What is DeFi?
Decentralized finance (DeFi) is an agreement and transaction system verified by permissionless code without intermediaries. The backbone of DeFi is the smart contract, a protocol stored on blockchains that run on an open-source platform that are self-auditing and at any point work based on a particular established rule set to execute transactions.
This new type of contractual system could change the entire landscape of financial institutions. Instead of third-party intermediaries holding on to assets while they engage in other actions for profit, individuals hold full control of their assets, do not need permission from other entities to send and receive them, and guarantee an outcome with the full knowledge on how these smart contracts interact with each other.
The blockchain backbone is Ethereum, a settlement layer in the DeFi ecosystem. This means that the purpose of Ethereum is to execute and finalize smart contract agreements in upper layers of the stratum. It also serves to store information and maintain the ruleset for the smart contract code. The asset layer is a layer just under that, wherein native protocols and token-based projects are issued (think ERC-20 tokens). Under that still is the decentralized autonomous network (DAO), which usually runs off-chain (real world data) so that on-chain (information on the blockchain) smart contract data can respond. This helps to solve one of the major issues with blockchain as they are closed information systems which means data needs to be fed to them in order for them to activate.
The type of smart contract gaining the most adoption right now combines on-chain code vs off-chain proofs. They are contractual agreements of permissionless verifiable proofs rather then signed agreements by third parties. They include things such as lending, borrowing, yield, exposure and/or protection vs risk. Arguably DeFi is currently a risky environment, but as these systems mature and grow we will see them become more scalable, secure, and stable over time once projects start to flock towards better designs and implementations.
Why use Defi?
Currently our contractual centralized financial structure works something along the lines of the following: A bank, insurance company, brokerage house, or some other third party holds your assets or products and promises to honor their agreements. There are however several question or problems that arise:
1) Why trust these entities?
2) How do we know they will keep their end of the bargain?
3) How do we know they aren’t using these contracts behind our backs to benefit themselves?
4) How do we know we will not be censored or locked out if we do something that is disagreeable to the company/bank managing our holdings?
5) How do we know that the agreement is just and valid?
6) How do we know and verify that there aren’t other contracts that are underlying the contract we are signing and what their relationships are?
7) How do we verify the historical trustworthiness of this system?
On the issue of number 7, banks and companies have proven themselves not to hold the public’s and/or communities’ best interests to heart. They are looking after themselves to accumulate as much capital as possible, regardless of the societal consequences. This is one of the consequences of the lack of transparency inherent to the way these institutions are set up. Decentralization of the means to form economic and contractual agreements with each other under a new framework based on cryptographic proof could help make the system more equitable, depending on how it is used. Here are three recent examples in recent public memory which show historical untrustworthiness:
1) The 2008 mortgage crisis where companies like BlackRock, JP Morgan, Goldman Sachs, and others profited to the tune of billions of dollars of the misery and suffering of millions of people when they distributed mortgages they knew would go insolvent only to buy them up at pennies to the dollar;
2) The Robinhood GME short squeeze where Melvin capital, owned by Robinhood, was one of the largest net shorters at the time and Robinhood froze the capacity of investors to buy/sell GME;
3) JP Morgan caught suppressing the silver market while accumulating the physical asset for themselves and slapped with a 920 million dollar fine;
cite more examples. If we were to do so this essay would never end. The point
is that this system is broken and needs to be structurally changed. In
opposition to this and as a proposed solution is DeFi, an agreement structure
based on a type of hybrid smart contract that use a different form of mechanism
to execute transactions. Blockchains and smart contract systems provide the
1) Force transparency and clarity of the contract by being open and transparent;
2) Allow individuals to control their own assets and become responsible for them;
3) Are global open-source systems that anyone can use without risk of censorship;
4) Provide better yield (less than 1% in banks vs 8% in DeFi);
5) The protocol/code can be verified and looked at;
6) Permissionless and thus anyone can execute them;
7) As smart contracts can be run autonomously, they guarantee an outcome and anyone can access them without custodial authority;
8) Interact without middlemen;
9) Track collateral in real time and calculate exposure and leverage.
The hierarchy in the modern corporate and financial system is as follows: A company is owned by a CEO and other officers, a board of directors, regulators etc. and raises capital to form an enterprise which has a high barrier to entry which requires office space, finances, employees, etc. In contrast DeFi simply co-ordinates people with low infrastructure requirements (the blockchain itself) and deploys permissionless contracts which connect services together. All that is needed is an understanding of how to use the service or write code. In return a participant is paid a portion of the network over and above compensation by helping to provide the service to others. Service examples include AAVE, SNX, CRV, and liquidity pools.
A few DeFi applications there are: ENS domains, Non-Fungible Tokens, and Decentralized Exchanges (DEXs). ENS domains are a type of domain that takes a wallet address and turns it into an easy to understand domain to send and receive transactions (among other things). NFTs are a type of digital asset on the blockchain. It can be used for art, music, land, and intellectual property rights. This tokenized item gives more power to artists, musicians, and transactions between property rights to eliminate middlemen. Finally, DEXs allow a user to hold their assets and trade between different cryptocurrencies while maintaining complete ownership.
Currently as DeFi is evolving there are four key trends to look out for: 1) interoperability; 2) more user friendliness; 3) more value placed into defi over time; 4) new defi markets as new pieces of off-chain data are provided to blockchains which leads to more services and use cases in a positive feedback loop. Given the above, the question is not “will people use DeFi?” but rather “when will people use DeFi?” And the answer is simply: “when will people know how to use it and onboard themselves?”.
When all is said and done, however, these systems at the end of the day are tools. Just like cryptocurrencies can lead the way to Central Bank Digital Currencies (CBDCs), so too can they lead the way towards a more equitable monetary and exchange system. They may also lead to decentralized contractual networks among individuals in a fair and equitable way, or lead to contractual agreements governed and created by artificial intelligence which serves the interests of our current financial infrastructure more than anyone can ever imagine. If people don’t take the time to learn about these technologies, how to implement them, and use them in a fair and just manner the potential for misuse could be just as great as in CeFi (Centralized Finance).