Episode 13 – Decentralized finance: What is DeFi?
“Imagine a world where you could lend, borrow and invest money in complex financial products – but do so without ever having to go anywhere near a bank. No, we’re not talking handing over oodles of cash to the mafia, or going down to your local pawn shop… this world already exists and it’s ready to be accessed by your, it’s right at your fingertips.
This is the world of decentralized finance, or as it’s more commonly known DeFi, and if software is eating the world, DeFi is gobbling up traditional finance (or TradFi) with a very large spoon.
DeFi can offer you significantly better interest on your savings, sophisticated and favourable incentives for taking out loans and way more ADVANCED financial tools than any branch on the high street, or indeed investment bank on Wall St could ever hope to. And all without caring two hoots about who you are, where you live or how much money you own.
Curious? I’m sure you’ve got a lot of questions so let’s see if we can answer them for you because, you know…
This is School of Block.
The TRADITIONAL world of finance isn’t wildly accessible to the man on the street. Yes, in developed countries we have high street banks, and they might let you BORROW money if you have a good credit score, or have a house as collateral, and you fit their profile in terms of income, job security and how close your shave is.
And if you’ve got money they’ll even offer you interest on your SAVINGS to the tune of a mighty 0.something percent.
But what if you don’t live in a country with accessible banking? What if your income is low, irregular or your haircut really rubs the bank manager the wrong way? Then borrowing isn’t going to go that well for you.
And if you’ve got savings – well, 0.something percent in a world where central banks are printing money at an unprecedented rate isn’t going to help you that much either.
Let’s say you want exposure to some more sophisticated financial instruments – OPTIONS, INSURANCE, even – ssssh… COLLATERALIZED DEBT OBLIGATIONS [insert clip from The Big Short]. Well, you’ll need to be an extremely heavy hitter and have access to investment banks or hedge funds on Wall Street. And even if you are lucky enough to be part of that 0.1%, then the fees you’re looking at to exploit these instruments are pretty eye watering too.
So all told, traditional finance has its share of pain points. The man in the middle – yes, the banks – make sure their pockets are well and truly lined, whilst offering mediocre products and inserting 40 grit sandpaper right where you don’t want it (yes, that’s some serious friction) into the process.
Not to mention the issue of trust – Robinhood project the image of being fintech for you and me, the little guy on the street – but the reality is that they make the majority of their income by selling your trading data to high frequency trading firms – who can then use their greater buying power to stack the decks against you. Talk about how the house always wins…
So quite clearly our financial interactions on this planet have been primed for a better solution for quite some time now, and arguably the DeFi ball started rolling in 2009 with the launch of Bitcoin, the first decentralized money system. Ethereum came along in 2015 and added the critical aspect of SMART CONTRACTS – which we’ll cover in more depth in the next episode. But basically smart contracts are a way of adding programmable, pre-set conditions to financial transactions.
The first time users could do more with their money on the blockchain than send it from point A to point B was in December 2017 with the launch of MakerDAO – an ethereum based protocol that created a way for anyone to take out a loan without relying on a centralized entity. It also created a dollar pegged digital asset called DAI, which didn’t rely on holding dollars in a bank like USDC, USDT and other stablecoins.
In September 2018 COMPOUND FINANCE launched, enabling the borrowing of one digital asset against another locked as collateral, charging variable fees and offering rewards to those who contributed to the liquidity of the ecosystem.
And now, three and a half years after MakerDAO made the technology accessible, there are now hundreds of DeFi applications.
So why has DeFi caught on so fast? What does it actually do?
In its most simple sense, we can define Decentralized Finance, or DeFi, as the ecosystem of financial applications being built with blockchain technology.
And what’s so special about it?
Well, firstly, it’s NON CUSTODIAL. That means you have control over your own assets, you’re not actually handing them over to the DeFi apps. You hold the keys to the wallets and are responsible for your funds. No intermediaries, no middle men.
Next, these networks are GLOBAL. There are no borders in this parallel financial system and everyone can access it, as long as you have an ethereum wallet and an internet connection.
Critically, the code for these financial applications is TRANSPARENT. This means anyone can verify how the applications work and track exactly where their money is.
DeFi is also COMPOSABLE. No, that doesn’t mean you can throw it in the compost bin. It means developers can build code on top of others’ applications due to the open source nature of the system, accelerating innovation and allowing these applications to bolt together, offering even more value. This is where the term MONEY LEGOS comes in. A useful metaphor for seeing how defi products can be combined.
And finally, it is – of course – DECENTRALIZED. The financial system is built on protocols like Ethereum, run by thousands of nodes around the world and almost impossible to censor or stop. And on top of this base layer, the DeFi platforms themselves are built to be managed by a community of users, not by one central force.
And what can you do on defi platforms? The list is growing fast.
It started with basic use cases like LENDING, BORROWING and TRADING, and now includes insurance, portfolio management, creating synthetic assets, streaming payments and even playing in a lottery where you can always get your money back.
One other thing worth adding when talking about DeFi is the culture. This isn’t some buttoned up, suit and tie affair like Wall St. This has, like all of crypto, been built by a different generation. Social media memes replace full page ads in the New York Times, and just look at the names of the platforms. No wonder the dinosaurs at Berkshire Hathaway are bamboozled by it [insert clip].
[YAM, Yearn, Curve, Balancer, Aave, Sablier]
And this is all because the fundamental values upon which the space is built is different from the legacy financial system.
Where there was EXCLUSIVITY, now there is OPENNESS. Where there was EXPENSE and FRICTION, now there is EFFICIENCY. Where there were TRUST-BASED institutions, whose reputation was cast in stone over decades, now there are TRUST-LESS smart contracts. You don’t need to trust the MAN in the suit in the 200 year old BANK, because the CODE that operates the MONEY ROBOT is right in front of you.
Of course, when it comes to money – it always pays to be prudent, and there are a few tips for starting out in DeFi. It can be a lot to get your head round on your maiden voyage into the sea of DeFi protocols out there, so start small to get a feel for it.
Look for the protocols that have the most total value locked – these smart contracts will have been well tested and any bugs ironed out.
One part of DeFi that is perhaps more intuitive and accessible than some of the others is insurance – Nexus Mutual, for example, where the decentralized ‘crowd’ shares risk together, and it’s surprisingly easy to cover yourself.
And yes, there’s a thing called APING, where crowds pile into yield farming. That’s a complicated business, and one we’ll be coming back to in the future.
Now at the start I promised you something. How on earth can DeFi outperform the traditional banking system that’s had hundreds of years to perfect its processes?
Well, the fundamental answer to that question is that the legacy system has perfected the process of lining its own pockets, not yours. It’s the greediest middleman since, oh… at least 2005, when I won a pie eating contest sitting between two absolute beasts at my uni’s old members day [ROBIN PIE DEMO].
And in the process of eliminating that greedy middleman, DeFi can share the value between the ecosystem – meaning that yes, you can get 14% interest on your USDC, or 18% on your DAI. Want to borrow instead? Try 0.1% on your ETH with AAVE. Will you find that kind of rate on Wall St, the High St or any other street? I very much doubt it.
DeFi protocols can optimise the incentives at any time to increase liquidity, offer better lending or borrowing rates and all of it is completely transparent.
It puts the power, control and choice in the hands of the users, and to quote our favourite crypto pin-up Vitalik, “The idea that just anyone, anywhere in the world can choose their financial exposure, is a really powerful thing”.
Indeed it is. Welcome to the future.
You’ve been watching School of Block, presented by Ledger and the Defiant, demystifying decentralisation, one block at a time. Don’t forget to subscribe, drop us a like as it helps the youtube algo spread the word, ping that notification bell to get the heads up early on the next episode… and as always – here’s to your financial freedom.”