DeFi tend to use social engineering and take advantage of many new crypto investors’ “get rich quick” mindset to get them to buy into a maliciously constructed DeFi product that has no intent to reward its investors. And because DeFi runs on permissionless networks, there is no easy, effective way to stamp out such scams and frauds other than educating the users on due diligence. By virtue of being decentralized, DeFi shifts the responsibility of product research and verification from financial institutions to individuals — a responsibility that not every user is financially literate or tech-savvy enough to take on. For instance, with most DeFi products, simply forgetting your log-in password could mean permanent loss of your crypto assets.
Similarly, because DeFi products run on blockchain networks that use cryptographic encryption to log all transactions and distribute them to every participant on the chains, it allows for a unique kind of transparent yet pseudonymous accountability. But this open-book approach is also a double-edged sword, since it both helps stymie internal corruptions and frauds and opens DeFi products to illegal transactions. Because they are not controlled or regulated by any one government, and their cryptography makes it much harder to track and reverse cryptocurrency-based transactions, crypto is vulnerable to theft and embraced by money-launderers. And since only those who are able to read code can understand the in-and-outs of the activities logged on a blockchain, most users tend to place their trust in the cryptographic encryption blindly.
Then there is the question of scale. Blockchain networks tend to have a smaller capacity for verifying transactions, since each transaction has to be encrypted and verified by a majority of nodes in the network via complex cryptographic algorithms before it could be logged. For example, Ethereum could process almost 13 transactions every second at full capacity. On the contrary, the centralized financial services could accommodate thousands of transactions per second. This limited transaction capability would pose a challenge to the scale of DeFi products, should they become more mainstream, and this is an issue for which the crypto community is actively working to find uncompromising solutions.
Besides scalability, the negative environmental impact of crypto-mining has received increasing press coverage in recent months. Bitcoin, for example, is energy-intensive by design, as it is “mined” by millions of high-powered computers around the world racing to solve the complex math equations used for encryption. The same is true for most decentralized applications that make up the DeFi movement. The ongoing debate is far from over in regards to whether the energy used in mining is higher than the energy wasted in the intermediary inefficiency in existing centralized systems. And developers of some blockchains, including Etherum, are already planning a transition to a mining method that is more friendly to the environment.
To recap, proponents of DeFi tend to promote the key benefits that a decentralized financial system could offer to consumers and investors, such as permissionless accessibility, transparent accountability, and elimination of intermediary fees. However, being an open-source system that anyone can join pseudonymously also opens up a lot of potential issues. So far, most critics of the DeFi movement have been skeptical about its ability to scale, prevent fraud, and function in a sustainable manner.
The Counter-Movement to Co-Opt DeFi
Needless to say, the DeFi movement is a major disruptive force that has the potential to transform how the entire global financial system operates. Bitcoin has been gaining adoption among mainstream users everywhere. Even Walmart recently added Bitcoin ATMs to some of their retail stores to allow shoppers to deposit loose change in exchange for cryptocurrency. As financial institutions and financial service brands recognize the turning tide on crypto, and by extension, the DeFi movement, many have also made proactive moves to capitalize on this growing sector via partnerships and integrations, or perhaps even neutralize the threats it poses to the existing order in the process.
Looking to appeal to younger consumers and their transaction preferences, many financial service brands have been partnering with crypto startups to introduce DeFi products into their own services. For example, Mastercard recently announced a partnership with Bakkt, a crypto marketplace platform, to allow cardholders to pay down their balances and earn loyalty points with bitcoin. They will also have the option to convert rewards points they already have into bitcoin and store it in a Bakkt digital wallet.
This partnership is recognition that we have reached a point where some credit card users prefer bitcoins over regular loyalty points, and Mastercard is just the latest example of financial service companies letting go of some of their apprehension about cryptocurrency. According to Visa, over $1 billion worth of cryptocurrency was spent by consumers globally on goods and services through their crypto-linked cards in the first six months of 2021. Visa has formed partnerships with three different crypto platforms (Circle, BlockFi, and Coinbase) to facilitate these transactions. Similarly, American Express also invested in a cryptocurrency trading platform called FalconX in 2020.
Credit card companies are just one example of traditional financial institutions making more room for regular people to acquire and use crypto. In April, Coinbase — a platform for buying and selling cryptocurrencies — became the first crypto company to go public — which effectively allows people to invest in cryptocurrency without having to actually buy any particular coin. In mid-October, the first cryptocurrency-linked exchange-traded fund (ETF), which is a basket of securities tied to the future price of bitcoin, began trading and pushed bitcoin price to a new height. Interestingly, these examples provide new ways for companies and individuals to invest in the DeFi movement without directly buying any cryptocurrency or NFT, which allows them to hedge their bets on the growing fractions of DeFi.
Conclusion
At its core, blockchains are about distributed trust, and in the world of financial services, trust is always at a premium. The empowering privilege of directly controlling where your money goes in investment comes with a hefty side of personal responsibility that may be difficult to manage for most retail investors. Therefore, it is perhaps unsurprising that most legacy brands in the financial industry have made investments and launched products to co-opt the movement, as they aim to combine the best of both models. Whether these two models are compatible in the long run is still to be determined, but it certainly doesn’t hurt to hedge your bets and give the customers what they want.
DeFi is a multi-pronged developing movement, and we’ve only scratched the surface in this introductory piece. If you wish to learn more about the DeFi movement, or discuss the implications that other blockchain-powered applications may bring to your industry, please reach out to our Group Director Josh Mallalieu (josh@ipglab.com) to start a conversation.
