Preamble
Decentralised Finance (DeFi) can be intimidating, especially given the pace of innovation. As someone who only started working full-time in crypto just over a year ago, I have found myself playing constant catch-up. When you think you have grasped one subject, another innovation comes along that counters what you have just learned. It is this innovation and experimentation; however, that makes it such an exciting area of crypto. Not to mention the fact that it has cemented the value of Ethereum and convinced many sceptics.
The mistake I made; not focusing enough on first principles. To help others avoid the same mistake, I want to strip back DeFi and explore critical concepts and technologies while being accommodating to DeFi plebs like myself.
DeFi
An entire alternative financial system is being built on top of public blockchain networks such as Ethereum.
DeFi can be considered as utilizing financial applications without a centralized financial entity or institution. DeFi is not one single application. Rather, it can be considered an entire ecosystem comprised of decentralized applications (DApps) sitting on top of a certain blockchain such as Ethereum. Collectively, these DApps can replicate the current financial system. And although there are still ways to go and issues to overcome before we see this, there are already many applications and uses cases (payments, lending and borrowing, and insurance, to name a few). For example, I keep my USDT (a stablecoin pegged to the US dollar) in a leading DeFi lending and borrowing protocol, Aave, where I earn a relatively high annual percentage yield (APY) compared to holding EUR in my local bank.
And I am certainly not the only one utilising DeFi applications and protocols. DeFi has witnessed significant traction and growth over the past year, with the total value locked (TVL) at the time of writing standing at $64.51B.
The Backbone
Central to DeFi being able to operate without an intermediary are smart contracts. In its simplest form, a smart contract is an agreement with specific conditions and rules between two counterparties embedded in code. Smart contracts are completely electronic and autonomous. Once the outlined condition(s) is met, the smart contract will carry out the programmed operation as specified, which is irrevocable. Also, anyone can verify that the smart contract has been executed, given that it is performed on a public blockchain.
Perhaps the best metaphor to describe a smart contract, as outlined by Nick Szabo, is a vending machine. A vending machine has logic programmed into it. For instance, if an individual inserts $1 and enters ‘12’, then return a Coke. Smart contracts also operate under this ‘if this, then that’ function—all without a middleman.
DeFi Principles
Decentralization: Public blockchains operate as open-source networks. Take Ethereum, for example. Ethereum is a distributed network of nodes running the blockchains software (verifying blocks and transaction data), keeping the network secure and data accurate. Given that it is globally distributed, there is no single point of failure, and hence, the network is decentralized. Any DeFi protocol built on top of Ethereum is decentralized as a result. No centralized party can take control of the funds or change any parameters.
It is important to note that the degree of decentralization achieved by a DeFi protocol depends on the underlying network that it is built on. A DeFi protocol cannot achieve decentralization that is greater than that of the underlying network. So, if you were to build a DeFi protocol on Binance Smart Chain (BSC), a more centralized public blockchain, it would not be considered decentralised compared to a DApp built on top of Ethereum.
Non-custodial: DApps built on top of public blockchain facilitate the option for individuals to have complete control of their assets. While using a non-custodial wallet (MetaMask) reduces the risk of censorship, you are ultimately responsible for the security of your cryptocurrencies. As a result, if you lose your private keys to your wallet, you will lose the assets. If this is too much of a burden, you can use a custodial wallet and trust a third party to secure your assets safely.
Permissionless: Anyone can interact with DeFi protocols so long as you have an internet connection, mobile phone and wallet. There are no permissions in place to deny access to certain groups or individuals.
Transparent: Given that DeFi applications and protocols are built on top of public blockchain networks, anyone can see the transactions between person A and person B, reducing the risk of corruption and censorship. Also, much of the code in DeFi is open-source.
Why is DeFi Important?
When you examine the traditional financial system, several problems are visible.
Legacy global payment systems and correspondent banking networks are inefficient and complex, involving multiple banks across different locations. This makes settling cross-border payments expensive and time-consuming. For example, settling cross-border payments involving African currencies today take between 3 to 5 days. It’s even worse when there are 2 African currencies involved. This is despite the growing demand for instant global payments settlement in the digital world we now live in. Furthermore, access to financial services is a prominent issue. There are as many as 1.7 billion still unbanked with cost, lack of necessary documentation and trust cited as primary reasons. This issue extends to developed countries, especially in low-income, cash-based households.
DeFi holds promise in overcoming many of the issues seen above. By bypassing intermediaries, payments can be settled in minutes, if not seconds and cost a fraction of the price (Of course, this depends on the public blockchain being used). Furthermore, as mentioned previously, anyone with an internet connection, mobile phone, and wallet can access DeFi services, opening many opportunities. And for those who hold little trust in the current financial system, DeFi guarantees transparency, given that DeFi protocols are built on public blockchains.
Closing Thoughts
Before the potential of DeFi is realised, a number of issues must be overcome. The performance of public blockchains such as Ethereum is still inherently slow when compared to the centralized counterparts. The user experience of DeFi applications remains poor, while many need to be educated on how to use such.
That being said, solutions are being rolled out that will address these issues. Scaling solutions are being developed, such as Optimism that will significantly improve transaction throughput and speed on Ethereum. Educational efforts are improving while Matcha is leading by example with regard to user experience.
DeFi is only getting started. In the coming decade, we will see a financial system that is more open, accessible and transparent as a result of DeFi.
Next, I’ll examine stablecoins.