Over $13.6 billion is currently locked up in the DeFi ecosystem — but what is DeFi, and what impact will it have on traditional finance? 

The “blockchain revolution,” catalyzed by the launch of the Bitcoin network in 2009, promised to decentralize value transfer and create an entirely new economic paradigm. Cryptocurrency would bank the unbanked, usurp fiat currency, and allow anybody to take complete control over their finances without the need for centralized banking authority.

The real-world impact of cryptocurrency and decentralized ledger technology over a decade later, however, is vastly different from the decentralized libertarian dream promoted by early cryptocurrency maximalists. 

The current distribution of Bitcoin ownership, for example, mirrors global wealth distribution — the most wealthy 30 percent of all Bitcoin holders own over 98 percent of all Bitcoin in circulation. While Bitcoin and other cryptocurrencies provide users with a value transfer mechanism, the same power structures that exist in the traditional financial ecosystem have transferred to the crypto economy.

Bitcoin wealth distribution — wallet holdings via BitInfo

Total ICO funds raised (USD) over the course of the “ICO boom” via ICO Data

Contemporary crypto assets primarily function as speculative investment vehicles, with lottery-like demand driving capital flow within the cryptocurrency market. The initial coin offering “gold rush” of 2017 saw blockchain technology significantly disrupt traditional capital raises, allowing hundred of projects to generate over $10 billion in startup capital — but rapid regulatory responses worldwide resulted in a swift end to blockchain-based crowdfunding.

The blockchain revolution isn’t over, however. The rise of decentralized finance, or DeFi, aims to emulate and eventually usurp traditional financial services through blockchain technology. DeFi focuses on providing a global, decentralized alternative to virtually any financial service, such as loans, savings, and insurance.

What is DeFi, though, and how does it work?

What is DeFi?

The core promise of DeFi mirrors the optimistic philosophy that drove early cryptocurrency adoption — the possibility of a universally accessible, decentralized financial system available to anybody in the world. 

DeFi, however, expands upon the basic value transfer and storage mechanism provided by cryptocurrency by creating additional service layers, facilitating the creation of decentralized financial services that can be accessed without the need for centralized or third-party arbitration.

The term “DeFi” can be used to refer to a broad spectrum of services and platforms. DeFi allows complete strangers to create automated loan agreements without intermediaries or counterparty risk, earn interest on savings, rapidly exchange one asset for another, or create “stablecoins” — cryptocurrency tokens pegged to the value of any real-world asset.

Key features of DeFi via Appinventiv

How Does DeFi Work?

DeFi can get complicated. The DeFi ecosystem is saturated with terms such as stablecoin, liquidity pools, staking, and yield farming. Understanding how DeFi works necessitates a basic understanding of what differentiates DeFi services from traditional financial services.

DeFi services are decentralized. DeFi platforms aren’t managed by a centralized institution or bank. DeFi ecosystem participants don’t need to trust a third party or each other in order to transact in a secure manner. Trust and accountability in the DeFi ecosystem is enforced by code

Many cryptocurrencies, such as Ethereum, are inherently programmable. The DeFi economy is driven by smart contracts — programs that run on the blockchain networks that drive cryptocurrencies. Smart contracts perform specific functions when certain criteria are met.

Example: A DeFi lending platform may allow users to lock up a specific amount of cryptocurrency as collateral for a loan of fiat currency.  A smart contract handles collateral management, automatically releasing it to the borrower when the principal and interest are paid in full.

Centralized versus decentralized
application networks

Applications that allow users to interact directly with smart contracts are called decentralized applications, or dapps. The most important feature of the dapps and smart contracts that drive the DeFi ecosystem is that they are completely transparent — anybody can audit them, delivering open-source trust.  

The trustless, open, and decentralized nature of DeFi applications deliver a range of benefits to users that include:

 

  • Global interoperability: The blockchain ecosystem is becoming increasingly interoperable, allowing DeFi dapps to connect to one another in a modular nature and creating entirely new complex financial services
  • Permissionless participation: Anybody can participate in the DeFi economy — there are no lengthy application processes, forms, or strict account rules. 
  • Full user control: DeFi is non-custodial, providing DeFi economy participants with full control over how their capital is stored and how they use it at all times.

How Will DeFi Transform Traditional Finance?

DeFi holds the potential to significantly disrupt the traditional financial ecosystem in multiple ways. The 2017 initial coin offering rush was the first major use case of blockchain applied to traditional financial systems, but the new services made available through decentralized finance possess a far greater impact than crypto-specific crowdfunding.

The biggest impact of DeFi is the potential it holds to provide financial services to the unbanked and underbanked. Over 1.7 billion adults worldwide lack a bank account, with over 30 percent of the global population lacking access to financial services. 

Factors such as a lack of trust in traditional financial institutions, minimum account balance gatekeeping, and identity requirements prevent the unbanked population from accessing both basic banking and complex financial services.

DeFi provides the unbanked and underbanked with the ability to participate in an unrestricted, global financial economy from anywhere in the world with just an internet connection and a smartphone.

Distribution of unbanked adults via Global Findex Database

Asset tokenization is a key use case of DeFI

Retail banking customers that lack access to credit also benefit significantly from the DeFi economy. Over 22 percent of consumers are denied credit in the current economic paradigm, with lending standards tightening significantly over the course of 2020 due to COVID-related economic uncertainty. The rise of AI-driven credit denial has made securing finance more difficult, with credit allocation now affected by potentially discriminatory lending practices driven by big data.

DeFi allows anybody to access credit from a broad spectrum of different lending platforms, allowing consumers to access a new credit market free from centralized control. 

The retail market isn’t the only sector that DeFi is disrupting. Institutional financial actors are now tentatively entering the DeFi market, attracted by the asset tokenization functionality that DeFi presents. DeFi allows for the creation of blockchain tokens pegged to any asset. 

Through DeFi, for example, it’s possible for institutional actors to transfer ownership of millions of dollars worth of precious metals instantly at a fraction of the cost presented by traditional intermediaries, with no liquidity limits.

What are the Key Obstacles Faced by DeFi?

The promise of truly decentralized finance holds the potential to create a truly global, open, and accessible financial ecosystem — but there are a number of key obstacles that must be overcome before widespread adoption accelerates.

The scalability of the blockchain networks that drive DeFi applications places a significant limit on the number of users that each can support. Blockchain networks used in the DeFi economy, such as the Ethereum network, are limited to a transaction throughput rate far lower than that of traditional payment processors such as Visa. 

In order to keep up with international demand, the blockchain networks that drive DeFi must scale rapidly, allowing for sufficient transaction throughput. Recent blockchain technology developments, such as the upcoming Ethereum 2.0 update, promise a solution to the scalability problem, but few current blockchains can keep up with the throughput demand presented by hundreds of millions of concurrent users.

Scalability issues cause Ethereum network transaction prices spike dramatically during peak use periods. Data via Etherscan

Cryptocurrency regulation by country via IG Bank

The most important obstacle faced by DeFi, however, is regulation. The highly disruptive nature of DeFi makes it likely to attract the attention of regulators — a joint research paper published by Crypto.com and global management consulting firm BCG Platinion predicts a rapid regulatory response to DeFi, citing potential money laundering risks.  

In order for the DeFi ecosystem to thrive, secure and reliable fiat to cryptocurrency bridges must be created — demanding compliance with international Anti-Money Laundering (AML) and Know-Your-Customer (KYC) rules.

Key Takeaways

The DeFi ecosystem is developing rapidly, creating new, decentralized, and accessible financial services that can be used by anyone around the world. While regulatory responses may impact the ways in which consumers and investors interact with DeFi, over $13 billion has already been invested directly into DeFi smart contracts. 

While DeFi remains in a nascent stage, the ability to create and access financial services governed by code — not people or banks — holds the potential to spark a Cambrian explosion of new, innovative financial services for anybody, anywhere.

Sam Town 

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