What is DeFi: Is decentralized finance the answer to a fairer financial world or is it just a utopia?

The true meaning of decentralized finance explained in simple words

DeFi, a buzzword in the crypto industry and a trending hashtag in Twitter, is an umbrella term for decentralized or open finance. It refers to financial services and products built on permissionless, cryptographically protected, and immutable architecture (mainly blockchain technology) in the form of open-source code.

Blockchain is sort of an XL spreadsheet stored and automatically updated on hundreds of computers. They create a network and participate in validating new transactions in that network by adding verified nodes (blocks of ciphered information). Blockchains may be proprietary (restricted to a group of authorized network members) and permissionless. A “permissionless” blockchain means open for everyone to join the network and build code, such as smart contracts, on top of it.

The DeFi ecosystem consists of several layers, such as the underlying distributed ledger (a blockchain such as Ethereum), 2-layer DApps (Decentralized Apps) or even 3-layer DApp integrated offerings. The term “decentralized applications” means programs or code with a user interface designed for people unfamiliar with coding. They get deployed on top of the decentralized underlying architecture, namely blockchain technology.

The rationale behind DeFi is building a truly open financial system that would be faster, more efficient, just, and open to the unbanked. Moreover, decentralized finance is immune to third-party interventions and void of the risk related to the custodian’s insolvency, typical for centralized intermediaries.

What are the applications of DeFi?

Decentralized finance is just a new evolutionary step in the development of traditional finance. It means that essentially, it offers kinds of financial services and products that exist in the traditional financial system, but in a different, decentralized, form. Typical applications may include payment systems, investment products, lending and borrowing services, exchange of assets, stablecoins, etc. An example of a decentralized ecosystem functioning may be trading ERC20 tokens to invest in a company pursuing microloans in the form of an ICO on a decentralized exchange. Most DApps run on the Ethereum blockchain which allows for the execution of smart contracts and the possibility of building any sort of DApps on top of it. However, it’s not a rule and any blockchain that supports smart contracts could potentially host DApps. Hosting DApps is also part of the mission of Cardano Foundation, which claims that they will underpin the economy of the future. It’s possible to deploy DApps even on the Bitcoin blockchain, contrary to the common opinion, however, it’s not so straightforward since originally it was not built with this purpose.

What are the advantages and disadvantages of DeFi?

As somebody has accurately suggested, DeFi is a field of exploration with a lot of research in progress. It is powered by great and revolutionary in nature ideas, such as the spirit of democratizing finance and inclusion of those unbanked. However, at the moment, the field is very nascent and highly restricted by the frames of traditional finance. Let’s have a look at the advantages of DeFi in theory and its limitations in the current practice.

Decentralized Finance, as the very notion implies, eliminates the intermediaries in the form of a single entity securing trust between the parties. This means that trust in open finance is laid in the very technology that should guarantee the execution of the contractual relations. For example, if Alice wants to send money to Bob, she goes to a bank, makes a transfer and if this money gets lost on the way to Bob, the bank, a centralized entity, takes responsibility for the loss of the money and compensates the loss. In the case of a decentralized app, the money is transferred directly from the proprietary account of Alice to that of Bob. The transfer takes place with the immediate settlement and the corresponding record in a block of a blockchain (an immutable and distributed ledger stored on multiple servers and not depending on any entity). The whole process is very simple, it’s enough to download a DApp which does not require any identity verification. It is assumed that this money cannot get lost on its way, the record of the transfer cannot be modified, and the transaction is subject to very low commissions due to the extreme simplicity and automation of the operation.

In theory, this decentralized alternative to traditional highly centralized financial world is the solution to all problems, especially, the abusive high fees, in practice, there are a lot of “buts” that hinder mass adoption of such DApps. Let’s have a closer look at them.

DeFi is based on open source technology.

Imagine a bank that openly publishes its code for other entities to be able to review, improve or copy it. Can you? Well, it’s hard to imagine such a case in the competitive industry of traditional finance. Open source technology is exactly the opposite. Many projects in the cryptocurrency space were born as groups of enthusiasts building a code to enable operations on permissionless blockchains. They build their code on collaborative platforms where all users can exchange their knowledge, review and correct the code. However, at the same time, the openness of the code implies vulnerabilities. Someone who sees a vulnerability in the open source code could report it to get a reward or take advantage of it to hack the platform. At the same time, a bug in the code could cause a problem in the execution of a transaction in a DApp and generate a loss. Since there’s no entity behind the code, it’s unclear who would have to reimburse the loss. For sure you remember at least one episode of a decentralized exchange hacked and robbed.

Technology is constantly changing and maturing, including quantum computers that potentially will be able to take us to a new generational level in cryptography. However, the current level of technological maturity is not high enough to guarantee a totally reliable functionality of Dapps that would exclude any risk for the user’s funds. And this is why other forms of risk mitigation have to enter the game to attract users and foster the DeFi mass adoption.

Getting back to the example of Alice sending money to Bob, imagine that the bank Alice chose to send Bob her money goes bankrupt. What happens in traditional finance is quite predictable: Alice is notified of bankruptcy and her funds are compensated by an insurance entity (be it the private or public sector the one responsible for mitigating this sort of risks). This is possible because the bank is a regulated entity and to operate on the market, it has to create conditions that would guarantee redemption to its clients in case of insolvency.

As for DeFi, it is mainly (if not totally) unregulated. It means that since it’s an open source code and everybody has access to it to build smart contracts, there is no entity behind it that can get regulated. Moreover, what sort of regulation would apply, if the very nature of open finance is global? There’s no international legal framework for open finance at all at the moment of writing. Furthermore, considering the pace with which blockchain technology is entering the agenda of national or supranational regulators, there’s little hope for the DeFi industry to get regulated in the near future. What is the implication for the users? Simply, they have to assume that in case there’s a bug, a vulnerability in the code, an attack or any other sort of risk related to a DApp, there’s no guarantee that the funds will not be lost forever.

How does risk mitigation work in DeFi?

As we have just seen, the only form of risk mitigation currently applicable to DeFi is financial engineering and technology. In traditional finance, economic models offer various forms of hedging risk. One of them is collateralization. Collateralization is a form of guaranteeing the redemption of loss in case the funds of the client have to be reimbursed. An example of a collateral may be your grandmother’s wedding ring that you take to a pawnshop to ask for a loan. If you fail to pay back the loan, the pawnbroker will sell your ring and recover the money lost.

In DeFi, stablecoins pegged to national currencies, such as the US dollar for example, are typically collateralized with other crypto assets, such as ether. However, due to the famous high volatility of cryptocurrencies, to make a product attractive from the risk hedging point of view, the issuer has to overly collateralize it. It’s not uncommon that a decentralized asset is 150% collateralized which makes it less attractive to speculative investors.

Here we have mentioned that DeFi product issuers face the problem of their product collateralization. An issuer sounds like an entity behind a product or service it offers. Which implies that there’s sort of a third-party risk arousing from this sort of obligation. And the logical question here is...

How decentralized DeFi really is?

If the underlying permissionless blockchain technology may indeed be decentralized, in order to take advantage of its possibilities, 2 layer products have to be built so that users could trade, lend, borrow, pay, transfer funds, etc easily. These products are known as DApps. In theory, everyone could build a DApp by writing code compatible with the given blockchain protocol. But in practice, one has to be very naive to believe that writing code for a DApp to solve the inefficiencies in the financial system is something within the capabilities of an average unbanked person.

The truth is that building a DApp is a lot of highly technical and professional work that can barely be executed by random people out of pure enthusiasm. In the current still capitalist world, people’s motivation is normally driven by the possibility of getting a reward, at least speaking of long-term goals not so easily subject to impulses of enthusiasm. Therefore, DApps are built by professionals who stay behind entities motivated by the opportunity of getting income. This means that there’s a grade of centralization practically in any decentralized application, at least at the current level of industry development. This is the main paradox hindering its evolution, together with the unfriendly UX, absence of regulation, little to zero liquidity or volume and its futuristic nature.

The unfriendly user experience implies that lots of work has to be done to improve it and hence, lots of developers’ effort has to be invested. If someone invests their effort, logically, they aspire to monetize it. That’s why in DeFi applications, there still will be fees, even if much lower than in traditional finance. Will they be fairer than those charged by centralized monopolists? Not necessarily. Just recall the famous example of transactions on the Ethereum blockchain that prioritizes those that have paid more GAS than others. Absence of regulation means that users have to do their homework before they engage in the exploration of DeFi products and services as the risk they undertake is hedged by vulnerable technology or volatile cryptocurrencies.

The absence of regulation, over and above that, means isolation. Banks simply don’t collaborate with decentralized service and product issuers due to the lack of regulation. How do then the unbanked physically access decentralized exchanges? For example, if you desire to deposit your funds to IDEX, you should do it in the form of cryptocurrency, you can’t deposit fiat. How do you then acquire Bitcoin or other cryptocurrency? You can do it at Lykke, which is a centralized exchange, by using its fiat gateway which allows you to send money from your bank account or your bank credit card. So, virtually, you don’t eliminate banks from this process. The only way of purchasing cryptocurrency without using your bank account is by selling cash for crypto on a P2P level and undertaking the corresponding risks. Or by searching for a Bitcoin ATM or shop, which is a quite rare phenomenon in most European cities.

Decentralized finance is a truly revolutionary approach to how the whole system of exchange of any object of value should work globally. The rationale behind this is based on very noble and advanced thinking, backed by the technology that can turn such ideas into reality in the near future. However, it’s quite difficult if not impossible to build something radically new in complete isolation from the old, otherwise it’s a utopia. At Lykke, our mission is to bridge traditional finance with the newest technology by radical tokenization of any asset in complete compliance with the existing regulations.

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