Intermediate Series
What Is DeFi?
DeFi is short for “Decentralised Finance.” It includes financial instruments such as loans, synthetic assets, exchanges, and stablecoins that are built on top of decentralised blockchains. Currently, a majority of the DeFi world is built on top of the Ethereum blockchain, which has been picking up speed as an upgrade to Ethereum 2.0 moves ahead. Already, tens of billions of dollars worth of cryptocurrencies are flowing through DeFi protocols every day.
Contents
- How is DeFi different from traditional finance?
- Programmable money instead of middle-men
- How can you use DeFi?
- The future of DeFi
How is DeFi different from traditional finance?
DeFi is a global, open alternative to the traditional financial system that lets anyone access the industry. Nobody can block your payments or deny you access. As long as you have an internet connection, you can access thousands of financial products at any time of the day. Let’s take a look at some key differences.
Here’s how traditional finance works:
- You’re trusting a company to hold into your money
- International payments take days to be processed
- A company must give you access
- Markets are closed because employees can’t work 24/7
- Many financial flows are kept hidden
Now, here’s how DeFi improves traditional finance:
- You’re are in control of your money
- International payments are processed in minutes
- Anyone can use DeFi
- The markets are always open because the code runs 24/7
- It’s fully transparent and anyone can see how a system operates
Programmable money instead of middle-men
DeFi is built on smart contracts, which is code that automatically executes transactions when certain conditions are met. Effectively, smart contracts make digital money programmable, so computer code can process complex financial transactions rather than relying on a person.
While a bank operates as a middle-man between two people in a financial transaction, DeFi lets two people connect directly. Because it operates without a centralised entity, it’s literally decentralised finance.
DeFi is great for developing countries where the economy couldn’t support a traditional banking system. The highly efficient smart contracts will make sophisticated financial products available to billions of people. For example, an Australian could use a smart contract to loan out money to an entrepreneur in El Salvador. This gives the Aussie regular interest payments and the entrepreneur capital to grow their business.
How can you use DeFi?
DeFi is bringing new innovations to finance. While innovation and entrepreneurship have traditionally been stifled by a difficult regulatory environment in finance, DeFi has reinvigorated the space. Let’s take a look at some of the most popular DeFi projects.
Decentralised loans with Aave
Aave lets people lend or borrow without having to go to a bank. Like traditional loans, people earn interest when they lend and pay interest when they borrow. However, these loans use cryptocurrencies rather than traditional fiat (government-created) money.
In the real world, people can get a loan from the bank using their house as collateral. With Aave, they deposit their digital assets as collateral. For example, if someone wanted to borrow $1,000 of Ethereum, they could first put up $1,000 of bitcoin. Then, as long as they make their interest payments, they will own both the $1,000 of Ethereum and $1,000 of bitcoin.
People can also lend and receive interest paid in cryptocurrency. For example, if someone deposits $1,000 of Ethereum they could get paid back $1,100 worth of Ethereum over the year—giving them an annual percentage yield (APY) of 10%.
Stablecoins with USD Coin
USD Coin (USDC) is a ‘stablecoin’ that can be redeemed for exactly 1 US Dollar. The peg to the US dollar works because every USDC is backed by 1 US dollar held in a bank account. Why not just use US Dollars?
USDC is built on a blockchain and therefore far easier to send and receive than actual dollars, which must travel through the legacy banking system. It’s even been used to give aid to healthcare workers in Venezuela.
Synthetic assets with Synthetix
In the traditional financial system, people trade a type of financial asset called a derivative. Derivatives are a contract that’s based on the price of an underlying asset such as 1,000 shares of Apple’s stock, but doesn’t give you any actual ownership of the stock. In DeFi, a similar type of financial instrument is known as synthetic assets or ‘Synths’.
Synthetic assets let you bet on the price movements of stocks like Apple, precious metals like gold, and even commodities like oil. Essentially, you can bet on the price of the asset without actually having to hold the asset.
Insurance with ChainLink
ChainLink is an oracle service that verifies real-world data to be used in smart contracts, such as the current price of Apple’s stock. This makes it a key part of synthetic assets. However, it has far more practical uses, such as crop insurance.
Imagine an Ethiopian farmer that purchases drought insurance. He used USDC to purchase the contract and then an oracle like ChainLink verifies whether there was any rain in the region his crops are located. If there was no rain, the contract would automatically send him USDC so he can buy more seeds and survive the drought.
Decentralised exchange with Uniswap
When you buy and sell stocks in the traditional financial markets, you use a centralised exchange like the NASDAQ, NYSE or ASX. In crypto, one way to buy and sell cryptocurrencies is through a ‘decentralised exchange’, more commonly known as a ‘DEX’.
Uniswap is one of the most popular DEX in crypto, letting users buy and sell thousands of different tokens built on the Ethereum blockchain, such as 1INCH, USDC and UMA. Uniswap also has a key advantage over centralised exchanges that use order books.
Uniswap uses an automated liquidity protocol that incentives traders to become liquidity providers, meaning a seller can execute a trade instantly rather than waiting for a buyer. This makes the exchange easier to trade on, especially for tokens with low liquidity.
However, unlike centralised exchanges, decentralised exchanges lack clear regulations, are more difficult to use and aren't compatible with fiat currencies.
The future of DeFi
Most DeFi applications run on the Ethereum blockchain, including all of the projects mentioned above. It’s the foundation of the current DeFi ecosystem. However, other layer 1 blockchains are emerging as DeFi competitors, including Algorand, Cardano, and Solana.
Along with Ethereum, these three cryptocurrencies were among several highlighted by The World Economic Forum (WEF) as prospective DeFi blockchains to support “smaller businesses in developing markets, particularly for remittances and small loans.” The World Economic Forum highlighted the need for DeFi as the need for financial instruments has been “unmet by the traditional banking system.”
Now, even the traditional financial institutions can see the inevitability of DeFi. Recently, Goldman Sachs filed to create a DeFi ETF while JP Morgan reported that the launch of Ethereum 2.0 could create a AU$54 billion staking industry by 2025.
Regardless, DeFi is seen by many as much more than an investment opportunity or simply a replacement to the traditional financial system. It allows new tools and techniques to make financial instruments accessible to people across the globe. It’s not simply a replacement, it’s a reinvention.
Disclaimer
Information provided is for educational purposes and does not constitute financial advice or investment strategy. You should obtain independent advice from an Australian financial services licensee before making any financial decisions.
