Updated: Mar 26, 2022
Discovery Path - DeFi Investing Series: Part I
The rise of blockchain is set to bring about major changes in the behaviour of banks and other financial intermediaries and their implications for new financial aggregates such as DeFi. DeFi is the promise of open access for all to financial services such as borrowing, lending and investing, without intermediaries, but through blockchains and crypto-currencies. After a decade of attempted partial reintermediation, the phenomenon of disintermediation of financial services is back on the agenda.
From Disintermiated Finance to Decentralised Finance
The 1980s, a Decade of Disintermediation in the Financial Sector
The 1980s have been characterized as the decade of deregulation in the financial industry. By the early 1980s, technological advances had greatly reduced the cost of storing, transmitting and evaluating the information needed to make credit and investment decisions. As a result, the central role of banks as financial intermediaries had changed significantly. This was, in fact, the first draft of a process of decentralization of financial services.
Technological innovations in the 1980s allowed non-bank intermediaries and investors direct access to trading in capital market instruments, which broke down the exclusive intermediary role of banking institutions. This openness created pressure for banks to expand their role as financial intermediaries to include securities and commodities brokers and dealers, investment advisors, and insurance brokers and underwriters.
These technological developments have also made it possible to link securities markets around the world in a way that allows for virtually round-the-clock trading; this has provided traders and investors with better tools to monitor their investments and to take advantage of the many new hedging opportunities in one market compared to those in another.
The development of financial engineering, supported by technological progress, has also stimulated the creation of innovative financial products and alternative ways for companies to raise capital directly from investors, as in the "Dot.com" wave of the 1990s and the early 2000s. Much of this innovation has been the result of exploiting opportunities in various areas where banks have faced strong competition from a new type of non-bank financial intermediary. The emulation effect of technology has allowed banks to respond to this new type of competition by developing new products such as, for example, credit, risk management and hedging tools that allow these new financial products to be taken off the balance sheet, thereby avoiding capital requirements and reducing the costs of products and services for their customers.
The early technological innovations have irreversibly affected the conduct of banking and the functioning of capital markets over the past four decades. The shift from the disintermediated financial services of yesterday to the decentralized financial services (DeFi) of tomorrow raises the question of whether a financial industry dominated by crypto-blockchains could be regulated?
The New Millennium's DeFi, an Unstoppable Transformation of the Financial Sector
What is DeFi? The crypto-currency system was created with the idealistic vision of making money and money transfers accessible to everyone, regardless of where they live or the quality of the payment system in their country. Thus, even the unbanked will be able to store wealth, send and receive money anywhere in the world without having to pay exorbitant fees to financial intermediaries. The launch of the first digital currency - which originated in a white paper - (Nakamoto (2008)), Bitcoin, realised this vision of a decentralised monetary system, without intermediaries or control by a central authority, and accessible to all.
Decentralised finance ("DeFi") is the next step in the development of the crypto-currency system. In addition to offering an alternative payment system, it plans to disintermediate a wide variety of traditional financial services and products used in everyday life, such as savings, loans, trading, investment, hedging, insurance, etc.
DeFI is a generic term for the emerging financial infrastructure of blockchain-based applications. Blockchains store digital records of transactions, derived from individual records, called "blocks", which are linked together in a single list, creating the "blockchain". Blockchains are used in DeFi to create peer-to-peer alternatives ("smart contracts") for conventional financial products, services and institutions, which are automated and enforceable agreements that do not require intermediaries, such as banks, brokers, depository banks, etc.
How does DeFi work? DeFi's infrastructure is based on secure distributed ledgers similar to those used by crypto-currencies and runs entirely on blockchain networks. The launch of the Ethereum network and its associated cryptocurrency, Ether (ETH), was the key milestone in the development of DeFi's infrastructure in the mid-2010s. This technology supports automated contracts with predefined protocols hosted on blockchains, commonly referred to as "smart contracts", and is instrumental in the growth of the DeFi ecosystem. The use of cryptocurrencies and smart contracts to provide financial services makes the role of intermediaries and guarantors obsolete. For example, many financial services can already be completely disintermediated: such as lending (where users can lend their crypto-currencies and earn interest per minute rather than once a month), granting a loan instantly, conducting peer-to-peer transactions without a broker, saving in crypto-currencies at a better interest rate than saving in a bank, easy access to derivatives such as options and swaps. The dApps allow peers to interact directly and also eliminate the need for a central clearinghouse.
To facilitate peer-to-peer business transactions, users use dApps, most of which are found on the Ethereum network and other smart contract platforms. The dApps allow peers to interact directly and remove securely the need for a company to act as a central clearinghouse for interactions between applications. Some of the most widely used DeFi services and dApps include bitcoin (Ether, Polkadot, Solana), stablecoins (whose value is tied to a currency such as the US dollar), tokens, digital wallets (Coinbase, MetaMask), DeFi mining (also known as liquidity mining), performance farming, staking, trading and borrowing, lending and saving using smart contracts.
DeFi is an open-source blockchain technology powered by decentralized apps (“DApps”), meaning that protocols and apps are theoretically open for users to inspect and to innovate upon. As a result, users can mix and match protocols to unlock unique combinations of opportunities by developing their dApps.
Decentralised Finance (DeFi), more than an Alternative to Traditional Finance
Since its launch, the DeFi financial ecosystem has grown dramatically to an estimated market value of over $100 billion. DeFi has enormous growth potential because its protocols are open source. Developers around the world can easily collaborate and add value to the DeFi ecosystem to unlock liquidity and growth opportunities. Within the DeFi infrastructure, product innovation becomes not only unlimited but also more secure, efficient and scalable.
Decentralised finance is emerging as a strong alternative to traditional finance, as it gets rid of a lot of red tapes, such as legal, compliance and KYC procedures, eliminates human "emotional bias", as well as the risk of human error (or fraud) in the execution of transactions, which can lead to heavy losses. The use of digital ledger technologies enables consumers to retain full control of their assets and personal financial data during the entire investment cycle.
DeFi has the potential to democratise financial systems, enabling anyone to access financial services, especially those in underserved communities who do not (e.g. those living in remote areas) or cannot (e.g. those who are unemployed or have criminal convictions) access financial institutions. DeFi is a system of consensus between members and users that encourages good behaviour and penalises bad "actors".
As there is no intermediary, transactions are instantaneous, barriers to entry are removed and costs are reduced as there is no need for clearing and settlement processes. Thus, delays and settlement problems, which could lead to heavy losses for traders, are also eliminated.
What should beginners know? It should be kept in mind that DeFi depends upon software applications, which could suffer from problems or "bugs", that are common risks associated with the embedded technology of any software. As it matures, the DeFi ecosystem will likely self-regulate to audit any application before uploading it to a blockchain. Despite an exponential growth rate, the cryptocurrency market remains still highly illiquid and, as such, is not immune to the risks inherent in any illiquid products, such as large price swings.
Ultimately, as with any other financial service or product, the users always have to conduct their due diligence and review the offer. It is essential to engage with reputable and transparent Apps and dApps products. One of the fundamental characteristics of blockchain technology is transparency. So if the developers of a DeFi App prefer to remain anonymous, this should raise a red flag as to whether it is reliable or a scam.
Without a doubt, all DeFi products and services must be compliant, secure and properly audited and controlled to ensure the security and privacy of users. Blockchain technology can also enable this.
Next Discovery Path - DeFi Investing Series: Part II - Portfolio Strategies