Banking on DeFi

An introduction to DeFi

Enter the DeFi world

DeFi (Decentralized Finance) is a movement. Its a ground-up disruption of how Finance works today. It is an eco-system of distributed financial applications built as smart contracts on a public blockchain (mostly on Ethereum). DeFi applications (aka dApps) allow borrowers, lenders and investors to undertake bank like transactions without banks. DeFi runs on digital wallet accounts — and anyone with an internet connection can access this new banking system. They can store value, transfer value, make a payment, earn interest, lend their assets, swap an asset and even create their own Financial Products & tokens via smart contracts and offer it to the world.

Exponential Growth in DeFi

We have seen exponential growth of DeFi thanks to the all of the seed work that was done in 2018/2019. The total USD value locked in DeFi which stood at $690.9 million on Jan. 1, 2020 has now grown to a staggering to $43.6 billion.

Source: https://defipulse.com/

This still pales in comparison to the trillions of dollars in traditional, centralized finance. But, the excitement of rapid growth and the possibility of meaningful investment returns in a low interest rate environment are starting to pull some real money away from traditional investment.

Banking on programmable Money legos

Each DeFi project has a protocol (smart contract) which is deployed on Ethereum or a comparable blockchain. A smart contract programming language (ex: Solidity) is used to program the behavior of the smart contract and its interactions with tokens (ex: ERC20 is the most common token protocol. ERC721 is the NFT token protocol). Within the protocol, these tokens can be minted, burned, transferred, and rules can be applied to get the expected behavior. Any change in state (Alice paying Bob, or minting a token or an NFT) is recorded on the immutable ethereum blockchain with a unique transaction id.

In building a new DeFi app, one can mix and match these protocols. Projects are designed to not only be used as a stand-alone product but also easily integrated into other new products that can benefit from their functionality.

Photo by Dmitry Mashkin on Unsplash

What can you do on DeFi today

• DEX — Decentralized exchange such as Uniswap (aka AMM automated market maker) are used for token swaps. AMMs are smart contracts that are used to define liquidity pools and markets. There is no orderbook, no centralized party and no central facilitator of trade. Each pool is defined by a smart contract that includes a few functions to enable swapping tokens, adding liquidity and more.
• Yield Farming or Liquidity Mining on platforms such as (Yearn). Yield farming contracts have an algorithm to automate the movement of tokens between different DeFi protocols to maximize yield.
• Asset Management protocols such as Set Protocol, allows users to create Asset Management strategies which can be published and others can replicate for a fee
• Lending such as Compound and Aave allows users to deposit your preferred token asset. After depositing, the user earns passive income based on the market borrowing demand.
• Flash Loans are designed for developers. They allow you to borrow any available amount of assets without putting up any collateral, as long as the liquidity is returned to the protocol within one block transaction.

Why DeFi is a game changer ?

DeFi has 4 distinctive features compared to today’s centralized banking system

1. Financial Inclusion — Unlike traditional finance and banking, there are no account onboarding, forms to fill, credit checks. In DeFi, an individual is BYOW (Bring your own wallet). The first thing a user does to interact (Lend, Borrow, Swap, Insure, Arbitrage) with DeFi protocol is link in their BYOW wallet to the dAPP. All of the transactions are recorded on the blockchain and so there is complete transparency.
2. Low barrier to entry in offering new innovative Financial Products — Unlike a traditional financial institution, anyone with smart contract development expertise and financial knowledge can create yield enhancing products and launch a protocol on the blockchain.
3. New Financial Infrastructure — The new DeFi financial infrastructure is here. And its totally automated. There are no operations teams, back office, phone numbers, agents or brokers. All settlements and payments are near instantaneous and the chain of record is written on an immutable blockchain.
4. A new form of Governance — The most successful DeFi protocols and products available today are not owned by corporations, but DAOs. DAOs are a new kind of corporation. DAO represents community owned and operated software. Any changes to these protocols are governed by their communities, people who have vested interest in the protocol

It is still the wild wild west…..

DeFi is still in its nascent stages of development. Even with the exponential growth and adoption of DeFi, there are still several challenges that need to be overcome

1. Scaling. Most DeFi applications are built on the Ethereum blockchain and currently Ethereum has challenges to scale with a transaction processing speed of around 15 txn/sec. This needs to scale to around 100K txn/sec for it to be a viable proposition.
2. Transaction Costs. The current ethereum transaction fee (gas) costs have seen astronomical growth given the uptick in the price of ETH. It can cost up to $40/txn to execute a transaction on ethereum, and this needs to be addressed.
3. User experience for Non-DeFi user. The current user experience is built for knowledgable DeFi users. It is not simple to use for the general purpose user base that is not conversant with DeFi.
4. Model transparency. Although the current rates & liquidity mining models are fairly simplistic, they are not transparent unless one is an expert in data excavation of the blockchain, has sophisticated tools and conversant at reading and interpreting Solidity code

There are several initiatives which are in play at solving the above challenges, but it will take some time for us to see these Live. The DeFi and blockchain ecosystem right now is akin to the ‘email stage’ in the development of the internet.

In the early days of the internet, the main usage was email and static websites mainly due to the lack of scalability, speed and infrastructure of the internet. This is where we are in DeFi today. However, the development of DeFi will accelerate far more faster than the development of the Internet.

In conclusion, DeFi is already here, growing really fast in TVL (Total Value Locked) and innovating rapidly with products that are replacing traditional finance capabilities. This development is truly disruptive. It is both a big opportunity & a threat to traditional finance.