DeFi-ing the rules of traditional finance
Cryptocurrency and blockchain are the next frontier of Fintech, promising to decentralize and democratize finance. While there’s been significant innovation, risks remain.
Traditional financial institutions work well for some customers today, but not at all for others. US banks are great at moving money securely, but not so good at transferring currency quickly. Increasingly, however, that’s what some people and institutions need, especially in emerging markets and payments.
As an investor in FinTech following trends in infrastructure and B2B payments, I’m fascinated by how crypto and decentralized finance (DeFi) have accelerated over the last two years. DeFi is the bleeding edge of innovation in blockchain, rewriting the rules about how we make payments, deposit money, take out loans, generate yield and trade assets.
Using blockchain as the basis for a trustless economy opens up a host of new possibilities, as well as new risks. Many decentralized apps (dApps) bear risks that are limiting mainstream adoption.
What are CeFi and DeFi?
The first wave of crypto relied on centralized finance (CeFi) wallets and exchanges such as Coinbase and Gemini for storing, buying, selling, or trading different cryptocurrencies. And like traditional financial services (TradFi), CeFi customers had to go through standard know-your-customer (KYC), anti-money laundering (AML), and other compliance procedures before they could deposit funds, and they had to initially use fiat funds to buy crypto. Funding accounts or withdrawing funds could take days and often involved high transaction fees.
Enter DeFi. Instead of relying on an intermediary for custody, clearing and escrow services, DeFi relies on smart contracts operating on a blockchain, often Ethereum. This provides resistance to censorship: central financial regulatory bodies are unable to dictate monetary policy or compliance procedures, and there’s no native state-sponsored currency. Instead of relying on a trusted party, users trust the code in the smart contract, which can be audited. (As to how many DeFi users actually perform such audits is an open question.)
Where Crypto money meets TradFi
There are many areas where crypto solutions are taking a share when traditional financial services fall short. Here are three of the most common.
Payments and Wallets
Payment gateways and centralized wallets allow merchants to accept cryptocurrencies or stablecoins as payment methods. While major vendors (i.e. AT&T, Microsoft, Starbucks) and merchants in some countries like El Salvador have started to accept bitcoin payments, it’s impractical due to volatility and slow transaction throughput on-chain.
Stablecoins, whose value is pegged to an asset such as the US Dollar, are a better, faster, and cheaper way to make payments domestically and across borders. There are centralized stablecoins and algorithmic stablecoins which are decentralized.
Earlier this year, Visa announced it will begin settling transactions in USDC, a centralized stablecoin created by the Centre Foundation, a joint venture between Circle and Coinbase. Each USDC is redeemable for $1, and USDC is backed by reserves held by Centre. Because USDC was built using an open standard (ERC-20), it gets out-of-the-box compatibility with a large number of wallets, exchanges, DEXs, etc.
The DeFi solution: Algorithmic stablecoins and non-custodial wallets have emerged that are testing instant and low-cost payments that allow for no trusted authority like Centre, just code and economic theory.
Algorithmic stablecoins such as DAI and UST are managed by a decentralized autonomous organization (DAO) and automatically stabilized by arbitrageurs when the peg is above or below $1. The system is overcollateralized and maintained by the DAO, ensuring there’s enough crypto deposited to maintain the peg. One can use algorithmic stablecoins for remittances and cross-border payments instantly and at a fraction of the cost.
A programmable money protocol such as Terra is building an interoperable financial system that utilizes UST for various DeFi applications. In Korea, ~$60M monthly of Ecommerce transactions are already taking place using the Chai Wallet with KRT, the Terra Korean Won-pegged algorithmic stablecoin.
Non-custodial wallets such as MetaMask or Terra Station allow you to transfer any crypto into the wallet instantly. This allows holders of crypto to quickly transact their crypto or engage with numerous dApps for payments, earning yield, and trading.
Potential Risks: Finality is a double-edged sword and there is no way to dispute and reverse transactions on the blockchain, unlike TradFi where you have chargebacks and ACH reversals. If you forget the private keys to your non-custodial wallet, you lose access to your funds. There is also a risk of stablecoins losing their peg (e.g. undercollateralized, bad collateral, reserve assets default), which could lead to total value loss such as what happened with Iron Finance earlier this month.
Yield Seeking (i.e. lending, savings, spending rewards)
With interest rates at historic lows, and inflation starting to rise, the ability to make passive income via TradFi savings vehicles is diminishing.
If you deposit certain cryptocurrencies into CeFi lending platforms such as BlockFi, you can receive a passive interest rate of 9% on your USDC (from DeFi Rate as of this writing). If you spend using the Eco app, you can earn 5% back. These rates are far higher than what TradFi offers on USD savings and spending.
The DeFi solution: In addition to higher returns, DeFi protocols also enable yield farming (borrowing crypto from one protocol and depositing it in another that offers higher interest rates) and liquidity mining (offering tokens to an exchange that lends them to others, offering you a percentage of their returns). Both of these options offer high yields of 10% to 100% due to the ability to borrow for leverage.
Examples are Aave and Compound, which enable peer-to-peer borrowing of various crypto assets using smart contracts. Unlike with TradFi, interest rates on DeFi are adjusted algorithmically based on supply and demand.
Due to the higher yields in DeFi, many CeFi lenders are also starting to move volume to DeFi lending protocols, blurring the lines between CeFi and DeFi. Celsius is integrating with Anchor Protocol, and Nexo is one of the biggest minters of DAI.
Potential risks: Crypto accounts are not guaranteed against loss by FDIC. Most of the borrowing is used for leverage, which amplifies price swings and can cause large liquidations.
Most traditional brokerages are not accessible or economical to everyone. It may not make sense for people in emerging countries to trade in local capital markets. Non-US citizens may be subject to high foreign tax rates if they want to trade on the US capital market, which is the largest in the world, making it cost prohibitive. People from sanctioned countries are banned from trading on the US capital market altogether.
The DeFi solution: Using decentralized exchanges (DEXs) and trading synthetic assets.
DEXs like Uniswap allow anyone with a crypto wallet to swap tokens directly using self-executing smart contracts called Automated Market Makers (AMMs) without an intermediary organization for custody and clearing transactions. This dynamic enables more asset pairs and instantaneous trades on DEXs, sometimes at a lower cost than on CEXs like Coinbase Pro or Gemini. (More on the DEX landscape here.)
Those who cannot easily access the US capital markets can trade synthetic assets that track real-world assets, giving them price exposure without holding actual shares. For example, Mirror Protocol allows you to trade synthetic shares of Tesla (TSLA) using smart contracts that guarantee you the difference in TSLA’s real-world price between the time you buy and sell your mTSLA shares.
Potential Risks: For a DEX, participating in liquidity pools can generate high yields but can also result in an impermanent loss when withdrawing tokens if the token prices have changed since the initial deposit. Trading synthetic assets requires depositing crypto collateral at a specified minimum collateral ratio (C-Ratio). There are risks of liquidation of synthetic assets: see here the Synthetix blog on the mechanisms.
DeFi is only going to keep growing
As its name implies, the key differentiator for DeFi apps is that they’re decentralized: they cannot be ‘censored’ by a central authority. This has both positive and negative implications. On one hand, DeFi has created an explosion of financial innovation: instant low-cost payments, high yields, liquidity pools, and synthetic tokens tracking stocks. On the other hand, the tighter security placed on TradFi deters money launderers and fraudsters.
The truth is that DeFi is rapidly evolving. It’s a disruptive force that’s forcing the traditional players in finance to make long overdue changes. Startups that can bridge the gap between crypto developers and financial regulators, and do it at scale, will be the ones that succeed.
If you’re starting a related company or love talking about crypto, CeFi, or DeFi, don’t hesitate to reach me at email@example.com or Twitter (@natluu).
Thank you to Jeremy Liew, Tony Wang, and Erik Reppel for reviewing drafts of this post.