DeFi or decentralised finance is the hottest new topic in crypto. What does it mean?
In essence, DeFi is basically a shorthand to describe moving traditional financial products and services onto public blockchains.
The opaque world of financial services creates significant barriers to entry for individuals and private investors. Some services are reserved for elites and the super rich institutions, such as investment banks or market makers.
DeFi promises to democratise this system, opening up these kinds of products to a vast and underserved worldwide market.
The main point of DeFi is to dramatically widen access to financial services, using the immutability of blockchains and their censorship-resistant nature — as in theory ledgers are spread out over thousands or millions of nodes worldwide and can’t be controlled, tampered with or shut down by meddling central banks or financial institutions.
dApps make it simple for anyone with a smartphone to get access to low-cost financial services. And there are around 1.7 billion people in the world without a bank account, two-thirds of whom do have an internet-enabled smartphone.
The first major uses for dApps were in gaming and online gambling. Remember CryptoKitties? The Ethereum-hosted collectibles dApp caused chaos with its early popularity, congesting the blockchain and bringing transaction confirmations to an achingly slow crawl.
But according to a recent state of the market report, the most rapid user growth in the last 12 months belongs to blockchain-based financial services, like lending dApps. In 2019 the number of financial dApp users grew by 610% and transaction volume increased 251%.
dApps like Compound, which we cover below, use Ethereum’s system of smart contracts to carry out functions and to verify transactions.
As the best-supported open-source blockchain, Ethereum is the platform where most DeFi is happening right now. Rivals like EOS, Tron, Steem and Terra do have footholds to varying degrees, but their much larger competitor takes most of the cake.
DeFi does allow startups to get involved in issuing complex financial instruments like decentralised exchanges, cryptocurrency derivatives or tokenisation platforms. But one of the best ways of explaining the power of DeFi is to look at its most popular current use.
According to listings site Dappradar, the dApp with the highest seven-day volume ($110m, at last count) is the Ethereum-based peer-to-peer lending and borrowing marketplace Compound.
Compound was born in 2017 as the brainchild of serial entrepreneur Robert Leshner. He realised one specific solution to the accusation often levelled at cryptocurrencies: that they are non-producing assets.
As with commodities and portfolio hedges like gold and silver, Bitcoin does not produce a yearly return. Cryptocurrencies hold value to a greater or lesser degree. Hang on to them for a number of years and you may get capital appreciation as the spot price rises, but your holdings won’t compound in value.
By contrast, shareholders are usually enticed to buy stock in a company by the promise of dividend payments. These are a, paid twice-yearly or sometimes once per quarter, handed out to shareholders as a kind of loyalty bonus for keeping hold of the shares.
And cash — even at today’s extreme low interest rates — produces some small amount of return over the long-term.
“90% of cryptoassets are sitting in people’s cold storage, on exchanges or in private wallets.They aren’t being used or traded,” Leshner told TechCrunch back in 2018.
If users could lend out their cryptocurrencies to other investors, they would earn interest for doing so. This is much the same model as peer-to-peer finance in the traditional world. In the UK, p2p platforms like Ratesetter, Zopa and CapitalRise match lenders with borrowers and offer up to 6% return for allowing businesses or individuals to borrow their cash.
Compound algorithmically sets interest rates by analysing the buying and selling of particular cryptoassets and allowing rates to fluctuate depending on supply and demand. Users earn that interest rate when they lend, and pay that rate when they borrow. Compound takes a 10% slice off the top.
In practice, this allows investors to short-sell cryptocurrencies that they believe will fall in value.
The decentralised aspect of the platform is that users are connected directly — without the need for a bank or intermediary as a middleman.
Compound caught the attention of some of the biggest names in finance when it launched: in 2018 attracting the first ever investment from the venture capital arm of exchange giant Coinbase. More recently Leshner’s platform raised $25m in Series A funding from the likes of Andressen Horowitz and Bain Capital to broaden its integration with cryptoexchanges and brokers.
Peer to peer lending is just one of many DeFi applications. The vision is for an interconnected system of dApps that allow unbanked people broad access to various financial services. It’s a pretty bold idea, as this infographic claims: “In a decentralized financial system, a top trader at a financial firm would have the same level of access as a farmer in a remote region of India. A woman in the Philippines could receive a loan from the U.S., invest in a business in Colombia, and then pay off her debt and purchase a home – all through interoperable apps.”
Cryptocurrencies have upended thousands of years of monetary policy. With DeFi, the blockchains they are built on could do the same to the centuries-old financial services industry.