What is Decentralised Finance?

This post follows a talk I did on the topic at #DeFiConf2020

Decentralised Finance (DeFi) broadly refers to a set of protocols which enables most of the functions that conventional banks offers, but with an open, decentralised framework. It makes use of smart contracts (programs on Ethereum) to facilitate functions such as lending / borrowing, trading, payments and decentralised exchanges.

It must be stressed that the DeFi ecosystem consists of protocols, not companies. Simplified, this translates to systems that function completely on their own while having no owners or administrators. Anyone can use the protocols and build decentralised applications (DApps) on top of them. These protocols or DApps live on the Ethereum blockchain, and are completely transparent and open for anyone to audit or use. They cannot be directly regulated, censored or stopped by any authority. It also means that if the software contains errors / bugs, it WILL be exploited and possibly lead to financial loss. So while DeFi will surely revolutionise finance forever, it should currently still be treated as an experiment.

Even though smart contracts can never be destroyed, DeFi protocol features such as interest rates, incentives, asset support and risk management can be changed. Some of them are programmed to algorithmically adjust to supply / demand dynamics, while others employ a governance system that typically involves a separate token model. These tokens are usually sold on an open market and holders can vote on protocol attributes while being incentivised through profit sharing mechanisms.

Use-Cases

Lending and Borrowing

Lending and Borrowing was the first use-case to gain traction within the DeFi ecosystem. It consists of protocols that enable anyone with cryptocurrency to lock their assets up as security in a smart contract and in turn take a out loan.

The most popular platform, MakerDao, mints a USD stablecoin (Dai) when you use Ether as collateral. It requires you to “over-collateralise” your loan by at least 50%, meaning that for every $150 of Ether that you lock up, you can loan $100. This is to protect the smart contract liquidity in the event that the price of Ether falls. When this happens, the collateral is sold on the open market to repay your loan, and you get to keep the Dai.

You might ask yourself “why take a loan when I can simply sell my Ether?”. There can be many reasons for opting for a loan, such as:

1. It allows leverage. You can use the loan credit to buy more Eth and repeat the process. This puts you in a leveraged long position on the price of Ether.
2. You might not want to lose exposure to your crypto-assets, but wish to unlock liquidity.
3. You might not qualify for a conventional loan due to AML, KYC or your reputation. A DeFi loan does not care about race, gender, age, social class, or jurisdiction. It does not even distinguish between humans and machines.
4. Since this loan is issued by a smart contract, no one will check if you ever repay it. You can refuse, and you won’t receive annoying phone calls with blacklist threats. If the price of Ether falls dramatically, you get to keep the cash. If the price appreciates, you can always pay back the original loan and unlock your assets. You are thus covered on both the upside and the downside risks with a DeFi loan.
5. Selling an asset is a taxable event in most jurisdictions. Using Ether as collateral for a loan allows you to unlock liquidity without triggering CGT.
6. You are ascending the sovereignty staircase.

Other lending platforms include Compound, Akropolis, Atomic Loans, BzX, DeFiner and Aave.

Compound is a protocol that allows for lending / borrowing a wide range of different assets, including three different USD stablecoins and wrapped Bitcoin. These assets can all be lent out or used as collateral to borrow another.

Since interest rates are market based, it can fluctuate quite quickly and dramatically. This, as well as an incentive to use the protocol, created lucrative opportunities now known as “yield farming”. Participants would borrow an asset at a low interest rate and lend it out again at a higher rate while earning incentive tokens as well. This can be fun, but there are multiple risks that need to be taken into account. Interest rates on DeFi protocols are typically adjusted every second and collateral ratios are calculated in USD. So if you lose track of the real USD value on any of the assets (both the collateral as well as the borrowed tokens), you could be liquidated and suffer losses.

Aave is a protocol popular for its flash loans. A flash loan allows someone to borrow an infinite amount of liquidity with no collateral, under the condition that the loan is repaid atomically. This means that the funds can only be borrowed if it is repaid within the same transaction. It enables some fascinating use-cases, including the ability to profit from marginal market inefficiencies by arbitraging potentially millions of dollars instantly between different protocols without any starting capital.

Currently, only native crypto-assets can be used as collateral, but soon participants will be able to use other forms of tokenised assets as well. Although it introduces new vectors to the trust model, these experiments provide us with hints to how massive DeFi will become.

Decentralised Exchanges

An exchange is essentially a meeting place for people that want to buy and sell assets. Traditional crypto exchanges are far from perfect. They are inherently biased, frequently hacked and contain many barriers to entry as a result of heavy regulation.

Under the realm of DeFi, decentralised exchanges (DEX’s) are smart contracts that atomically swap one asset for another. Although they have been around for some time, their order books have always been an unsolved problem. A conventional exchange order book is entirely dependent on trust in administrators, which obviously does not exist in a DEX. This matter was addressed through locking the assets in escrow during transfer, which in turn causes many inefficiencies and a bad user experience. As a result, decentralised exchanges used to suffer from low liquidity and frequent price manipulation.

This problem was solved through the programming of Automated Market Makers (AMMs), employed by Uniswap among other. The basic concept of an AMM is that the value of an asset is based on a predefined Price/Volume curve, instead of price discovery through matching a fluctuating order book. Many AMM algorithms of various complexity exist, but Uniswap uses a simple ratio of assets to determine price:

When large orders shift the ratios, it opens opportunities for arbitrage, either with other decentralised platforms or custodial exchanges.

Trading

Apart from the simple exchange of crypto-assets between each other using decentralised exchanges, DeFi also offers more complex financial trading instruments. From decentralised betting, to derivatives, Perpetual Contracts and leveraged trading, there is something for every trader.

Synthetix is a decentralised synthetic asset issuance protocol on Ethereum, collateralised by an intrinsic token (SNX). The protocol currently supports synthetic Forex, cryptocurrencies (long and short) and commodities such as gold and silver. This essentially means that traders can use the protocol to take positions on the price of these externals assets.

Why DeFi?

The traditional financial system is inherently flawed. Banks are fortresses designed to serve a small group of elite individuals who operate with moral hazard. They are riddled with rent seekers that sell trust at infinite margins, purposefully excluding anyone who does not fit their client criterion.

Until recently, Cryptocurrencies threatened to disrupt mostly the retail functions of conventional banking. DeFi adds the missing puzzle pieces, and could lead to a complete transformation of finance as we know it. It is yet another product of permissionless innovation, proven by the phenomenal growth rate.

A decentralised global economy is one where everyone has equal access to the tools that make up our financial systems. Its characteristics are entirely determined by the market it serves. It has no barriers to entry, no rent seekers, no geographical borders, politicians or office hours. DeFi brings us a lot closer to this world which used to be but a dream.