Decentralized Finance: A Primer

Introduction

Experimentation is happening at a breakneck speed in a sector of the crypto industry, which is popularly known as DeFi, short for Decentralized Finance. Billions of dollars’ worth of digital assets is exchanging hands, earning interest, and speculating on various financial services that could end up redefining how we obtain financial services in the future.

In this article, I will introduce the concept of Decentralized Finance with limited jargon. I will then explain how DeFi is different from the current paradigm, why the internet of the 1990s could not decentralize financial services and how we have the right technology today to achieve it. I will further explain why DeFi can unlock a wave of innovative products and use cases in the future. DeFi also provides everyone with an opportunity to participate in the upside of the future equivalents of Amazon, Google, etc. from day 0.

Centralized Finance

In the current paradigm, financial service providers are fragmented. Most service providers specialize in a few use cases at most and do not interact with each other. This limits our ability to achieve more with our money. What are the drawbacks of a fragmented system? There are many, a few of which are mentioned below:

Slow: 5-7 business days for simple transfers. Imagine if email was sent at the speed of post.

Expensive: For instance, check average remittance costs today globally

Siloed, i.e., presence of friction: Individual companies act as standalone services

Opaque: You are not privy to the financial status of your service provider in real time

Cumbersome: Involves a lot of same paperwork time and again for every service provider

Lack of self-custody option: Access to your own money has a lot of constraints once it is with the service provider

Lack of financial inclusion: Huge swathes of population cannot access basic financial services because banking them is not a profitable business for banks.

There are consequences of above shortcomings that we do not appreciate because we have not seen an alternative so far. Our attitude is that this is the price to be paid for accessing financial services. Well, with the advent of the crypto networks, we have the technology to challenge this assumption. It is not ready for prime time, but rest assured that the experimentation is happening at an incredible pace.

What is Decentralized Finance?

Internet of the 1990s broke the monopoly of media and centralized institutions on information distribution. It democratized access to and dissemination of information. It pushed innovation to the edges. It enabled permissionless innovation. It allowed us to communicate faster, at a cheaper price point and seamlessly across applications. We used these advantages to unleash a new wave of innovation. We started exchanging ideas at a rate previously unseen in the history of mankind. Human progress skyrocketed. Technological progress of the last twenty years is a testimony to that. That was the internet of information.

With all the successes that the early internet helped us achieve, it had not found a solution to one basic requirement when it comes to exchanging money. It could not guarantee the scarcity of digital information without a central intermediary. What I mean by that is for example, let us say I send a hypothetically valuable digital music file to you. You save it on your local folder and forward it to ten other friends of yours, who in turn do the same thing. In this example, there are 112 copies of the same file now and indistinguishable from each other (fungible). Furthermore, you can copy paste it practically infinite times on your own machine. In the world of traditional finance, you can compare this to relentless money printing. Consequently, ascribing value to such a digital information is a meaningless task because of hyperinflation. Hence, to be able to transact online, we needed a central party to ensure people stayed honest.

Satoshi Nakamoto, in his/her/their seminal paper on Bitcoin precisely solved this issue and suggested a solution that could cryptographically prove digital scarcity. Poof! He instantly solved the problem of double spending. This has enabled people to exchange valuable digital information “without a central intermediary”. Now you can ascribe value to digital information because digital scarcity is cryptographically assured. Bitcoin was born.

Now that we understand the reason why finance stayed centralized for this long and how we now have the technology to decentralize it, we must decentralize it – for the good of the consumers and the society. DeFi aspires to break the monopoly of today’s centralized financial institutions and to replace them with software protocols thereby allowing everyone in the world to access basic financial services, build faster, cheaper, more transparent, and auditable products. It promises to be the internet of value. 

Financial Services in DeFi

Financial institutions are in the business of primarily providing credit and liquidity in one form or the other and in the process transfer risk from one party to another. They can be roughly categorized as follows: lending/borrowing, trading/investing, insurance, derivatives, etc.

In the DeFi world, we have protocols that are experimenting not only with the above financial services but also with novel use cases such as flash loans, personal tokens, governance tokens, hybrid ways of raising capital, etc. (outside the scope of this article). Especially interesting is the aspect where you have gazillion opportunities to earn digital assets by providing your services – mainly liquidity to the system. All you need is your digital wallet loaded with digital assets and you are ready to access the new financial system. Following is a chart showing the rise of total assets under management in various DeFi protocols and it is followed by examples of several protocols.

Total assets under management under DeFi protocols. Source: https://defipulse.com/

Lending and Borrowing

Projects such as Compound, Aave and Yearn allow you to lend your digital assets such as ether, stablecoins (digital assets that try to maintain parity with another asset, usually USD), etc. to earn yield. You can borrow against your collateral regardless of the size of it. No bank gives you interest on digital assets and I do not think that you can borrow against your small portfolio of equity at a reasonable LTV from brokerage houses. Furthermore, you can see the financial position of these protocols in real time – amount supplied, amount borrowed, etc. Good luck getting these numbers more than once a quarter for centralized institutions.

Snapshot of assets lent and borrowed with interest rates on Compound platform
Source: https://app.compound.finance/

Snapshot of interest rates across lending platforms from Yearn, an aggregator (& more)
Source: https://yearn.finance/apr

Assets under management under different lending protocols. Source: https://defipulse.com/

Trading and investing

We have decentralized exchanges and aggregators that allow you to trade across a wide range of digital assets without ever jumping to fiat in between. Imagine if you could swap one stock for another without paying transaction fee twice. Ironically, a lot of these digital assets are not even listed on centralized exchanges because they are slow. It is an avenue for retail to get access to these tokens at an early stage. All in a matter of a few clicks.

Furthermore, you can earn value by providing liquidity to the digital assets pool of these decentralized exchanges – similar to how you lend digital assets to Compound/Aave/Yearn – you could lend it to decentralized exchanges and instead of interest, you can earn a percentage of the transaction fee that the protocol makes.

An example of conversion from Ethereum to Dai on uniswap.org 

A decentralized exchange aggregator helps route your order to multiple exchanges to get the best price

 

Assets under management under different decentralized exchange protocols. Source: defipulse.com

Decentralized Exchange volumes are going parabolic. Source: https://www.duneanalytics.com/

Insurance

We are in the 1st innings of building decentralized financial system. There are a lot of known risks and unknown risks. We are allocating people’s wealth to software protocols that can be hacked or have bugs. There is a lot of risk such as technical, smart contract, composability, liquidation, etc.

A company called Nexus Mutual is providing insurance against a few of these risks. In traditional finance, you would have an insurance company whereas in this case, you have a group of people coordinating globally on what should insurance policies look like and what hacks/bugs qualify for reimbursements. Participants in the governance process of Nexus Mutual are rewarded with digital assets that may appreciate if the insurance protocol becomes successful. Similar arrangements are in place for Compound and Yearn platforms. This is what incentivizes communities and accelerates innovation as you have exponentially higher number of people in this open source community looking at these protocols.

Derivatives

Derivatives are used in three fundamental ways in traditional finance – to hedge risk, to allocate capital efficiently and to speculate. They are an essential part of a thriving financial ecosystem. There are a host of protocols vying to become the powerhouse of derivatives solutions in digital assets space. Synthetix, Opyn, Augur etc. are experimenting with synthetic assets, options, prediction markets, etc.

As an example, Synthetix is bootstrapping its ecosystem with the help of its native digital asset SNX. You can lock your SNX tokens to borrow synthetic USD (sUSD). You can use sUSD to get synthetic exposure to equities, commodities, crypto and other bespoke markets. You can express your views via different financial instruments such as binary options, futures etc. To be clear, I made it sound very non-technical but when you try these platforms, please understand there are more technicalities to these smart contract solutions, and they are extremely risky.

Assets under management under different derivatives protocols. Source: defipulse.com

DeFi vs CeFi

There are strong reasons to believe why DeFi is here to stay. A few of those reasons are mentioned below:

Composability: This is the holy grail. It is what the real innovation will likely be about. In the current paradigm, various entities do not interact with each other seamlessly. Hence, creating innovative solutions by combining these services is impossible. In the smart contract world, you can create complex applications by combining various applications such as lending, borrowing, leverage, exchange, etc. Examples such as flash loans, liquidity mining of governance tokens, etc. will be new solutions that we have never seen.

Cheaper, Faster and Smoother: Today, DeFi is not cheap, may be fast depending on the use cases, and wrought with friction for retail. But in the steady state it aspires to make financial transactions as simple as sending a text message.

Open, Permissionless & (mostly) non-custodial: We can participate in the global economy regardless of our location and wallet size. Developers can build applications without seeking permission and the design space for this virtually looks like a blank canvas. You can control your own funds with a much higher degree of autonomy and lock them in smart contracts instead of relying on third parties. This may or may not be desirable depending on the use case, but we do have an option unlike right now.

Transparent: Code is open source and auditable. Data surrounding the protocol health such as deposits, interest rates, volumes, etc. is publicly available in real time.

We have seen staggering returns in the DeFi space in recent months as you can see in the above table. One important thing to note though is that DeFi applications are hardly decentralized today. A few of them may never reach full decentralization. Decentralization in DeFi needs to be understood as a spectrum and different trade-offs will put projects at different points on the decentralization spectrum. My bias is that projects that can decentralize as much as possible while scaling, will be the largest beneficiaries.

DeFi protocol returns. Source: https://twitter.com/ceterispar1bus/status/1300566438764335107/photo/1

Furthermore, the most critical advantage of the current CeFi model is the scale at which it can operate. DeFi is far from operating at that scale and hence it is not ready for prime time. But top-notch developer talent is working on finding scaling solutions.

Conclusion

To summarize, the internet of 1990s revolutionized how we share and consume information. It did not solve the problem of digital scarcity (double spend problem). Satoshi, in the seminal paper on Bitcoin, provided a cryptographic way to solve the double spend problem. That has allowed us to ascribe value to digital information and transact without requiring a central party. Bitcoin was born.

Central parties are usually rent seeking, siloed, slower, opaque, exclude people who do not add to the bottom line of the business and innovate slowly. All types of financial services such as lending, borrowing, trading, investing, insurance, derivatives, et. al. is ready to be disrupted. A plethora of teams are working on these financial services solutions. Enthusiastic and vibrant communities are forming around these projects. Experimentation is happening at a breakneck speed – so much so that the crypto native people cannot stay abreast with the developments.

This financial disruption is going to happen. It is not a question of if. It is a question of when. And the answer seems to be that it is has begun. Asking whether DeFi is solving real world use cases on USD is like asking if the internet improved performance of postal services, if cars made horse carriages more efficient, or if electricity enhanced oil lamps. Crypto-networks are creating a new & better system. Most importantly, we have an opportunity to participate in the upside of these successful protocols of tomorrow from the very beginning. Imagine Amazon, Google, Apple, etc. provided their early adopters with the financial incentives to bootstrap those companies. Retail never had this opportunity in the past. It has a chance today. Leverage it. Participate and accelerate the decentralization of finance!

P.S.: Cryptoassets are very risky. You can lose all your money. I am not personally endorsing any projects that I have mentioned in this article. This article is not an investment advice. Do your own due diligence.


About the author:

Vishal Kankani has worked in the derivatives sales, trading and structuring divisions of global investment banks and proprietary trading firms across equities and interest rates for a decade. He is excited about the potential of cryptoassets to disrupt various industries; especially finance. He has a Master of Financial Engineering from UC Berkeley and a B. Tech in Aerospace Engineering from IIT Bombay. You can reach him at on Twitter.

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