DeFi – Decentralized Finance explained

A new paradigm is taking over the financial world - DeFi is on everyone's lips, but what does it really mean?

DeFi is a new paradigm that is gaining popularity in the financial world. Using automated processes, a peer-2-peer approach and blockchain technology, it challenges traditional finance. Following the DeFi logic, intermediaries such as banks, stock exchanges and insurers will soon be obsolete.

Decentralized Finance or simply “DeFi” is a new paradigm that is currently spreading in the financial world. DeFi is based on the idea that financial services should not be dependent on centralized intermediaries, such as banks, stock exchanges or insurers. Instead, financial services are provided decentrally by users for users using software in a peer-2-peer network. This is based on the blockchain, where the necessary programs, so-called “smart contracts“, are stored, which guarantee the provision of services for the users.

Origins: Automation and Blockchain

In doing so, DeFi is essentially based on two precursors: Automation and Blockchain. We have been familiar with the automation of processes in the financial sector for decades. Be it standing orders, credit checks and securities trading orders, many processes or at least large parts of them already take place automatically and largely without human intervention.

The blockchain, as the second precursor to DeFi, allows users to send and receive money among themselves, i.e., on a peer-2-peer basis. In the meantime, the Ethereum network extended this pure transfer functionality to include smart contracts, i.e. programming logic that can be used to execute business processes without the intervention of intermediaries.

What is important in this context is that while automation ensured that intermediaries were connected to create a service, the blockchain and the Ethereum network based on it now make it possible that intermediary connection is no longer necessary at all. Rather, the service is provided by users for users through the linking of information technology components, or “tech stacks” as it is known in new German. In addition, there is always complete transparency, both with regard to the processes and the IT components. This is because the software that is used will largely be available as an open source version.

An example from securities trading

What DeFi means for the financial world in concrete terms can be illustrated using a securities purchase: In the past, the customer, who previously had to establish a business relationship with the bank, had to contact his bank for this purpose and place the purchase order. The bank in turn commissioned a broker to purchase the security on the stock exchange. The broker thus purchased the security on the stock exchange for the customer. In this example, which simplifies the purchase of securities, three intermediaries were involved: Bank, broker, stock exchange. On the sell side, however, three intermediaries were also involved: Bank, Broker and – admittedly – the identical stock exchange. Each of these five intermediaries not only charges customers for their services, but is also a potential source of error in the entire buying and selling process.

Consider the analogous process in the DeFi world. Any customer, located anywhere on this planet, surfs with smart phone or computer to a so-called “Decentralized Exchange” or “DeX” as these types of defi exchanges are called. There he places the purchase order for a so-called digital asset, or a “token”. Such a token effectively represents a certificate of ownership for any type of asset. Smart contracts execute the order as soon as the parameters correspond to the purchase order. The token is transferred directly from the seller’s wallet to the buyer’s wallet. At no time does the token come into the possession of an intermediary. Moreover, this transaction is completely anonymous.

DeFi characteristics

This example shows what is important and what is not in the DeFi world: the technology is important, while the intermediary is unimportant. The automation and immutability of the order is important, while the type of product traded is unimportant.

Moreover, those features of DeFi that distinguish DeFi from traditional finance become clear: DeFi is not only automatic, but it is also decentralized, meaning that it runs on the blockchain, which is replicated on numerous nodes. Since the data security of the blockchain is extremely high, this system is also called trustless, as this system does not require any trust in a counterparty. Moreover, in such a decentralized system, there is no single point of failure, i.e., no single point of failure that could cause system to fail. Conversely, this also means that it is autonomous, i.e., there is no one who could censor or subsequently manipulate data in this system, not even government authorities. Furthermore, it is anonymous per se. Anyone can participate in this system without having to identify themselves anywhere beforehand. This feature makes it accessible, i.e. usable by billions of people who otherwise would not have any access to financial services. Furthermore, DeFi is completely transparent – from the underlying software components to the data and processes. Because the software is largely open source, DeFi is also fundamentally permissionless, meaning no user has to ask permission to program DeFi applications. The open source basis of DeFi also means that the system is highly flexible than any users can contribute to extend and improve the system. Ceteris paribus, DeFi is also more secure than traditional systems in finance, as processes are mandatorily executed as programmed, since the system cannot be manipulated. The security of the system also comes from its transparency and the fact that middlemen are eliminated as a source of error.

Last but not least, DeFi is unregulated. This follows from the characteristics mentioned above: If a system is decentralized and anonymous, i.e. if there is no central party that can decide on participation in the system, no regulatory authority can enforce laws and regulations.

DeFi application examples

In order to be able to process securities or even goods in a decentralized environment, a digital token must first be created that represents this security or good. This process is called asset tokenization. It is decentralized and allows illiquid goods to be tradable. Barrels of crude oil are tokenized in the same way as works of art. This also opens up completely new asset classes for small investors. But liquid assets such as shares can also be tokenized and brought into a decentralized environment.

Alongside payment systems such as Bitcoin, the aforementioned decentralized exchanges are probably the best-known example of applications in the DeFi world. On these platforms, users can trade the previously tokenized goods directly with other users. In this context, it is completely secondary which goods are involved.

Credit transactions are also offered in the DeFi environment. Transparent protocols enable the borrower to borrow funds, while interest and repayment are ensured by smart contracts.

Furthermore, wealth management services are already offered in the DeFi world. For example, users can have their assets managed by third parties, and this is done transparently and automatically, making it cost-effective. Here, too, smart contracts guarantee ownership rights.

Since a large number of users can be networked quite easily in a DeFi network, this paradigm is also well suited for problems from the insurance sector. For example, users can purchase insurance from other users, which is then paid out automatically by smart contracts in the event of a clearly defined claim. Conversely, the users who have to pay in the event of damage receive the insurance premium.

Another area of application for DeFi can be found in the field of data. Like payment flows, data is currently still collected and controlled by a small group of intermediaries. DeFi will enable the democratization of data by transparently incentivizing the acquisition and sharing of data and fairly pricing its use accordingly.

An example of how central banks are also getting involved in the crypto space: Central Bank Digital Currency (CBDC) – Digital Money for Central Banks.

Where there is much light, there is also shadow

DeFi not only possesses characteristics that make it superior to traditional banking and finance, but it also enables entirely new application examples. Nevertheless, systems based on this new paradigm have weaknesses that must be identified as such.

For example, DeF systems are currently still quite illiquid, since only a few users are using these systems. This results, for example, in users being offered less favorable prices on a DeX than on centralized trading platforms. Furthermore, DeFi systems are less scalable than centralized systems due to their peer-2-peer architecture. This is sometimes expressed by bottlenecks in the network, so-called “network congestions”, which can massively slow down business processes and make them more expensive. Furthermore, there are currently still compatibility problems between DeFi platforms, which are based on different blockchains. However, incorrectly programmed smart contracts could prove to be the biggest and most fundamental weakness. If such an integral part of the system is programmed incorrectly and then runs in an automated and unstoppable manner, this can have fatal consequences for the entire system. Properties such as automatic, trustless and autonomous, which normally represent strengths, turn into massive disadvantages in the event of an error.

DeFi outlook

Without a doubt, DeFi is currently one of the most discussed topics in the crypto world (Crypto Trends 2021). With a certain time lag, it will also soon attract the interest of the traditional financial services industry. However, it will take a while for the topic to reach the standard end user or retail banking customer. Like any new technology, DeFi will experience advances and setbacks along the way. However, any setback where retail customers lose money will put the regulator on notice. It is quite possible, therefore, that we will soon see a division of the DeFi world, into a sub-sector that remains unregulated and a regulated sector for those users who want the protection of the regulator. It is obvious which area will offer the wider range of products and the greater opportunities for profit, but will also carry the greater risks.

Dr. Patrick Schueffel is Adjunct Professor at the Fribourg School of Economics, Switzerland. His research focuses on banking, finance and entrepreneurship. As a consultant and founder, he contributes to various Asian-European crypto projects. Before his three-year stay in Singapore, he worked for years in banking in Zurich. He holds several university degrees.

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