DeFi Explained – Is This Innovative Financial Technology the Future of Banking? (2021)

DeFi Explained

DeFi Explained – Today I’m going to discuss Decentralised Finance (DeFI). I’ll cover what DeFi is, its defining properties, how it works, how people can benefit from it and the challenges and limitations that this popular cryptocurrency application faces in reaching mass adoption.

Defi Explained – What is DeFi?

Decentralised Finance (DeFi) is a non-custodial, permissionless, openly auditable and composable financial innovation that provides an egalitarian system of finance to the world. From a technical perspective, DeFi operates as a group of decentralised applications (dApps), built primarily on the Ethereum smart contract ecosystem. It utilises blockchain technology and smart apps to provide access to financial services such as investing, lending and trading, without relying on an intermediary such as a centralised institution. As such, DeFi is a collection of goods and services that substitute centralised financial entities such as banking, insurance, bonds and money markets.

The Four Main Properties of DeFi

While appearing complex on the surface, DeFi can be understood by its four main properties:

Non-Custodial

Permissionless

Openly Auditable

Composable

I’ll break down each of these components to highlight what DeFi is and why it’s being adopted at a monumental rate.

Defi Explained- Property 1: Non-Custodial

Traditional finance operates on a custodial model, where an intermediary such as banks, governments and payment companies hold custody of funds. Originally, this was seen as a more stable and necessary form of wealth management, with custodial services being necessary for cross-border payments. However, there are issues with the custodial model, such as being susceptible to hacks, being slow (it can take days and even weeks to transfer money), non-private (they can capture user data) and exclusive, with billions of people being unable to create or access bank accounts.

DeFi was introduced to combat these concerns, with the first property being that it is non-custodial. This means that users have full control over their funds at any point in time. Holding on-chain assets can be done without a custodian due to smart contracts, which are capable of executing deterministically and verifiably on an underlying blockchain. By cutting out the middle-man, DeFi enables its users to maintain complete control of their assets and execute transactions/trades instantaneously and transparently.

Defi Explained – Property 2: Permissionless

Traditional banking isn’t permissionless, with multiple barriers to entry existing. These barriers can include but aren’t limited to licensure laws, capital requirements, access to financing, regulatory compliance and security concerns. At the time of writing this, almost 1.7 billion people are unbanked globally. This represents almost a quarter of the global population.

As seen in the diagram below, less than half of the population of some countries such as Morocco, Vietnam, Mexico, Peru and Nigeria have access to bank accounts. However, these populations are constantly gaining more access to the internet, which is where DeFi can come into play.

DeFi is permissionless, meaning that anyone with a crypto wallet and internet connection, regardless of their geography, race, gender, culture or starting capital can access DeFi applications. This overcomes global poverty barriers, enabling anyone to access traditional banking features such as savings accounts, loans and credit on their phone. As such, DeFi aims to provide what has traditionally been centralised financial services to the masses.

Defi Explained – Property 3: Openly Auditable

Traditional financial institutions and payment providers have been exploiting user data and spending habits for profit. This shouldn’t come as a surprise, by having access to your financial trails, banks can sell this data to third parties who can then tailor their ads and services to users. In Australia, Westpac has been found to sell anonymous aggregated information about customer’s spending habits to other businesses.

This occurred through a data-sharing platform called ‘Data Republic’, which is jointly owned by NAB and ANZ. Similarly, Commonwealth Bank was identified as selling anonymous aggregated information about transactions to its business banking clients. As such, the Big 4 banking institutions in Australia have ties to selling consumer data, sparking a debate on what banks do with personal information.

DeFi however, is more transparent and offers a greater degree of privacy. On the Ethereum blockchain, for example, every transaction is broadcast to and verified by other users on the network. These addresses are encrypted keys, which enable users to be pseudo-anonymous. DeFi protocols are also built with open-source code that is available for anyone to view, audit and build upon. Similarly, the transparency around transaction data allows anyone to verify the legitimacy of network activity and ensure that the network is fully collateralised and healthy.

Defi Explained – Property 4: Composable

Centralised financial institutions offer their products and services. These products and services are subject to the bank or financial institution’s approval, meaning that you need to be approved to use these services. Similarly, if you wish to use another financial service, you may be rejected by your current provider or by the prospective provider. This limits the potential for you to access and optimise available products.

Alternatively, DeFi overcomes this issue by being highly composable. Composability in DeFi refers to the ability for applications and protocols to interact with one another in a permissionless way. The resulting product is a series of financial products operating synergistically with each other to offer new forms of utility and services.

To simplify this, a common analogy is to think of DeFi applications as ‘money Legos’. Each app or Lego brick is a specific financial product or service that is capable of being combined with other apps/bricks. New DeFi apps can be built upon prior bricks to combine many of these specific-purpose Lego-brick products.

The resulting product is a more complex and comprehensive DeFi service that is customisable to specific user needs. For this reason, DeFi offers a world of investment products. These products include flash loans, automotive investing and yield farming among others. For more information on Defi Compatibility, please refer to this guide:

The True Power of DeFi Composability  

Summary of Four Main DeFi Properties

PropertyWhat it Enables
Non-Custodial  Users maintain complete control of their assets 
Permissionless Everyone is capable of accessing financial services  
Openly Auditable  Anyone is able to view transactions to ensure that they are transparent and truthful  
Composable DeFi apps are interoperable and capable of being used together to provide customisable services.  

DeFi Explained – What are Smart Contracts?

DeFi Explained - Smart Contracts

Smart contracts are programs stored on a blockchain that lay out what will happen when predetermined conditions are met. Designed primarily to transfer value through digital assets, the code enables these transfers and transactions to occur purely based on what is programmed into the code. As such, they create a trustless relationship. This trustless relationship automates transactions to ensure that all participants can be immediately certain of an outcome, without a centralised intermediary such as a bank or payment platform like PayPal being involved.

By eliminating the need for an intermediary, smart contracts remove personal judgement from transactions, eliminating human error and providing an efficient, frictionless exchange.

DeFi Explained – How do Smart Contracts Work?

Smart contracts follow an ‘if/when…then…” statement that is written into code on a blockchain. A network of computers then executes the actions after these predetermined conditions have been met and verified.

Once these conditions are met; the contract is executed immediately without the need of an intermediary. This eliminates a plethora of issues associated with centralised institutions such as additional fees, long processing times, human error and malicious interference.

For example, under traditional banking systems, it can take up to 5 days to send funds from one location to another. Banks and payment platforms can also prohibit funds from being sent to certain parties such as crypto exchanges or charities. This was seen with the infamous bank blockade of WikiLeaks.

Smart contracts overcome this issue due to their simple, yet efficient programming. In addition to significantly increasing the processing time, they also provide an additional layer of trust and transparency. When a transaction is executed on a smart contract, an encrypted record of the transaction is shared across all parties. This provides a secure and transparent way of ensuring that no information has been altered or interfered with by an external party.

DeFi Explained – DeFi Categories and Their Use Cases

DeFi Explained - DeFi Categories

There are numerous categories of financial products that enable the DeFi ecosystem. These include Stablecoins, Exchanges, Borrowing and Lending, Derivatives, Fund Management, Lottery, Insurance and Payments among others. To provide a comprehensive overview of the DeFi ecosystem, I have broken down each category further below.

Stablecoins

Cryptocurrencies are notorious for being a highly volatile asset class. To overcome this, stablecoins were introduced to provide a stable, unfluctuating asset class to the cryptocurrency space.

Stablecoins are indexed to other stable assets such as the US dollar or Australian dollar. Due to being pegged to a stable asset class, they do not fluctuate in price as other cryptocurrencies do. While not technically a financial program, stablecoins are fundamental for making DeFi applications more available by providing a stable store of value. There are two types of stablecoins available – centralised and decentralised.

Centralised Stablecoins

Tether (USDT) was the first stablecoin to be released and it is indexed to the USD. It is also the largest stablecoin by market cap. However, as it is centralised it requires trust from users that Tether’s USD reserves are completely collateralized and that they even exist in the first place. This has been a point of debate raised numerous times as seen in the below articles.

The Tether Controversy: A Brief History

Tether’s First Reserve Breakdown

Decentralised Stablecoins

Decentralised stablecoins attempt to address this issue of trust. Differing from centralised stablecoins, decentralised stablecoins are generated through an over-collateralisation process which is run entirely on decentralised ledgers. Decentralised, autonomous organisations and individuals alike can audit their reserves. This is why smart contracts and being openly auditable are paramount features for ensuring a decentralised financial network.

Borrowing and Lending

Traditional financial services require customers to have bank accounts to access their services. As discussed earlier, approximately 1.7 billion people, therefore, are excluded from services such as borrowing and lending for that reason. Additionally, borrowing from banks is subject to further conditions. These conditions typically include having adequate collateral and depending on the country, a high credit score. This is problematic for people without a history of bill paying or credit cards, as it can be hard to generate an appropriate credit score without these proofs, particularly in the United States.

DeFi overcomes these impediments to borrowing and lending by allowing anyone to utilise their digital assets as collateral to access loans on dApps. Users can also participate in lending pools, where they can receive interest on these assets for participating in the lending market. By simply having access to a phone and internet connection, users can access these features without traditional barriers of entry such as having adequate collateral in centralised-approved assets or a credit score.

Exchanges

Exchanges are crucial financial instruments for buying, selling and trading cryptocurrencies. Traditionally, crypto exchanges have been centralised, with Binance and Coinbase being some of the most popular. These exchanges act as centralised markets, meaning that they act as both middlemen and custodians for the exchanged assets. Subsequently, users of these exchanges don’t technically have control over their coins and are susceptible to losing their funds if said exchanges become compromised or hacked.

A prime example is Mt Gox, an early centralised exchange that during its peak, handled 70% of all bitcoin transactions worldwide. They were hacked, resulting in users losing 740,000 bitcoin and the company losing 100,000 bitcoin from their private reserve. This is where the phrase “Not your keys, not your coins” comes from.

DeFi Explained - Mt Gox

While these exchanges have improved their security over time and some are insured in the event of hacks, many users prefer to use decentralised exchanges, as they aim to address this issue. Users who utilise decentralised exchanges do so without ever giving up ownership of their coins. Such examples include PancakeSwap and UniSwap, which operate through personal wallets rather than custodial ones.

Derivatives

Derivatives are contracts that derive value from underlying commodities such as stocks, currencies or bonds. Traders typically use derivatives as a hedge against their trading positions to reduce the risk of specific trades.

While these are primarily offered on a centralised exchange, DeFi is growing to encompass derivatives markets. This makes yet another financial product available to people who may not be able to achieve access to centralised exchanges or those who wish to access these contracts in a decentralised way.

Fund Management

Fund management is the practice of monitoring assets and controlling their cash flow to produce a return on investment. There are two primary forms of fund management – active and passive.

Active fund management has a team that makes specific investment decisions to try and generate a return on interest (ROI) that beats a specific index. This is more often than not the S&P500.

Passively managed funds are funds that don’t have a management team but are intended to replicate a specific index’s performance.

In recent times, DeFi initiates have been put in place to provide decentralised passive fund management. Due to DeFi’s transparency, users can conveniently monitor how their funds are handled and identify their fund’s costs.

Lottery

Due to the transparency of public blockchain and smart contracts, it was only a matter of time before the lottery and other chance-based financial activities were adopted in DeFi. While traditional lotteries have relied on a central authority identifying the winning combination, smart contracts and DeFi protocols provide an openly auditable and verifiable system of chance. This eliminates the
guesswork out of the validity and legitimacy surrounding how winning numbers are generated.

In yet another DeFi innovation, there are No-Loss Lottery Systems that provide refunds for purchasers of failed tickets, ensuring that no one loses money. For more information on how this system works, please refer to the following guide:

Ethereum No-Loss Lottery System

Payments

One of the main intentions for the introduction of Bitcoin and cryptocurrencies as a whole was to facilitate decentralised and trustless value transfers between two entities. In simple terms, it allows a payment or exchange in value to occur without a centralised authority or intermediary (bank, PayPal etc.). While Bitcoin succeeds in this regard, DeFi is introducing a more innovative payment method as it grows in popularity

. Some DeFi projects are trying to repurpose payments as streams rather than as traditional transactions. For example, bank transfers may not be processed on a weekend as they are often processed on business days. Similarly, the stock market only operates on weekdays during specified periods, meaning that trades can’t be executed over the weekend. Transactions can also take days to be processed due to individuals having to manually input this data into a ledger.

Smart contracts which facilitate automatic payments can help businesses and people transact on a global scale, almost instantaneously. Subsequently, DeFi enables a digital asset market that runs 24/7, 365 days a year without failure.

Insurance

Similar to traditional insurance, DeFi insurance aims to protect users from losses in return for a specific premium based on the size of their holdings. However, it deviates from traditional insurance protocols which are generally issued and underwritten by a multinational issuer. Instead, DeFi insurance policies rely on a community of users to dictate premiums and orchestrate payouts.

This occurs through a DeFi insurance protocol which consists of underwriters that provide capital to the pools for each protocol covered. Users that provide capital then take a share of premiums (also known as staking). The decentralised nature of DeFi insurance makes this an innovative and new form of insurance. As users can receive insurance from a non-centralised issuer and can even generate income by underwriting/staking due to the regular income stream that is provided from premiums.

Challenges and Limitations

DeFi despite being a promising form of technology, in theory, is still in its infancy. Subsequently, it is only being used by a small minority of the global population at the time of writing. Due to this small adoption, DeFi is yet to be tested on a large scale and has several challenges and limitations to its ability to be adopted by the global population.

Technical Risks

As previously discussed, smart contracts and the blockchain protocol are crucial for ensuring the success of DeFi. Therefore, there is a significant risk of coding errors on the blockchain and bugs in smart contracts, which can lead to hacks and other security-related attacks.

Additionally, the majority of dApps are built on the Ethereum platform which has experienced issues in the past surrounding high volumes of users. These issues have included network clogging resulting in congestion with transactions being processed and exorbitant gas fees which can make it impractical to facilitate exchanges and transactions on the Ethereum network.

These issues of coding errors and smart contract bugs are progressively being addressed through third-party audits, insurance protocols, bug bounty programs and advanced dApp protocols and networks being introduced. Similarly, different smart contract platforms such as Solana, Cardano and Avalanche have been growing in popularity. This provides a diverse ecosystem for DeFi to operate out of, as there is less of a dependence on Ethereum to run as the primary DeFi platform.

User Risk/Human Error

DeFi is a new technology that encompasses a variety of complex financial services. Such forms of technology and financial products remain esoteric to the majority of people, particularly people who aren’t familiar with technology or economics. As such, there is a risk of users accidentally losing their money by failing to understand how non-custodial wallets or the correct security procedures for storing their tokens. Additionally, new users may participate in scams such as rug pulls or become over-leveraged in margin trades that they don’t understand.

These issues will diminish over time if DeFi and cryptocurrency as a whole become more widely adopted. In a similar vein, better security protocols and education will be developed over time, mitigating the risk for human error. However, for the immediate future, usability risk remains a large concern and anyone entering the DeFi space should do so with caution after conducting their own research.

Regulation Risk

DeFi is a relatively small aspect of the crypto space, accounting for less than 3% of cryptocurrency market activity. However, it is growing at a rapid rate, which will undoubtedly cause further regulatory reviews. Additionally, DeFi is about providing banking services to the masses, which inherently threatens the profitability of large banks and other centralised financial institutions.

For this reason, DeFi will likely be continuously targeted by regulatory bodies to enforce different limitations on how people can utilise DeFi protocols, countering the core tenant behind a decentralised financial system.

Governance Risk

Some DeFi protocols such as Uniswap operate autonomously through smart contracts. However, other protocols may run on a human-controlled governance process. This process actively adjusts protocol parameters to keep the system solvent.

To participate in the governance process, users and investors need to acquire a governance token that is directly assigned to governance rights on a liquid marketplace. Holders of these tokens are then able to vote on protocol changes that can guide future direction.

Subsequently, there is a looming threat of governance attacks where a financially equipped adversary can acquire the majority of liquid governance tokens. This could enable said users to influence the governance in a way that benefits their best interest at the expense of the community’s. As of now, there are no documented successful governance attacks on an Ethereum-based DeFi project. However, the threat remains feasible among dApps.

Scaling Risk

DeFi protocols such as Ethereum and other Proof of Work (PoW) blockchains have a fixed block size. For a block to become part of the chain, miners of these platforms need to execute all of the included transactions into their machines. Subsequently, if these protocols are unable to scale sufficiently, it is unfeasible for these platforms to process large amounts of financial transactions. This can be a hindrance to mass adoption and can lead to significant congestion in times of peak market action.

Currently, Ethereum can execute 13 transactions per second (TPS). Bitcoin can execute approximately 5 TPS. To put this into perspective, Visa can process 65,000 TPS. As such, a lack of scalability places DeFi at risk of being unable to meet requisite demand and global adoption.

This is currently trying to be addressed through Ethereum 2.0 and Layer-2 scaling solutions such as Polygon (MATIC). Similarly, the emergence of other blockchain platforms such as Cardano, Algorand and Solana which allows for 257, 1,000 and 50,000 TPS respectively has bolstered hopes for the future of DeFi scalability. However, these for the most part are yet to be tested to their full capacity.

Defi Explained Summary – What Does the Future Hold for DeFi?

DeFi Explained

DeFi is a revolutionary technological innovation that has the potential to lead to a significant paradigm shift in the financial sector. Of the almost 1.7 billion unbanked, DeFi represents an opportunity for these individuals to gain access to financial services that they otherwise would be unable to, such as savings accounts and the ability to lend and borrow wealth.

Additionally, DeFi is also highly transformative in its ability to provide the opportunity for people and institutions to access financial platforms without the need for a centralised intermediary or trusted third party. For these reasons, DeFi can provide a level of financial autonomy, freedom, discrepancy and transparency that has not been witnessed throughout history.

Despite its promise, however, DeFi is not without its limitations, which can be largely attributed to it still being in its infancy stage. As of November 2020, DeFi represented 1% of the overall crypto market cap. Whilst growing exponentially during the previous year to 3% at the time of writing (September 2021), DeFi still only accounts for a small minority of the overall crypto market cap.

This percentage is significantly smaller when factoring in the global financial markets. Additionally, there are several challenged and limitations surrounding the use of DeFi and dApps. These include but aren’t limited to: user error, technical risks, scaling limitations, government risks and regulation from external financial agencies and governments.

However, DeFi shows immense promise in providing global access to financial products in a transparent and trustless manner. Additionally, if DeFi continues growing at such an exponential rate, many of DeFi’s current challenges can likely be addressed through expanding technological innovations and a greater degree of blockchain education among the general population. This has been seen through several metrics such as the expansion of crypto-related education programs, academic peer reviews and books, the rapid expansion of scaling solutions and the addition of third-party audits, insurance protocols and increased security protocols on dApps and DeFi platforms.

For these reasons, DeFi may very well be a mainstream product within the next decade, given the widespread, systemic issues that it aims to address and the constant evolution of blockchain technology to enable such visions.

Want to Learn More about DeFi?

The following resources helped me write this article and expand my general knowledge of DeFi. They are highly recommended.

SoK: Decentralized Finance (DeFi)
Decentralized Finance – Ethereum.org

Want to Buy Crypto and Earn Interest?

The following reviews cover my favourite crypto exchanges and interest earn platforms

The Best Crypto Exchange for Beginners – Digital Surge

The Best Crypto Exchange for Advanced Traders – Binance

The Best Interest Earn Platform – Celsius Network

The Best Crypto Rewards Card – Crypto.com

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