Why is DeFi the Future of Finance

What is DeFi?

DeFi is a portmanteau of decentralized finance, and is a movement that aims to create an open-source, permissionless, and transparent financial service ecosystem that is available to everyone and operates without any central authority. You can think of it like a network of financial services providers, and support and infrastructure systems that offers its services without the need to supply private information, or involve human interaction, and in a fast, seamless and fully automated way with full transparency. This can have several implications but, in general, users maintain full control over their assets as they interact with an ecosystem of peer-to-peer (P2P), decentralized applications or dapps.

History of DeFi

One of the earliest DeFi apps to come into existence was MakerDAO, a platform that was designed to lend a stablecoin called DAI, which it also conceived, in exchange for ETH posted as collateral. The entire lending transaction was handled via Smart Contracts. The concept was first pioneered in 2015 by Rune Christensen and several years later in 2018, received a USD 15 million investment by prolific venture capital firm, Andreessen Horowitz at a valuation of USD 250 million. It was the first investment deployed by the firm’s USD 300 million crypto fund.

What Problem Does It Solve?

To understand what problems DeFi is solving, we need to understand DeFi’s nearest competing industry – centralized finance, sometimes referred to as CeFi. Prior to the DeFi movement, nearly all cryptocurrency and blockchain financial applications were centralized, save for a few wallets and protocols.

The most commonly understood centralized financial institution is the cryptocurrency exchange. The issue with these centralized exchanges is that customer funds are held on the exchange’s centralized wallets, meaning the exchange controls the private keys to all funds held within it. This “custodial” arrangement also means customer funds can be subject to arbitrary withdrawal holds or delays, or worse yet, theft from hackers, which happens to be one of the greatest risks. In fact, as of January 2020, some USD 11 billion in funds have been siphoned from exchanges due to hacks. The immutable nature of cryptocurrency means that funds lost from such hacks are essentially unrecoverable.


Get the inside view of what’s next in the crypto and blockchain industries with the Saidler & Co. newsletter.


DeFi solves this problem by using a series of Smart Contracts to allow customers to interact with exchanges and other decentralized finance products such as cryptocurrency lending and borrowing. These DeFi platforms are “non-custodial” meaning funds are not held on it – participants can deposit and retrieve their cryptocurrencies from these smart contracts as they please, using their own private keys and wallet. As such, the risk of theft from hacking is substantially less.

DeFi apps are also permissionless and anonymous, meaning anyone can interact with them, and they can do so without providing any information to these platforms. There are no KYC or AML checks, no account application or opening process, or any central intermediary to dictate how participants can interact with the platform. The implications of this are significant.

Growth in DeFi

As a testament to its acceptance by the broad market, the DeFi industry has been experiencing incredible growth. Despite a rather short-lived existence, the total value locked in DeFi platforms is currently at over USD 35 billion as tracked by DeFi Pulse. Compare this figure with a year ago where the total was just over USD 1 billion, and it’s easy to see how popular DeFi platforms have gotten over the last 12 months.

Not surprisingly, the first DeFi platform, MakerDAO, is the category leader in terms of total value locked, standing at USD 5.69 billion at the time of this writing. However, this isn’t the only indicator of just how popular the DeFi movement is. Take for instance, Uniswap, which has less locked value at USD 3.62 billion, but a daily trade volume of USD 1.92 billion making it the most active decentralized exchange currently operating. It is also worth the most, in terms of the value of its token, UNI, which has a current market cap of USD 6.55 billion, which is more than the combined value of the next two most valuable DeFi platforms, Aave (AAVE), and Maker (MKR).

The total trading volume on decentralised exchanges increased by about 100x over the last 12 months:

Alternative to Traditional Finance

Perhaps the most important aspect of DeFi is its potential to disrupt the way customers do business with financial institutions, in general.

DeFi platforms utilize efficient programmable smart contracts that run on software code to execute and manage complex financial transactions and arrangements. This eliminates the overhead associated with bank administration, management, legal and compliance. Case in point, DeFi platform Uniswap handles over USD 1 billion in daily volume, generating USD 30m daily revenues. All with minimal employees and operational costs, almost entirely leveraging its software code.

They also solve the problem of accessibility as DeFi platforms are available 24 hours a day, 7 days a week, and every day of the year. A single platform can sufficiently service a global audience with little downtime, and tremendous scale. DeFi apps offer advanced privacy and control. Banks need to know who you are, do KYC, AML and constantly collect this information with every interaction. This information is susceptible to theft from hackers or is shared with partner institutions for marketing purposes at the cost of each customer’s privacy. Financial institutions can choose to freeze customer account funds for arbitrary reasons. DeFi platforms in contrast give full control to the individual’s that interact with them, allowing them to unlock and retrieve funds at a moment’s notice and without any specific approvals.

Finally, DeFis open up the world to newfound financial accessibility and inclusion. The 1.7bn unbaked individuals, or the billions of underbanked participants, can store cryptocurrencies and transact with DeFi applications with just an internet connected and a smartphone. They can be in far-away lands away from banking infrastructure, and still make payments, borrow cryptocurrencies and earn interest, something that was deemed an impossibility just a decade ago.

Summary

DeFi’s explosive growth is not without reason. Participants within the ecosystem have experienced a level of convenience, accessibility, privacy and control that has largely been unavailable with traditional financial institutions. While banks earn billions in profits at the literal expense of their customers, DeFi platforms pay competitive interest rates, and transaction fees to its users, greatly rewarding their participation.

We expect the trend in usage to continue increasing as more “main street” investors become aware of DeFi’s offerings. We also believe continued innovation will result in new products that will disrupt other areas of traditional finance, ultimately expanding DeFi’s capabilities and conveniences.