Decentralised Finance (DeFi): The Current State

London, the hub of traditional finance

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:

  1. 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.
  2. 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:

1. Stablecoins

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:

  1. 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”.
  2. 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:

  1. 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.
  2. 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:

  1. Vulnerabilities in smart contracts – like any software, bugs in the code can be exploited, potentially allowing hackers to siphon funds locked in smart contracts.
  2. 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.
  3. 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:

  1. There is no need for a trusted financial intermediary.
  2. 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).

Decentralised Finance (DeFi): The Basics

The Maboneng Precinct, Johannesburg

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.

Generation TikTok

Quantum physicist and author, Michio Kaku, writes about the Cave Man Principle in his book, Physics of the Future. He argues that modern humans, despite many advances, still think like our caveman ancestors. Whenever there is a conflict between modern technology and our innate preferences, technology loses out and is not fully adopted. Case in point: remote working (in the pre-pandemic world) did not take off because we prefer interacting with our fellow humans in the flesh.

Corollary to the Cave Man Principle… there will be a premium placed on gossip, social networking, and entertainment.

Michio Kaku, Physics of the Future

With an estimated 800 million monthly active users, TikTok has found the secret sauce that appeals to our primitive caveman brain.

The big idea 💡

For the uninitiated, TikTok is a short-form video platform. Think YouTube but shortened. TikTok videos are capped at 60 seconds – short enough to be digestible but long enough for creative flexibility.

It is not a new idea. Vine, the first such platform, was popular in early 2013. Twitter bought it and discontinued it 4 years later due to dwindling monetisation opportunity and increasing competition from Snapchat and Instagram.

TikTok itself is not new. Its parent company, ByteDance, has been operating a version called 抖音 (Douyin) in mainland China since 2016. The app was iterated upon and perfected before launching worldwide in 2018 following its merger with Music.ly, a lip-syncing video app. As TikTok is engineered to appeal to our caveman desire, its popularity outside of mainland China should not be a surprise.

Unlike Snapchat, which is mainly the domain of digital native Gen Z, TikTok is intuitive and user-friendly, making it accessible to an older audience like myself. Having used TikTok casually for the past few weeks, it’s easy to see the appeal. Its popularity can be boiled down to:

  1. It’s super easy for users to discover compelling content;
  2. It’s fun for content creators.

The above creates a powerful network effect. New users are attracted to interesting content, which in turn draw in talented content creators who want access to a sizeable audience.

Optimised for you

TikTok videos range from the silly (e.g. lip-syncing, dance challenges, pranks etc.) to the informative (e.g. tutorials, short-form documentaries etc. #learnontiktok). The overriding theme is that you will find these videos engaging.

The keyword is “you” 👈. TikTok’s “For You” page (#FYP) is a continuous feed of videos which its recommendation engine has optimised based on an amalgamation of data you feed the app. The end result is a stream of highly digestible morsels of pure entertainment.

Netflix and Amazon Prime Video would benefit from TikTok’s secret algorithm; more time is spent looking for content than watching content on these video streaming platforms.

Cosying up to creators

A social media platform lives or dies by its pool of content creators. One of the reasons Vine failed was the exodus of creators to other platforms. TikTok attracts the best creators by:

  1. Making it fun – Hank Green (one of the earliest YouTubers and one of those rare breeds who has had a long-running career as a content creator on the internet) has said that as a creator, he’s found TikTok to be very fun.
  2. Providing the fund – TikTok has been courting creators by paying them to create content regularly.
  3. Making content discoverable – Unlike traditional social media platforms (e.g. Twitter, Instagram), TikTok creators do not need a large group of followers to reach an audience. TikTok’s recommendation engine ensures that good content gets seen.

Monetisation

TikTok’s main business model is advertising. With 800 million monthly active users, TikTok is prime real estate for brands. The very same recommendation algorithm that provides users with engaging videos is likely being used to serve up highly targeted ads. Advertisements on TikTok are seamlessly integrated into the video feed. Some are extremely well done and are entertaining in their own rights.

A potential growth area is live-streaming which is hugely popular in mainland China (Viya, a popular Chinese livestreamer, once sold a rocket launch) but has yet to fully take off in the rest of the world. Creators on TikTok with at least 1,000 followers can broadcast livestreams. TikTok sells an in-app currency called “Coins”, which users exchange real-world money for. These TikTok Coins are then used to buy virtual gifts to reward/tip livestreamers. TikTok has not disclosed the cut it takes from these virtual gifts but it’s safe to assume that this is a profitable side business.

Microsoft ⚭ TikTok

TikTok, like most apps, collects an inordinate amount of data on its users. Its parent company is based in Beijing where it could be subject to demands from the government to hand over data. On national security grounds (and in part geopolitical posturing), Donald Trump issued an executive order in August 2020 that would ban “any transactions” with TikTok’s parent company. Overnight, TikTok’s operations in the U.S. has become a distressed asset that needs to be sold.

Microsoft has emerged as a likely buyer. Buying TikTok would be an uncharacteristic move for Microsoft. The acquisition courts scrutiny and attention, which goes against the modus operandi of CEO Satya Nadella. It is a purchase that only ex-CEO Steve Ballmer, with his brashness, could fathom making. Social media is also a toxic business to be in, with a multitude of minefields (e.g. users’ data protection, content moderation, hate speech/harassment monitoring etc.).

With its increasing cash pile (more than US$100 billion), however, there is no better way for Microsoft to deploy capital than to acquire a fast-growing and exciting social media platform. If the deal does happen, Microsoft will have in its portfolio a new golden goose. If anyone understands the value of owning a platform, it is Microsoft (having dominated the industry in the past with Windows).

What’s next?

TikTok’s success has spawned countless imitators. Some of them are real contenders. Facebook, with its characteristic “let’s-steal/incorporate-all-good-ideas”, has launched a replica of TikTok on Instagram called Reels. Instagram, with its huge installed base, poses a serious threat to TikTok. Smaller competitors like Triller and Byte are also gaining traction.

TikTok, however, has achieved critical mass and a certain degree of brand affinity among users (for now at least). It has perfected the delivery of short-form videos with its uber personalised recommendation algorithm. It is like crack to our caveman brain.

Download the app and start scrolling through your “For You” page to see what I mean. I dare you.


The bottom line: TikTok is a compelling product. Its proprietary recommendation algorithm serves up irresistible and digestible morsels of pure entertainment.