What is DeFi? Let's dig into that..

So far, the world of blockchain has seen an overachieving trend every year. In 2009, the story was around Bitcoin. In 2015, Ethereum, and 2017 brought the world ICOs (Initial Coin Offerings). The answer for the upcoming year is unmistakably DeFi. Also known as Decentralized Finance, this movement has turned the most heads in the past few months in the entire crypto and blockchain ecosystem.

In order to better understand the reason for this popularity, let’s break down what makes this open financial movement so revolutionary, and analyze the strides that De-Fi has made towards creating an open financial system.

What is De-Fi?

Decentralized finance, or open finance, refers to the paradigm shift from today’s closed finance systems. It is based on open protocols that are programmable, composable, and inter operable.

As we see the Blockchain and Crypto ecosystem expand, the goal of this entire destination becomes more and more clear - that of creating Open Finance. Ethereum is already creating a new on-chain economy that integrates with present financial systems. Open finance doesn’t intend to create new systems from scratch, but instead aims to democratize the existing system and make it more equitable using transparency and openness. 

Key properties of Open Finance

The key properties of what makes DeFi such powerful a revolution include:

●     Interoperability: The legacy financial system is comprised of limited transfer ability and only one-way access. Where interoperability is even possible, it is controlled by rent-seekers and middlemen. Open finance is defined by platforms that can operate together with a degree of transparency, in a way that complements each other.

●     Programmability: Bitcoin revolutionized money and how we see it. Ethereum enabled new types of financial assets and instruments that are extremely customizable than the legacy ones. Digital assets and securities will bring in a new era of financial mechanisms and growth.

●     Composability: For many of us, we grew up playing with Legos - where we would build blocks as per our imagination. Composability is the concept of selecting pieces and assembling it into multiple combinations. Ethereum has strengthened the value of this, having already become a protocol for other protocols, such as UMA, Maker, Compound, and many more. 

Criteria of an Open Finance Economy

No financial system can become an economic engine without numerous traits. First, we must define those criteria. There are a few accepted characteristics that are needed to comprise an economic system, including:

 ●     The ability of transferring capital between borrowers and lenders.

●     A process of trading and exchange with necessary liquidity.

●     Means for investors to move, save, formulate, and allocate capital.

●     Capacity to manage any forthcoming risk.

●     Regulatory protections for investors and individuals.

 So, a financial system that is truly open must meet the above-mentioned attributes while eliminating the intermediaries or central points of control.  

Let’s talk more about the characteristics and how they compare to the Ethereum ecosystem.

Borrowing and lending

For a financial system to provide liquidity to borrowers, it needs lenders, and vice-versa, to obtain lenders, the system needs borrowers. Classic chicken-egg problem.

This is initially solved via speculation. Crypto, which is majorly a speculative asset class, has created interesting lending and borrowing protocols. 

MakerDAO was one such protocol which created a means for individuals to speculate through collateralization. While MakerDAO vaults have enabled users to borrow, many new lending and borrowing protocols have dominated most of the last year’s crypto narrative. Compound and Fulcrum, both create pools of capital allowing users to borrow or lend crypto-assets like dai, USDC, Ether, and more. 

Most recently, MakerDAO’s anticipated upgrade from single collateral dai to multi-collateral dai was successfully completed. This upgrade also came with a new dai savings rate (DSR) - which offers interest to individuals who keep their dai in the Maker protocol. In the short-term, this is a smart contract that can be seamlessly integrated into any other exchange and may also become the base interest rate for the crypto DeFi space.

In the long-term scenario, the DSR has the potential to become a trust-free savings rate, similar to how treasury bills act as the risk-free rate. This distinction between trust-free and risk-free is subtle yet distinctive. While this protocol does come with elements of risk, it does not require trust from a single entity, as it is governed by MKR token holders. This is one step towards reducing systemic risk - by eliminating reliance on large organizations, and even the government.

These various protocols showcase the power that lies in ‘composability’.

Exchange and Trading

Financial systems operate through open markets and require robust mechanisms for trading as well as transferring value. The 2019 trading landscape was majorly dominated by a few large players, like Coinbase, Kraken, Gemini, Bitstamp, Bitfinex, and Binance.

The year that went by showcased crypto exchanges are poised to become the UI for investing, trading, and all other activities. Most major exchanges offered new trading pairs and developed products and services like mobile wallets, educational tools, and even token products. Similar to Apple’s product stickiness, even crypto customers will probably remain loyal to a couple of crypto exchanges because of the lengthy on-boarding process coupled with people’s desire to custody assets in one location.

Notably, though, a few exchanges decided to focus on capturing institutional clients, building out custody solutions or acquiring the required infrastructure. While centralized trading has been widely profitable as well as popular, it is not quite the path breaking financial economy that crypto enthusiasts are hoping to achieve. 

Uniswap emerged this year as the go-to DEX (decentralized exchange) for trading cryptocurrencies in a disinter-mediated fashion. They reported trading volume over $8Mn in a twenty-four period in November 2019. Uniswap is currently composed of 33% of all DEX volume which exceeds IDEX and Kyber. dYdX developed another DEX platform to combine trading, lending, and borrowing. This platform aggregates spot prices and liquidity across multiple exchanges for the users. Notably, Binance too offers customers lending capabilities on its centralized exchange. 

Initial Exchange Offerings (IEOs), too, were massively popular in the first half of 2019, where a centralized exchange acted as the token sales platform. In essence, the exchange acts as the gatekeeper for the token sales and only verified customers are permissioned to participate. The sales were conducted using tokens such as Binance Coin (BNB) which offers reduced trading fees and buy-backs similar to stocks. A report by Token Insights halfway through 2019 said that the IEOs was hyped up throughout the first couple of months of 2019 but then it slowly faded in popularity. Despite IEOs, ICOs, and STOs (security token offerings) having had their share of scams and misuses, the ability to raise capital is a necessary tool for any financial system. 

Investing and Allocation of Capital

In the definition that we laid out during the beginning of the article, the ability to formulate capital and move money were also present. Ethereum has solved these two issues by providing the ability to transfer ether and also by using STOs as mentioned above. 

Investing in crypto assets has definitely evolved throughout last year and will, without a doubt, continue to expand in the years to come. Speculation remains the most popular use case for crypto assets, however, many people perceive this as a negative trait. Mechanisms for speculation are vital for any new asset class, especially if the asset aims to be the bedrock of an open financial system. One of the most important (and the hardest) aspects to creating a new financial system is creating the required liquidity required for efficient investing.  

Liquidity is the capacity for an investor to convert any asset into cash, without much hassle. The term also refers to an individual’s ability to sell or buy a financial instrument without affecting the asset’s price. This is incredibly difficult, especially when the entire crypto-economy is valued at less than 200 billion dollars. Highly liquid assets are composed of trillions of dollars in value, which makes it easy to sell or buy any asset. The world’s six largest companies have a market value three times greater than the market capitalization of all cryptocurrencies. 

Some about other assets:

• Gold: 7 trillion.
• Stock Markets: 70 trillion.
• Global debt: Over 200 trillion.

So, how does a new asset class attract liquidity? Simply, by allowing anyone to create and trade assets that don’t trade elsewhere. The best part is that Ethereum literally enables individuals or groups to build new financial products and instruments which will definitely be one of the greatest financial explosions in our lifetime.

The most critical aspect here is that these protocols are open. UMA is creating a derivatives platform to provide standardized contracts for financial products. Synthetix, yet another in the list of names, is a protocol that supports creation and issuance of synthetic assets such as fiat currencies, cryptocurrencies, and commodities. Synthetic assets and derivatives provided by such open-source protocols create value for investors who seek to hedge against risk, diversify capital allocation, and also find system to increase the ROI. The types of derivatives are literally endless, and there are already over a dozen variations of Dai in existence which have been created by other DeFi protocols. 

Staking

Staking is, undoubtedly, increasingly becoming a method of capital deployment. This concept has emerged alongside the growth of cryptonetworks, especially proof of stake Blockchains. Staking is a broad term, but in this context, it refers to a mechanism by which individuals are required to support their action with capital. Numerai’s stock prediction tournament requires that data scientists stake their prediction with NMR tokens (their capital). The data scientists are then rewarded based on how accurate their prediction is, plus the amount of capital they staked. The greater the conviction, the greater will be an individual’s will to stake.

Other staking models for Blockchain, like Ethereum, require 32 ETH to partake in block validation. If an individual acts in bad faith, then their staked capital can be seized according to the protocol. Cosmos and Tezos have other staking models with unique properties, including governing (using voting) and rewards.

Because of the increasing popularity of staking and lending protocols, companies are helping individuals manage their operations. Coinbase stakes Tezos on behalf of customers and submits the rewards directly into customer accounts.

Another approach for staking investments has been using non-exchange custodians such as Staked and Atlas, which offer staking as a service for individuals. While centralized exchanges have the opportunity to offer this feature to existing users, specialized services may be able to capture a percent of market share, if individuals are more interested in the active governance of a particular crypto network versus simply earning rewards. It is possible that such lending and borrowing protocols will eventually offer staking features. We can expect many more applications and exchanges to offer such services in the year to come, especially because of Ethereum’s shift towards proof of stake, as well as the launch of many PoS blockchains. 

Risk Management and Regulatory Protections

These are admittedly less robust than the previous categories within Ethereum and crypto as a whole. In general, Ethereum mitigates some of the risks faced by current financial systems, that come from involvement of intermediaries, opaque information, proprietary systems, and ineffective social coordination. However, it comes with its set of drawbacks that are a result of the rapidly developing technology, like smart contracts that can be manipulated if not created correctly. To add to this, there are always insurance risks, liquidity risks, and other nuanced features of crypto networks that make open finance complicated, especially from a risk management perspective.

ConsenSys Codefi’s DeFi Score has gone in-depth in outlining many of these risk factors. De-Fi is a rapidly growing space in Ethereum, and 2019 brought many of these issues into spotlight as developers, companies, and individuals, all seek to minimize these risk factors. One thing is for sure, that new business models will definitely help eliminate (or at least reduce) these problems, albeit it may take some time.

On the regulatory front, things are definitely looking up, but there’s a lot to wait and watch, especially in terms of what CFTC, SEC, and other regulatory bodies say about crypto assets. In 2019, the regulatory clarity has increased and become more defined, especially in regards to trading, usage, and issuance. 

However, there’s no denying that there are still hundreds of questions full of nuances that need answers, and dozens of laws that will be required before widespread adoption is possible. However, there are still hundreds of nuanced questions that need answers, and subsequently, dozens of laws that will be required before widespread adoption is possible.

But whatever be the case, one thing is for sure - such a revolutionary approach will definitely open way for new markets and new categories for the economy.

Soon I will be publishing second part of this article to discuss more about DeFi (Decentralized Finance). I will look forward for some great feedback till then.