Explain like I’m 5: What is DeFi?
The greatest trick modern banking ever pulled is convincing the world it doesn’t create new money. So how and why is DeFi different?
DeFi and fountain pens: The origin story
A common misconception is that banks can only lend the money depositors save with them. This idea fails to explain where new money comes from. Because, if banks choose to operate only with the money depositors entrust with them, business would grind to a halt.
There simply won’t be enough money.
Although most money exists today in the form of bank deposits, new money emerges in the financial system when banks make a loan.
Here’s how it works: When you request the bank for a loan, it does not reach into its savings accounts and lend you depositors’ money. Instead, it creates a new deposit account in your name and simply credits it with the sum you need. Et voila! You have new money at your beck and call.
Economists call this fountain-pen money. Every sign off a banker makes on a loan creates more of it. To judge you worthy of this magic-trick money, a bank runs your profile through a set of benchmarks and determines your creditworthiness. And if you don’t meet its benchmark, you’re cut off from the capital and most financial services in the system.
If you’re looking for a workaround, there isn’t one. That’s it.
CeFi can cut you off from cheap capital
Centralized finance (or traditional banks; CeFi hereafter) makes money in the fine margin between the interest it pays depositors on savings and the interest it earns on loans. In this jugglery between interest rates, when the latter outweighs the former, banks promptly turn a profit.
Say, your bank decides these profits aren’t cutting it anymore. They shake up their strategy and move their revenue-generating focus to a different line. Wouldn’t this tie your access to capital to the perennial ebb and flow of the shifting tides within this centralized monolith? This puts entrepreneurial spirits under duress and limits the expansion of vital revenue-generating IP.
After all, what the fountain pen giveth, a fountain pen can indeed taketh.
This explains why more investors than ever are saving money with decentralized services–especially in the age of web3. Guided by public ironclad algorithms, they replace opaque fountain-pen decision making with a rule-bound system where anonymous individuals can unite to transact.
What is DeFi?
Decentralized Finance (DeFi hereafter) offers automated and open source credit lines and services that replace traditional banking. It eliminates the middle-man and throws banking open to anyone with a smartphone and working internet…
… which tells us nothing about DeFi.
How does DeFi actually work?
Consider a use case detailed in this Forbes article on DeFi.
Assume the money you save with a bank earns you an interest of 0.5% on the sum. Moments after paying you, the bank opens a deposit account, credits it with new money, and lends to a borrower. For its trouble, the bank charges 3% interest on the sum loaned.
The 2.5% difference between what the bank pays you and what it earns disappears straight into the pockets of bankers and a host of middle-men. This need to feed the chain makes access to capital expensive for those who need it the most: cash-strapped entrepreneurs, students, and home buyers.
But DeFi rips this chain out. Peers can transact with each other directly with programmable smart contracts. This (theoretically) lowers the premium borrowers pay and increases the percentage lenders pocket–while still keeping access to capital cheap and truly democratic with peer-to-peer systems.
For instance, a DeFi lender can make a flash loan via the ethereum blockchain and pocket an interest of 1.5% on it. This is more than the 0.5% they would have earned with the bank and less than the 3% borrowers would have paid.
Suddenly, access to affordable capital isn’t subject to the mood swings of fountain-pen wielders.
Can DeFi really do a better job than banks?
Traditional finance is a proven time-tested system. Lenders typically lack the resources and knowledge to scout for borrowers. Enterprising banks pry open this space and camp in it with their stratagems. Soon, multiple services converge under one bank’s roof.
Customers can waltz in and cherry pick from a neatly arranged shelf of loans, asset swaps, leveraged trading, investing, insurance, and every other financial product humans can think up. But, despite how tried and tested traditional banking is, it’s a system fraught with all-too-human biases.
However, the day one fails to meet the criteria for the bank’s ideal borrower profile–which may be too broad or too narrow for you–you risk losing access to all capital available in the system. Suddenly, your project could be robbed of the resources it needs to scale because an executive crunched your details against a set of arbitrary benchmarks and decided you don’t make a good fit.
Sometimes, even having enough assets to back one’s loan doesn’t guarantee capital. After all, one may not be able to showcase those assets in a way that’s digestible for the bank. In fact, your assets could also fail to tally with the bank’s definition of acceptable holdings.
In the face of such risks, decentralized protocols offer two striking benefits. First: a more democratic and accessible alternative to traditional streams of capital. Second: the opportunity for banks to identify points of friction and rethink their financial products.
We don’t expect DeFi to even remotely compete with CeFi anytime soon–especially in established bastions like Europe and North America–where adoption rates for emerging technologies are traditionally slower. But it gives centralized financial institutions enough food for reimagination–which is significant.
You, I, and DeFi
DeFi hurts from the misconception that it’s a catch all movement for hipsters that is irrelevant to the practical workings of the world at large.
But DeFi applications simply unbundle traditional finance. It crystallizes the work done by banks, insurers, and exchanges–like lending, borrowing, and trading–and throws access open to every individual.
Running on top of blockchains and crypto assets, DeFi records your transactions on an anonymized public ledger (the blockchain) with proof of asset (crypto) ownership and zero middle-men.
However, it’s still far from being a silver bullet to every CeFi problem there is. Currently, it’s suffering from early-stage issues like overcollateralization–which might inefficiently lock up capital. But, with almost $77B locked up in value, the boat could tilt either way on this issue.
Although DeFi is a thrilling playground for some of finance’s smartest brains, it still comes with significant pitfalls. For instance, every smart contract carries an inherent risk. When smart contracts plug into one another and interact, this risk compounds, making your investment a ticking bomb.
And even overcollateralization cannot account for cryptos that lose their value in a heartbeat. Traditional mechanisms like margin calls wouldn’t be able to act quick enough to safeguard your investment.
Our verdict: Why DeFi will reshape the future of finance
Traditional investors looking to park money through DeFi services might harness the peer-to-peer freedom of the system to build more regulated and less mercurial mechanisms. Conventional assets like stocks, real estate, and bonds could enter DeFi as tokenized instruments via NFTs.
This would increase system-wide regulation (otherwise traditional investors would never partake) by introducing protocols like KYC and more fluid credit scores. We predict that a new system that is between CeFi and DeFi will become the more practical resort in the near future while DeFi’s protocols mature.
People normally excluded by today’s financial system will find a voice within this newer system. Financial instruments unlike anything we have seen before will become the norm. And a strange blend of CeFi’s safety and DeFi’s agility might become the more common approach to finance for the homo economicus.
