The backbone of the global economy and a key element in most transactions involving the exchange of value are financial institutions, in particular banks. In a similar way, when trading crypto currencies, crypto exchanges act as the central authority figures. Decentralized Finance (abbreviated as “DeFi”) refers to an alternate financial ecosystem that offers elements similar to traditional finance, such as loans, insurance, trading of assets and derivatives, crowd funding, and even betting. DeFi is a way to do away with these centralized intermediaries by using permissionless, open-source blockchain rails for smart contracts. The creation of “Decentralized Applications” (DApps), which further carry out financial processes on distributed ledgers, is supported by these smart contracts. It enables peer to peer interactions and does not require any intermediary to facilitate the interactions.
A smart contract is a self-executing computer program that contains the terms and agreement between two parties, written in codes. This encrypted agreement is kept on a public blockchain and replicated across several nodes to guarantee its security and accessibility. When the predetermined criteria are met and verified, these contracts or DeFi protocols go into effect.
To further comprehend a real-world application, let’s look at a use case. Amit wants to purchase Gaurav’s vehicle. This agreement will be created using smart contracts on the ETH blockchain and could initially seem as follows: “WHEN Amit pays 50 ETH to Gaurav, THEN the car will be registered on Amit’s name”.
To avoid any trust concerns, once this agreement is made, it cannot be changed. DeFi saves time and money compared to using traditional processes that involve third parties to complete the same transaction. As a result, these contracts can be applied in a wide range of situations, including supply chains, dividend payments, vehicle registration, asset purchases, and many others.
The blockchain system serves as the base of a conventional Defi architecture, upon which first order implementations like stablecoins are developed. Wallets are used to innovate, capitalize on first-order applications, and provide users with these services.
In some circumstances, a smart contract is built to go into effect based on a specific real-world result.
Let’s say that, ‘If Brazil beats Argentina in a football game, Amit will pay Rob 20 ETH’.
Now since blockchain is a closed system, it cannot directly access data from the outside world. This is where Oracles, which are entities that make data from the outside world accessible on blockchain, come into play. These oracles collect data from the real world, such as stock prices, foreign exchange rates, etc., and make them available on the blockchain.
Lending applications, wrapped bitcoins (WBTC), stablecoins, prediction markets and decentralized exchanges (Dexs) are the key spaces disrupted by DeFi keeping the core intention of removing the intermediaries and providing the same and potentially better offerings. DeFi is also being explored in experimental areas like yield farming, in which cryptocurrency deposits are made in exchange for interest, and flash loans, in which uncollateralized loans are made available.
Though in a nascent and experimental stage, DeFi looks very promising and has already started disrupting the market. Here are some interesting examples of entities riding this wave:
a. FIS has partnered with Fireblocks to deep dive into DeFi and offer these services starting with their capital market clients.
b. Monetary Authority of Singapore (MAS) has launched ‘Project Guardian’ in conjunction with banks like DBS and JPMC to explore the application of DeFi for tokenized bonds.
c. JPMC has a dedicated blockchain unit and have announced their plans to tokenize traditional financial assets.Total Value Locked (TVL) is the term used to refer to all the crypto assets locked in smart contracts in a liquidity pool through a proof of stake consensus method. Although this is volatile, the value currently locked in smart contracts ($96.3B as depicted below) clearly depicts that the adoption of DeFi is significant.
DeFi, and for that matter the entire crypto and blockchain space is yet to gain the trust of users. Here are a few key drawbacks which are yet to be addressed in DeFi space:
a. Fluctuating exchange rates for ETH (and other) mean that the transaction cost is not confirmed until contract execution
b. Maintaining financial records for tax purposes is cumbersome given regulations vary from one geography to another.
c. To use DeFi services the end user has to know specific details and be familiar with using the token system. This may lead to costly user error.
d. As there is no central authority to govern the exchange, there is no mechanism for recovering fraud losses.
e. A smart contract is not (yet) considered a legal contract. In the event of a dispute, this can’t be relied on as evidence of a transaction, or ownership.
DeFi offers a framework which has the potential to cause significant disruption across a variety of industries. There are concerns about its adoption and use, as there are with any new product or service in the market. The key driver for acceptance is regulation, which perhaps could also offer some fraud controls and protections. A few large-scale use cases carried out in the real world by well-known institutions (banks, fintechs, etc.) will further build the case for DeFi, leading to greater value propositions and ultimately adoption.
An interesting and less explored use case is the need of a compatible, trustless financial system in the metaverse as it evolves, and DeFi most definitely fits the bill. This may present boundless opportunities for market players.