What is DeFi?
DeFi simply means Decentralised Finance. This refers to financial services using smart contracts. These smart contracts are automated enforceable agreements that don't need a third party such as a bank or a lawyer, but instead make use of the blockchain technology.
Between the time periods of Sept 2017 and the time of witing this, the total value locked up in DeFi contracts has exploded from US$2.1 million to and estimated US$15 billion.
Because of the increase this has driven a massive rise in the value i.e market capitalisation of all tradable tokens that are used for DeFi smart contracts. Numerous tokens have risen in value by three or four times this year alone – and for some considerably more. An example , Synthetix Network Token has increased more than 20-fold, and Aave almost 200-fold. So if you had bought $1,000 of Aave tokens in August 2019, they would now be worth nearly $200,000.
Why is it the hottest ticket?
To discuss about this we would be looking at two points, which would give us a clear idea on what is going on in this space:
Maximum Disruption
Most of the DeFi programs which are built on the blockchain network, is the next step in the revolution in disruptive financial technology that began with Bitcoin in 2009. One area in which these decentralized applications (dApps) have taken off is cryptocurrency trading on decentralized exchanges (dexs) such as Uniswap. These follow the P2P protocols, without any company or other institution providing the platform.
Other services from DeFi allows you to:
- Borrow and lend cryptocurrencies to earn interest using platforms such as Compound or Aave.
- Create and exchange derivatives of real-world assets such as currencies or precious metals on Synthetix.
- Bet on the outcome of events using Augur.
- Take part in a no-loss lottery on PoolTogether, where everyone gets their money back and one lucky participant wins all the interest that has accrued in a shared pot.
- Buy cryptocurrencies known as stablecoins, which are pegged to the value of a particularly currency or commodity.
For example, DAI and USDC are both pegged to the US dollar.
DeFi is sometimes known as “Lego money” because you can stack dApps together to maximise your returns. For example, you could buy a stablecoin such as DAI and then lend it on Compound to earn interest, all using your smartphone.
Though many of today's dApps are niche, future applications could have a big impact on day-to-day life. An example will be you probably being able to purchase a piece of land or house on a DeFi platform under a mortgage agreement whereby you repay the price over a period of years.
The deeds would be put up in a tokenised form on a blockchain ledger as collateral and, in the event that you default on your payments, the deeds would automatically shift to the lender. This would happen automatically and so no lawyers or banks would be required, it could make the whole process of buying and selling houses cheaper.
Why the craze?
To start with, regulators have been behind the curve, and DeFi has been able to flourish in this vacuum. Take this scenerio, in the normal unsecured lending, there is a legal requirement that lenders and borrowers know one another's identities and tht the lender assesses the borrower's ability to repay the debt. But in DeFi, there are no such requirements. As a matter of fact, everything is about mutual trust and preserving privacy.
But the thing is regulators are having to weigh the delicate balance between stifling innovation and failing to protect society from risks such as individuals putting their money into an unregulated space, or banks and other financial institutions potentially being unable to make a living as intermediaries. But it seems more sensible to embrace change – and that seems to be happening. In July, the US Securities and Exchange Commission (SEC) made a major shift towards embracing DeFi by approving an ethereum-based fund, Arca, for the first time.
This is a welcome development and important one, since we know that one of the major challenges towards financial innovation is the hostile environment created by archaic regulations written for an era bygone. This has caused some DeFi projects to fail – including major ones such as New-Jersey-based Basis, which returned US$133 million to investors in 2018 when it concluded it couldn’t work within the SEC rules.
Another area to look at for the DeFi surge is that mainstream players are getting involved. Many high-street financial institutions are beginning to accept DeFi, and seeking ways to participate. For example, 75 of the world’s biggest banks are trialing blockchain technology to speed up payments as part of the Interbank Information Network, spearheaded by JP Morgan, ANZ and Royal Bank of Canada.
Big asset management funds are beginning to take DeFi seriously as well. The Most prominent is Grayscale, the world’s largest crypto investment fund. In the first half of 2020, it was managing in excess of US$5 billion of crypto assets, which includes US$4.4 billion of bitcoin.
We should also take into account the effect of COVID-19. The pandemic has driven global interest rates even lower. Some jurisdictions, such as the eurozone, are now in negative territory and others such as the US and UK could potentially follow.
In this present state, DeFi potentially offers much higher returns to people who saves than traditional institutions: for example, Compound, has been offering an annualized interest rate of 6.75% for those who save with the stablecoin – Tether. And that is not all, you also receive Comp tokens, which is an added attraction. With two-thirds of people without bank accounts in possession of a smartphone, DeFi also has the potential to open up finance to them.
One final important reason for the surge in people putting money into DeFi tokens is to avoid being left out of their explosive growth. Many tokens are worth nothing or close to nothing in practical terms, so we are seeing a lot of irrational exuberance.
But like it or not, we are heading towards a new financial system that is more liberalized and decentralized than before. The central question is how best to guide its development with checks and balances that minimize the risks and spread the potential benefits as widely as possible. That is the challenge for the next few years.