Decentralised Finance (DeFi): The Basics

The Maboneng Precinct, Johannesburg

This is the first of a multi-part series on decentralised finance (DeFi). DeFi is a blockchain use case that is potentially disruptive to the traditional finance industry. A primer on blockchain (including examples of insurance use cases) is available in this paper I co-authored.

My wife grew up in Johannesburg, South Africa. I’ve visited Joburg a number of times but have always kept mainly to the suburbs. The inner city was a notorious no-go zone. On our last trip in 2018, we visited the Maboneng Precinct, an area in the Central Business District (CBD) that has been rejuvenated and now exudes a hipster vibe.

At Maboneng, we came across a street vendor selling cute hand-stitched baby clothes. We could only buy one piece as we didn’t have enough cash on us (walking around the CBD with too much cash was ill-advised). The vendor couldn’t take card payments as she didn’t have a bank account. She mentioned something about not being able to open an account because she didn’t have a passport.

There she was in the flesh – the fabled “unbanked” frequently mentioned in the blockchain community. One of the promises of blockchain technology is that of financial inclusion – democratising access to financial services. That promise is gradually coming to fruition in the fast-growing space that is decentralised finance (DeFi).

I’ve spoken and written about DeFi at a high-level. This blog post is the first of a multi-part series that delves into the world of DeFi.

Defining decentralised finance

DeFi, in the broad sense, is an ecosystem of financial products and services built on decentralised permissionless blockchain. Let’s unpack that:

  • Ecosystem of financial products and services Products and services available today in traditional finance are available in DeFi, including payment, savings, borrowing/lending, trading, insurance and so on. These DeFi products are interconnected; for example, a savings product generates yield by supplying assets in lending markets; lending markets, in turn, rely on liquidity providers seeking yield.
  • Built on DeFi products are fully digital and are in the form of decentralised apps (dApps). These dApps are implemented using “smart contracts”, software code deployed on the blockchain that automatically executes an action when certain conditions are triggered (i.e. if x happens, then execute y action).
  • Decentralised All DeFi products are “architecturally” decentralised (i.e. distributed across a network of computers with no single point of failure). Some but not all DeFi products are “politically” decentralised (i.e. no single entity controls them), whereby the governance, management, and development of the products are grassroots-led, incentivised by tokenomics.
  • Permissionless There are two key aspects to being permissionless: 1) permissionless innovation – anyone with the know-how can build and deploy DeFi products; 2) permissionless access – anyone with an internet-connected device has access to DeFi products.
  • Blockchain Blockchain is a foundational infrastructure technology. At its most basic level, it’s a database shared by multiple participants. Data, after being verified by multiple entities instead of a single organisation, are propagated and stored by each participant. A primer on blockchain and how it works is available in this paper I co-authored.

The philosophy and raison d’être

Bitcoin, the first application of blockchain technology and arguably the first DeFi service, has streaks of libertarian ideals in its design. The core tenet of Bitcoin is financial self-custody in that users have complete control of their assets. Transactions between willing parties happen without the need for a trusted third party.

The Times 03/Jan/2009 Chancellor on brink of second bailout for banks

Secret text in the Bitcoin blockchain genesis block

Satoshi Nakamoto created the genesis block of the Bitcoin blockchain on 3 January 2009. He/she/they included a secret text (the headline from the Times newspaper) in that very first block which initiated the crypto-economy. The embedded text is either 1) a mere coincidence or 2) a thinly-veiled criticism of a system that allowed large financial institutions to privatise the profits from taking outsized risks and to socialise the losses. No one knows for certain. Satoshi, whose real identity is still a mystery, isn’t available to clear things up.

DeFi inherits Bitcoin’s philosophy; the aim is to create a financial system that is open, transparent, and operates without the need for trusted central authorities. The promise is that of financial inclusion and economic freedom.

DeFi products available today enable the aforementioned unbanked street vendor at Maboneng to receive digital payments for her goods, access credit to expand her business, build up savings in a high-yield product, and ultimately have full control of her financial destiny. All without a bank account.

Defying traditional finance 🤷‍♂️

In February 2020, the amount of money in the DeFi ecosystem reached the US$1 billion milestone, as measured by the total value locked (TVL) in smart contracts. Since then, TVL has grown exponentially and reached a record high of US$11 billion in September 2020.

Despite the growing interest, DeFi remains at an experimental stage and is not ready for mainstream adoption. DeFi currently lives in a parallel financial world with limited interactions with the existing financial system. Traditional businesses are still reluctant to adopt cryptocurrencies and regulators are still figuring out how best to regulate crypto-assets (a legal framework in the European Union has just been recently proposed).

In short, it is unlikely to disrupt the traditional finance industry for the next few years.

What’s the end state?

It’s early days as to how the DeFi trend will play out. The pace of innovation in the DeFi space is rapid and is accelerated by two key characteristics:

  1. Permissionless innovation – Anyone, anywhere can build and deploy DeFi products;
  2. Open source – The software code underlying DeFi products is freely available for anyone to remix, reconfigure, and include in his/her own DeFi product.

Human creativity and ingenuity is such that many applications cannot possibly be predicted. Just think of when iPhones first came around; who would have known that one of the most popular apps would be one that lets you compulsively consume AI-curated short-form videos (yes, I’m referring to TikTok)?

In the next part of this DeFi series, I will write about the current state of the DeFi ecosystem, delving into the financial products and services currently available, and the limitations and risks of interacting with a dApp. Join me as I go further down the DeFi rabbit hole.

The bottom line: Decentralised finance (DeFi) is an ecosystem of financial products and services built on decentralised permission-less blockchain. It promises financial inclusion and economic freedom. The pace of innovation is rapid and no one can quite predict what the killer applications will be.