An Introduction to DeFi (Decentralized Banking)

May 24, 2021. By Matthew Okaty:

The rapidly expanding world of cryptocurrency is a challenge to keep up with.  While most people are aware of Bitcoin and could maybe name a few others, there are literally thousands of digital coins out there.  While most of those coins have little to no following, the 100 largest coins by market cap have a combined value between $1.5 trillion and $2 trillion (depending on the week’s volatility).  With so many coins, the most obvious question perhaps is, “What differentiates one coin from another?”  The answer to that question is not so simple and can make you feel you have been led down a rabbit hole into a very strange world.  The digital asset ecosystem is vast and complex—there are platform tokens, security tokens, transactional tokens, utility tokens, governance tokens, stable coins, digital rights tokens, non-fungible tokens, oracle tokens…the list could go on depending on how you want to slice it.  Exploring the cryptocurrency world for the first time is almost like discovering an underground city with its own language and economy and wondering how such a place could exist for so long without a whole lot of people knowing about it.

One of the major ways cryptocurrencies are being utilized is in an emerging space called Decentralized Finance, or DeFi for short.  DeFi has essentially the same features as traditional finance (i.e. borrowing and lending, earning interest, trading derivatives and other assets, buying insurance, etc.) except that it cuts out the middleman.  Instead of using a financial intermediary to facilitate, such as a bank or brokerage firm, DeFi connects participants directly with one another online using blockchain technology to verify and record the transactions.   And instead of transacting solely in dollars or other government issued currency (called fiat money), cryptocurrency is exchanged. 

Whatever your feelings are about Bitcoin or cryptocurrency in general, the blockchain technology which it is rooted in is considered revolutionary and has the potential to disrupt many industries, finance being one of them.   Blockchain is a new way of recording information that lends itself very well to decentralized applications.  Rather than having to rely on a particular entity to maintain the integrity of the data, blockchain can distribute that function across all the individual participants of the network with algorithms in place to prevent any one user from altering the data.  Proponents argue that this can speed up transactions, decrease costs, and foster greater personal autonomy.

As an example, for a traditional loan, a person would typically go to a bank and complete a loan application, submit supporting documentation, undergo a credit check, wait for a loan officer to review the file, the whole process possibly taking several days or more.  On a DeFi platform, this whole process could take just a few minutes.  Borrowers remain anonymous but still must put up collateral (in the form of cryptocurrency), usually greater than the amount of the loan itself.  You might wonder why borrowers would do this rather than just sell the collateral if they needed the money, but that could trigger a capital gains event which they might want to avoid, or they also might want to maintain their position believing that it is going to rise in value.  Additionally, in DeFi, anyone can be a lender and earn interest, something that is generally only available to banks otherwise.  The mechanics involved get a bit more complicated, such as the use of liquidity pools to spread around risk, but basically almost any traditional (i.e., centralized) financial service or product can be decentralized and find its counterpart in the DeFi world.              

For all the potential benefits that DeFi might offer, it is still very risky at present and not recommended for the average person.  Cryptocurrency is extremely volatile, and governments are still grappling with how to regulate the industry, with some countries attempting to ban it altogether.  However, sophisticated parties are becoming more and more involved.  The European Investment Bank (the investment bank of the European Union and one of the largest lenders in the world) recently dipped its toes in the water by issuing a $121 million dollar bond on the Ethereum blockchain, currently the leading blockchain for DeFi applications.  One of the individuals involved said that if banks do not embrace this change and learn to adapt, they face sort of a “Kodak moment,” referring to the famous camera company’s failure to transition successfully to the digital era.             

Another large European bank, ING, released an in-depth white paper entitled, Lessons Learned from Decentralized Finance (DeFi), and concluded that “the best of both worlds is achieved if centralized and decentralized financial services cooperate.”  If DeFi is ever going to become mainstream and find legitimate support with the regulators, it will most likely have to address its lack of anti-money laundering (AML) safeguards, something that centralized institutions are perhaps better equipped to handle.  The developers of one leading DeFI platform are actually already testing out a permissioned pool for institutional investors to experiment with that includes KYN (Know Your Client) and AML restrictions.  While this kind of public/private partnership represents an unholy alliance to a lot of DeFi and cryptocurrency purists, it might actually be necessary to its long-term survival.