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DeFi
9. DeFi
Core message: DeFi, or Decentralized Finance, is a loose concept used to describe the digitisation, automation and expansion of traditional financial services (i.e., payments, lending, trading, investments, insurance, and asset management) using blockchain, digital assets and smart contracts.
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Our 2-Cents: A milestone in the evolution of digital assets. Expect a wave of innovation and widespread involvement of traditional financial institutions in the coming years through "Permissioned DeFi".
Let's break it down...
DeFi is most often defined as the transformation of traditional financial products into products that operate without an intermediary via smart contracts on a blockchain.
In its truest form, DeFi exhibits four properties; it is:
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1. Non-custodial: participants have full control of their assets at all times
2. Permissionless: anyone can interact with DeFi services without being censored or blocked by a third party
3. Openly auditable: anyone can audit the state of the system at any time
4. Composable: New financial products and services can be created using existing ones (similar to how one creates Lego models based on a few basic building blocks)
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DeFi is a nascent industry and has grown from nothing to total value locked (TVL, or analogously “assets under management") over USD 100bn in a few short years.
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While there is much work to be done to address significant growing pains (in the form of hacks and immature offerings), continued rapid growth seems inevitable due to:
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the possibilities that streamlined settlement and transfer of ownership of digital assets offer
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the higher yields on offer through the automation and rationalisation of processes
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the potential to transform illiquid assets (real estate, equities,…) into liquid, and fractionable, assets using tokenisation
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the opportunities “composability” provides to create new services
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24/7 services (which means harder working capital)
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Access to a growing global marketplace
Examples of DeFi
While at present DeFi largely exists within the use cases of trading, borrowing and lending of digitally native commodities (predominantly bitcoin and ether), the number and type of DeFi solutions are steadily growing and gaining traction:
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Decentralized Exchange (DEX)
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A decentralized exchange is a marketplace for digital assets that employs smart contracts that self-execute under set conditions and record each transaction to the blockchain.
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While exchanges can operate order books either on or off the blockchain, the most prominent form of DeFi exchange, automated market makers (AMMs), does away with the traditional order book entirely.
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Any holder of digital assets can lock up funds as liquidity for potential trades, earning a yield paid by traders. The price of any trade is determined algorithmically, based on the ratio of available liquidity in the assets being traded. A trader is therefore dealing against liquidity pools supplied by market makers, rather than an order book of potential counterparties subject to a bid/ask spread.
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Borrowing/Lending
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Borrowing/Lending pools are similar to DEXs / AMMs in that they are all about providing liquidity. The difference is that the liquidity is provided in the form of debt rather than sales.
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DeFi lending allows anyone to lend digital assets to anyone else to earn interest (and possibly receive additional rewards in the form of governance tokens that can be sold on the market).
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Overcollateralized Loans
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To buffer against price fluctuations, loans are generally overcollateralized, meaning the borrower must supply collateral greater than the value of the loan amount.
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Why borrow on these terms?
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Borrowers don’t lose exposure to their collateral, unless they fail to repay their loan and there is a liquidation event (collateral sold to cover a lender’s losses). For this reason, they can post collateral in Asset A, whose value they think will appreciate, take out the loan in Asset B, and switch Asset B for Asset A to effectively leverage their position.
Because loans are secured with assets held in smart contracts, there is no need for credit checks or other borrower-specific evaluation prior to a loan.
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Flash Loans
Flash loans are an alternative to over-collateralized loans.
These are uncollateralized loans for the duration of a single transaction, requiring the borrower to repay the full borrowed amount plus interest by the end of the transaction.
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The transaction fails if the loan is not repaid in the same transaction. This type of loan is used for decentralized exchange arbitrage, however, they can also be used in attacks on DeFi projects.
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Staking
Staking is the process of allocating tokens to a pool to achieve a collective outcome. The type of pool, and form of outcome, can vary massively, yet the principal is the same.
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Maybe the best example of staking is used in Proof of Stake (POS) blockchains.
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POS blockchains produce and validate new blocks through the process of staking. Staking involves validators who lock up their coins so they can be randomly selected by the protocol at specific intervals to create a block. Usually, participants that stake larger amounts have a higher chance of being chosen as the next block validator.
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A staking pool is a group of coin holders merging their resources to increase their chances of validating blocks and receiving rewards. They combine their staking power and share the rewards proportionally to their contributions to the pool.
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Derivatives
It is estimated that the global derivative market is 10 times bigger than the total gross domestic product (GDP) of the world.
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Importantly for the open finance landscape of DeFi, derivatives only emulate the underlying asset(s), without providing a right or ownership rights. They thus represent an attractive option for bringing conventional financial products on-chain.
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At the same time, the composable nature of the space allows for the creation of highly sophisticated financial assets that follow unorthodox rules.
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When referring to derivatives in DeFi, we often mean one of the following:
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Wrapped tokens: narrow-focused derivative applications – mostly used for cross-chain interoperability purposes (e.g., Wrapped Bitcoin, which is an ERC20 token on the Ethereum blockchain representing Bitcoin).
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Synthetic assets: more akin to conventional derivatives as they use oracles to track the price of an underlying real or financial asset or some physical commodity in the real world.
Blockchain-based derivative markets: a form of decentralized exchange (DEX) specialising in derivatives trading, including forwards, futures or options.
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Stablecoins
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Stablecoins are digital tokens that are pegged to an underlying asset (such as US Dollars) in order to combine the stability of the underlying asset with the benefits of a digital currency.
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They are a very important part of the DeFi ecosystem as they act as a bridge between fiat currencies and digital assets.
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(For more information on Stablecoins see.)
Tokenisation
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Tokenisation is the process of transformation of an accounting system so that all balances are managed by users through cryptographic keys, and the ownership of an asset is represented by a digital token.
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The tokenising of real-world assets, especially those like real estate that have historically been illiquid, allow them to be used as collateral or traded on a public blockchain.
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This can unlock liquidity for firms by allowing historically illiquid assets, such as commercial real estate, to be represented as tradable, fractionalized tokens on a public blockchain. These tokens can then be posted as collateral or included in investment pools on DeFi protocols
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Challenges Facing DeFi
DeFi is a nascent technology: DeFi is growing rapidly both in service offerings and total value locked (TVL) but it is a nascent technology/industry yet to be fully stress-tested at scale over an extended period.
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Lack of consumer protection. DeFi has thrived in the absence of rules and regulations. But this means users often have little or no protection when things go wrong.
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Hackers are a threat: DeFi offers a big attack surface for hackers.
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Collateral requirements are high: Nearly all DeFi lending transactions require collateral of > 100 percent of the value of the loan.
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Security: As investors are in full control of their own digital assets, if they lose their private key, they lose access to their funds forever.
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Permissioned DeFi is a new form of intermediation that allows:
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the ability to automate and rationalise workflow processes
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streamline settlement and the transfer of ownership of digital assets
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enables the development of high yielding services
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24/7 availability
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access to a burgeoning global market.
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Financial Institutions are ideally placed to:
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Expertise and Customer Service: Offer access to Permissioned DeFi services, a secure custody solution and robust customer service (while the delivery may be different the underlying financial products and yields are based on the same principles).
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Liquidity: Provide liquidity to protocols as a source of revenue (yield) or leverage protocols to manage liquidity needs.
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Innovation: Build on and improve existing protocols and services offered by utilising industry knowledge and expertise.
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Permissioned DeFi
The last 2 years have seen large inflows of institutional investors along with the development of “Permissioned DeFi” which addresses legal and regulatory concerns such as KYC and AML.
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Permissioned DeFi requires participants to undergo a whitelisting process that involves identity and background checks. In this way, compliance-conscious institutions can be assured that all of their trading counterparties have been vetted, and that they won't be left holding blacklisted assets.
