This is the second of a multi-part series on decentralised finance (DeFi). DeFi is a blockchain use case that is potentially disruptive to the traditional finance industry. The first part of the series explains what it is and the philosophy behind the movement. A primer on blockchain (including examples of insurance use cases) is available in this paper I co-authored.
Financial super app
Becoming a super app of anything is the holy grail. Tencent’s WeChat is a prime example of a super app; users access multiple products and services within its walled garden of micro apps. Revolut, the fintech start-up disrupting the banking industry, has ambitions of becoming a super app of financial products; it currently offers a multitude of products including payment, investment, and insurance.
Decentralised finance (DeFi) promises financial inclusion by democratising access to financial products. With a freely available Web3 wallet, users have access to a slew of DeFi apps. The wallet is effectively a super app of financial products and services. These wallets are also non-custodial in nature, in that the user has full control and sole access of the wallet.
In its current form, DeFi has two distinct advantages over traditional fintech businesses:
- Censorship-resistant – It is harder (though not impossible) to ban the use of DeFi products. WeChat, in contrast, had been threatened with a ban in the United States by the Trump administration.
- Global in nature – DeFi products are available globally by default. Revolut, in contrast, is not fully multi-jurisdictional yet. Expanding to other countries is really hard.
The proposed Markets in Crypto-assets (MiCA) regulation in the European Union is likely to change the status quo as it requires providers of crypto-asset services to operate like a centralised legal entity. It remains to be seen if DeFi could exist in its current form, or what regulatory arbitrage, if any, would be available for DeFi to innovate unencumbered by regulatory constraints.
Ethereum dominates (for now)
DeFi products and services are digital and are fully automated. These products are built on permissionless blockchains that permit programmability via smart contracts. Ethereum is the first such smart contract platform. It has been described as a “world computer”, storing data and computing smart contract logic. Metaphorically-speaking, this world computer is fuelled by “gas” which is paid for using Ether, the native token of the Ethereum blockchain.
While there are a multitude of smart contract platforms, Ethereum is the dominant DeFi platform. It has attained the enviable network effect with a vibrant community of users and developers. More importantly, users and developers are locked-in as Ethereum does not interoperate seamlessly with other blockchains.
DeFi products and services
The explosion of DeFi projects in recent years is thanks to a number of foundational DeFi protocols, the building blocks on top of which other DeFi projects build their products on. These include:
Cryptocurrencies like Bitcoin are notoriously volatile in price. In contrast, stablecoins are pegged to a target price (for example, 1:1 to the US Dollar). Stablecoins are the backbone of DeFi products, enabling payments, savings, and other services on decentralised networks.
Dai is the de-facto stablecoin on the Ethereum blockchain. Dai is “minted” when users enter into a borrowing arrangement by posting crypto-assets as collateral (i.e. Dai is a collateral-backed cryptocurrency). Its value is soft-pegged 1:1 to the US Dollar via 1) various levers designed to control the demand and supply of DAI, and 2) market participants seeking arbitrage opportunities, buying DAI when it drops below the target price and vice versa.
2. Decentralised money markets
“Money makes the world go round”. In truth, loans and credit drive the economy. The crypto-economy has been supercharged by the creation of decentralised money markets where crypto-assets are pooled and could be borrowed to be used in other DeFi services; for example, traders could borrow an asset to short sell on decentralised exchanges.
Aave and Compound are examples of decentralised money markets on the Ethereum blockchain. Credit provision in traditional finance relies in part on the borrowers’ character and reputation (encapsulated in credit scores/ratings). A digital identity infrastructure does not exist yet, hence loans in DeFi are collateral-based out of necessity. Lenders earn interest on the assets they supply to the asset pool; the interest rate is dynamically set based on demand using a pre-defined formula.
3. Decentralised exchanges
Centralised exchanges are arguably the weakest link of the crypto-economy with a history of high-profile hacks. Decentralised exchanges aim to solve the problem by allowing users to trade crypto-assets directly from their non-custodial wallet. Decentralised exchanges have evolved from the traditional “order book” approach (where orders are filled by pairing buyers and sellers) to the “automated market maker” (AMM) approach.
Curve and Uniswap are examples of AMMs on the Ethereum blockchain. AMMs work by fulfilling orders from a pool of assets provided by liquidity providers (who are incentivised by rewards in the form of trading fees and governance tokens). Asset prices are dynamically set using a pre-defined model that’s linked to order size and the quantity of assets available in the pool.
A number of innovative DeFi products and services have been built on top of these foundational DeFi protocols. A couple of interesting ones are:
- Yearn Finance – DeFi’s popularity in recent months can be ascribed to a trend known as “yield farming” – the process of seeking the highest yield on crypto-assets by lending in decentralised money markets and/or by providing liquidity to decentralised exchanges. Yearn Finance automates this process, acting effectively as a “robo-advisor”.
- PoolTogether – PoolTogether is modelled on the concept of “no-loss lotteries”. Users deposit fund in exchange for a chance at winning the lottery. The lottery prize is generated from the interest earned on users’ pooled fund supplied to decentralised money markets. Users could withdraw the full amount of their fund at any time.
Limitations and risks
Despite the growing interest in DeFi, it is far from mainstream adoption due to poor user experience. Current limitations include:
- Not user friendly – Interacting with a DeFi app is not a seamless experience for users. For starters, users need to exchange fiat currencies for cryptocurrencies. They then need to transfer those cryptocurrencies to a Web3 wallet, incurring transaction fees in the process (transaction fees or gas costs are paid to miners who maintain the Ethereum blockchain). Finally, to interact with a DeFi app, users need to send transactions to a smart contract, incurring more transaction fees. Some Web3 wallet providers have emerged to make using DeFi frictionless.
- Slow and expensive – The current version of the Ethereum blockchain has a low throughput (i.e. the number and speed of transactions). Completing a transaction could take minutes, depending on how much the user is willing to pay in terms of transaction fees. In recent months, transaction fees have been relatively high, making small transactions not worthwhile. Ethereum 2.0 will likely resolve some of these limitations.
Using DeFi apps also comes with a long list of risks; key ones include:
- Vulnerabilities in smart contracts – like any software, bugs in the code can be exploited, potentially allowing hackers to siphon funds locked in smart contracts.
- Attack on governance – Some DeFi projects are controlled by a community of governance token holders. The community votes on proposals pertaining to various aspects of the DeFi project. A malicious actor could gain sufficient voting power and act against the interest of users.
- Reliance on centralised oracles – DeFi products often rely on external data feed (i.e. off-chain data not created on the blockchain) such as crypto-asset prices from sources known as “oracles”. Some oracles are data silos operating in a centralised fashion, creating a single point of attack.
Reinventing the wheel?
DeFi products and services mirror those in traditional finance. The key differences are:
- There is no need for a trusted financial intermediary.
- The provision of financial products and services is fully automated.
Another innovation lies in how DeFi projects organise themselves. Some DeFi projects operate as a Decentralised Autonomous Organisation (DAO). DAOs eschew the traditional top-down hierarchical structure and favour a bottom-up approach to resource management and decision-making.
In the next part of this DeFi series, I will delve into the workings of a DAO and how it could change the way companies of the future are run.
The bottom line: Foundational DeFi protocols such as stablecoins, decentralised money markets, and decentralised exchanges have enabled innovative DeFi products. However, DeFi is far from mainstream adoption due to a number of limitations and risks.
Disclaimer: DeFi projects mentioned in this post are the most notable examples to use to illustrate a point. Mentioning a project does not imply endorsement or recommendation. Investing in or using DeFi products could potentially result in severe financial losses (getting “rekt” in crypto parlance).