Decentralised finance (DeFi) is a new way of providing financial services based on blockchain technology. It aims to cut out traditional centralised services and remove intermediaries, replacing them with automated protocols.
How does DeFi work?
Participants in DeFi are part of a peer-to-peer (P2P) network built on a public blockchain. Assets on the network are transferred using smart contracts. These are programs or protocols that automatically execute once a set of conditions are met. The terms of an agreement between buyer and seller are directly written into the protocol’s code.
In most cases, DeFi is used to replicate traditional financial systems using cryptocurrency. The draw is in providing a perceived greater value to the end user.
For example, a customer can today place their savings in a bank-held account to accrue interest. The bank offers 0.5% interest on the savings but uses that money to lend to another customer at 2% interest. The bank keeps the 1.5% profit. In a DeFi ecosystem, customers lend directly to one another, cutting out the bank and receiving their full return.
DeFi applications use open-source technology, allowing a high level of composability. The different services can then be combined to create new decentralised applications (dapps). These run on the blockchain instead of executing from a single computer. Dapps and DeFi are already in use to create a variety of services:
- Securities trading
- Digital wallets
- Distribution of NFTs
- Exchange hosting
What is the value of DeFi?
The DeFi market has experienced exponential growth in the past few years. The value of the network is measured using what’s known as total locked value (TVL). This is the sum of all digital assets deposited in DeFi protocols. The TVL reached a high of $240 billion in November 2021. That number has since shrunk to $43.8 billion due to a fluctuating cryptocurrency market.
According to the European Central Bank, DeFi relies on attracting new users to propagate its system of profits and returns. Incentives are offered for new joiners to protocols, including high revenue potential and highly attractive interest rates to P2P lenders. In February 2021, providing liquidity in the Tether stablecoin yielded interest rates as high as 11% APR.
How could DeFi impact the banking industry?
DeFi is designed to empower individuals and give them control of their finance. It aims to give users the freedom to choose how to invest their assets without the input of an intermediary. Naturally, its applications for the two billion unbanked or underbanked people worldwide have been highlighted.
The global smartphone penetration rate hit 83% in 2022. Proponents of DeFi and stablecoins believe this enables a whole swathe of the global population to borrow, spend, and utilise digital money without the identity checks, documentation, or regulation that traditional banks require.
Beyond the retail sphere, investigations are underway into the potential of blockchain networks and decentralised finance in improving operational efficiency in existing institutions. For example, the tokenisation of real-world assets on public blockchains could enable traditionally illiquid assets – like real estate – to be represented digitally and used in investment pools.
What are the risks associated with DeFi?
DeFi is subject to the same vulnerabilities as traditional finance. These include excessive leverage, liquidity mismatches, and interconnectedness. If market value fluctuates – as happened in early 2022 – investors are forced to liquidate holdings. This can create a spiral of devaluation. The crash of the TerraUSD stablecoin caused the collapse of the Anchor DeFi protocol.
In traditional financial markets, central banks act as buffers and shock absorbers to the system. DeFi has no such backstop. A lack of regulatory oversight and reliance on technological protocols mean ripple effects can occur quickly in the event of problems. Smart contracts are built to execute, and do not consider prevailing market conditions when they do so.
The nascent technology underlying DeFi also poses problems. The irreversibility of the blockchain offers little recourse in the event of unexpected losses. Accounts hold no insurance, and no regulatory body is as yet ready to protect consumers from abuse.
As the value of the DeFi market increases, so does the activity of those looking to exploit it. In the first three months of 2022, hackers stole $1.3 billion from exchanges, platforms, and individuals. Almost 97% of all cryptocurrency stolen in those months was taken from DeFi protocols, up from 72% in 2021 and 30% in 2020.
The future of DeFi
Without a doubt, DeFi has the potential to be a significant milestone in the evolution of digital assets and finance. The market is growing rapidly, and with experience and exposure comes increased security and reliability.
Yet the sector has a long road ahead, especially as regulators begin to focus on its impact on the traditional financial system. How DeFi will evolve and whether it will reach its potential in revolutionising access to finance remains uncertain.