There are currently over 4,000 (four thousand) cryptocurrencies in circulation and about 51,200,000 (fifty-one million, two hundred thousand) active traders of cryptocurrency around the world. With the proliferation of cryptocurrency and the associated technology that backs it, disruptors and innovators have begun to take advantage of the multifunctional nature of cryptocurrency and have created products that could change or disrupt traditional banking and finance. Enter Decentralised Finance or ‘DeFi’ for short.
DeFi refers to an emerging area of finance where financial products are offered to customers using blockchain technology such as smart contracts, limiting reliance on the traditional institutional nature of finance where financial products and services are offered by banks and other financial institutions.
When compared to the traditional or centralised financial industry, DeFi is still a small drop in a big pond. However, DeFi products or protocols have started growing rapidly and are attaining monumental gains. In 2019, only USD$275,000,000 (Two Hundred and Seventy-Five Million Dollars) worth of cryptocurrency was locked in the DeFi economy. By February 2020, that number grew to USD$1,000,000,000 (One Billion Dollars) and by January 2022, over USD$78,000,000,000 (Seventy-Eight Billion Dollars) worth of cryptocurrency has been used on decentralised financial products.
So, with this rapid growth of DeFi products, it is important to consider whether DeFi as an alternative financial infrastructure is complementary or an adversarial to traditional financial and banking systems.
In this article, we will examine this question by breaking down what DeFi and conclude with our opinion on the future of DeFi.
Understanding Decentralised Finance
Dr. Usman W. Chohan, an international economist-academic, describes DeFi as: “…an experimental form of financial praxis that is removed from dependence on centralized financial intermediaries, which in this context might include banks, exchanges and brokerages. As such, DeFi purports to disintermediate financial activity from the traditional mechanisms of finance, and it does so through the use of a blockchain substitutive architecture.”
In a nutshell, DeFi is a movement that aims to create an open-source and transparent financial service ecosystem that is available to everyone and operates without any central authority such as banks or brokers. The users maintain full control over their assets and interact with this ecosystem through peer-to-peer (P2P) applications that are decentralised “Dapps”.
Dapps are used by DeFi protocols or product customers to interact which each other and are powered by ‘Smart Contracts’, programs which run like contracts when predetermined conditions are met and are stored on a blockchain. Smart Contracts are self-executing contracts with the terms of the agreement being directly written into lines of code, such that when the pre-agreed conditions are met, the smart contract enforces the performance of the relevant terms of the agreement. The code and the agreements contained therein exist on a blockchain network. The code controls the execution, and the transactions are trackable and irreversible.
Ethereum.org defines a Dapp as an application built on a decentralized network (blockchain) that combines a smart contract and a frontend user interface. Therefore, the layers of a DeFi product are made up of the backend (Smart Contract) which contains the terms and conditions embedded in the line of code and the frontend (Dapp) with which the users interact. The Dapp can be programmed to carry out various functions to enhance the user experience like tools to compare and rate services, allow users to perform otherwise complex tasks by connecting to several protocols simultaneously, and combine relevant information in a clear and concise manner.
Read also: IOSCO explains how Decentralised Finance is cloning Financial Markets
Dapps are the means by which customers access DeFi products. For example, Luffy may be looking to get a loan and instead of going to a bank, he could decide to log on to a Dapp which compares and rates the different services on offer. Upon selecting one of the offers, Luffy enters into a Smart Contract and accordingly, the Dapp stipulates the conditions required of Luffy for disbursement of funds. Once Luffy fulfils these conditions, the disbursement term of the Smart Contract is executed and the loan amount is disbursed to Luffy (usually in cryptocurrency) instantly and parties are bound by the Smart Contract.
The DeFi product, a loan in the example above, may also be secured by collateral. Subject to the terms of the Smart Contract, collateral may be deposited in an escrow account (off-chain collateral) or the collateral is deposited on the native blockchain the Dapp is built on usually in the form of the cryptocurrency native to the blockchain (on-chain collateral). In some cases, there may be no collateral requirement at all.
The hypothetical loan transaction is just one of the many financial services/products available via DeFi. In the next part of our article, we will explore a few DeFi products.
DeFi – Financial Services and Products
Though there are several ways DeFi protocols are being used today, we will highlight the most prominent use cases.
Stablecoins: Stablecoins are the most popular use cases of DeFi protocols around the world because crypto holders, traders and even Whales (individuals who own a large amount of a particular cryptocurrency) can hedge against the volatility of the prices of cryptocurrency by buying digital assets that are pegged against fiat currency (money issued by a government and declared as legal tender) or commodities.
Stablecoins are digital assets tied to a stable asset such as fiat currency or a commodity like gold. They tend to stay stable for longer periods of time than those that are non-asset backed e.g., Bitcoin (“BTC”) or Ethereum (“ETH”). The entity issuing the stablecoin usually sets up a “reserve” where it securely stores the asset backing the stablecoin and theoretically, the holder of the stablecoin can redeem one unit of the stablecoin for one unit of the asset that backs it i.e., 1USD Coin (“USDC”) for $1.
There are also some complex forms of stablecoins backed by other stablecoins. For example, the NGN Token (“NGNT”) is a collateral-backed digital currency issued by Token Mint that is pegged to the value of the Naira and is not volatile. In addition to being pegged to the value of the Naira, NGNT is also backed by USDC. USDC is issued by regulated financial institutions in the United States, backed by fully reserved assets, and redeemable on a 1:1 basis for US Dollars. Therefore, a holder of NGNT, can redeem the USDC equivalent of NGNT he holds and trade it in for US Dollars.
However, criticism of stablecoin as a DeFi product remains. Critics argue that stablecoins are only as stable as the asset backing them; thus, they are still affected by the volatility of the underlying asset. They also believe that there is a counterparty risk investors need to note as most stablecoin issuers do not specify where they store their ‘reserves’ and how much value is actually stored. In instances where the value of the reserves of the issuer is less than the value of the stablecoin issued, this impacts the ability of investors to redeem their stablecoin for the underlying asset.
Despite these criticisms, stablecoins remain one of the more popular DeFi products and are even being used in countries where their fiat-based currencies are losing value, e.g. in Brazil where hyperinflation, poor economic factors and a host of other issues, have caused a crash in the value of the Brazilian Real. Now, most of its citizens are using Tether Coin, a stablecoin pegged to the Dollar, to carry out transactions and have more stable savings.
In the second part of this article, we will consider other financial products and use cases for DeFi.