DeFiing the Norm

defi

12 min

defi

12 min

At the beginning of the movie “Gladiator” Marcus Aurelius tells Maximus that there used to be a “whisper” about the future of the civilized world, the dream known as Rome, and anything more than a whisper and it would vanish...well that’s sort of how we feel about Decentralized Finance, more commonly known as DeFi.  DeFi is the future of finance and one of the final frontiers for the application of blockchain technology. However, we almost hesitate to write about it because it’s still a relative secret - the potential only appreciated by a select few and dependent on increasing blockchain adoption.  And so, at the extremely small risk of scorn from the blockchain community, welcome to this week's adventure: DeFi, early access!  (this WBS is just an intro, DeFi is a massive space with a multitude of applications - and we’ll definitely revisit this topic in more depth)

DeFi is a very broad term; generally it's DeFined (couldn’t resist) as the types of financial products and services made possible by decentralized, smart contract enabled networks that feature an active unit of value overseen by a distributed ledger.  For the sake of sanity (and a shorter WBS), let’s focus on blockchain based decentralized networks.  As you read on, understand that smart contracts and Dapps integrating multiple smart contracts into a complete and automated business process are like the mycelium and the mushrooms (maybe not the best analogy, but fungi are VERY cool) of a DeFi ecosystem.

As adoption of blockchain technology grows and token-based monetary policy, or tokenomics, approaches the proper scale, interconnected digital societies with their own economies are emerging.  As these network economies grow and multiply, they want participants to hold native tokens for the long term (sometimes referred to as “HODLing."  Hodling (in your face spellcheck), or storing value via tokens is important because it represents trust (and reliance) in the current and future valuation and viability of a network, aids in stabilizing token price fluctuations caused by speculation, and you guessed it, manages token velocity!  Networks often incentivize longer term holding by using things like staking based consensus, which ultimately leads to demand for financial services like lending and borrowing tokens.  Network economic models can present an opportunity and a need for decentralized token-based alternatives (yes, DeFi) to traditional financial products and/or services (e.g., sending and receiving payments, interest-bearing token holding accounts [using digital wallets of course], token loaning and lending services, token trading and conversion, and token investing).  DeFi can also provide structured products that mimic different types of securities, including interest yielding (like bonds), and derivatives (like options).  Even things like insurance and credit exist in the world of DeFi.

There’s one more thing that deserves mention when discussing DeFi, Stablecoins.  Real-world fiat currency is more stable and widely accepted than network tokens or coins, but cannot be utilized on a blockchain.  Stablecoins are a type of network token pegged to the value of a country's currency (making them “stable”) but blockchain native - potentially acting as a bridge between TraFi and DeFi (quick read here, but we encourage you to dig further as stablecoins and DeFi have an almost incestuous relationship in the short to mid-term).

It should come as no surprise that DeFi improves traditional finance by leveraging blockchain tech to increase efficiency and remove the need for a central authority.  Regular banks, investment banks, lenders, payment processors, and traditional brokers all rely on contracts and manual input to do things like agreeing on deal/loan terms, sending funds, running background checks (AML/KYC), and settling trades - and they add to the cost, time and complexity (not to mention errors) by serving as the central party.  Underlying nearly all of DeFi, smart contracts allow for the automation of these often manual and fragmented processes.  When combined with the advantages of DLT and using token-based consensus models like staking - central authorities are no longer required.  Speaking of consensus, the growth of the crypto mining and validating industry is both a result and a driver of DeFi.  There are “pools” today that combine resources and tokens from many participants to ultimately write more blocks and get more rewards.  Miners and validators do the heavy lifting that keeps all of the transactions resulting from DeFi moving along (this will give you some idea of current mining scale and tech: and for a REALLY “deep dive,” check out this whitepaper)

Let’s discuss some examples to solidify all this info floating around your short term memory (FYI: Solidity is the most popular programming language for implementing smart contracts).

The simplest example of DeFi is when a company sells tokens to fund its network development and future operations.  Capital formation, or the financing of a company, is obviously in the realm of finance.  And when you substitute tokens for fiat, and implement smart contracts that automatically execute investment transactions without the need for a central authority (like a bank, a central custodian, and/or a regulator), you have a prime example of decentralized finance.  Unfortunately, this simple example also highlights why DeFi is the future that isn’t quite here yet.  The ICO craze proved that until there is more information transparency and equality, as well as accountability - there is still the need for some sort of central oversight to protect investors and companies.  Coincidently (not!), that is what Prometheum has built with its blockchain securities market infrastructure.

Another example comes in the form of lending tokens for validating (PoS), shorting, or other purposes.  In these situations,  network participants (anywhere in the world) can create a loan agreement via a smart contract that executes when terms are met (may include interest rate, loan term, principle amount, KYC, AML, and a credit check), and smart contracts also automate and enforce a repayment schedule.

Some food for thought (and maybe some further reading??):  In the future, DeFi has the potential to replace current finance related businesses (think banks and Wall Street) with decentralized autonomous organizations (DAO’s) using decentralized applications (remember Dapps?) composed of interconnected smart contracts as well as utilizing newer consensus models, network monetary policy and governance, and interoperability between DAO’s.

We have to admit that was intense for an intro to DeFi...but it really is that vast of a topic, and more importantly, we have a lot of faith in our readers.  And on that complimentary note is where we end this WBS - have a great week!