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Decentralized finance

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Decentralized finance (commonly referred to as DeFi) is an experimental form of finance that does not rely on financial intermediaries such as brokerages, exchanges, or banks, and instead utilizes blockchains, most commonly the Ethereum blockchain.[1][1] DeFi platforms allow people lend or borrow funds from others, speculate on price movements of a range of assets using derivatives, trade cryptocurrencies, insure against risks, and earn interest in a savings-like account.[2] DeFi is promoted as offering high interest rates, with some providers offering triple-digit interest rates,[2] but is subject to high risk.[1] As of October 2020, over $11 billion was deposited in various decentralized finance protocols, which represents more than tenfold growth during the course of 2020.[3][2]

History

MakerDAO, which launched in 2015 and allows people to take out loans of the stablecoin Dai and seeks to keep the price of Dai pegged to the U.S. dollar in a decentralized manner, is credited with being the first DeFi platform.[2]

In June 2020, Compound Finance started rewarding lenders and borrowers on its platform with, in addition to typical interest payments to lenders, units of a new cryptocurrency known as the COMP token, which is used for governance of Compound's platform but is also tradeable on exchanges. Other platforms followed suit, launching the phenomenon of "yield faming" or "liquidity mining," where speculators actively shift cryptocurrency assets between different pools in a platform and between different platforms to maximize their total yield, which includes not only interest and fees but also the value of additional tokens received as rewards.[4]

In July 2020, The Washington Post did a primer on decentralized finance including details on yield farming, returns on investments, and risks involved.[4] In September 2020, Bloomberg said that DeFi made up two-thirds of the cryptocurrency market in terms of price changes and that DeFi collateral levels had reached $9 billion.[5]

How DeFi works

DeFi revolves around applications known as dapps (or decentralized applications) that perform financial functions on digital ledgers called blockchains, a technology that was invented for Bitcoin but has since caught on more broadly.[2] Rather than transactions being with and through a centralised intermediary such as a cryptocurrency exchange, transactions are directly between participants, mediated by smart contract programs.[1] Many of these dapps can connect and work together to create complex financial services.[2] For example, stablecoin holders can commit assets to a liquidity pool. Others can borrow from this pool, by contributing additional collateral, typically more than the amount of the loan. The protocol automatically adjust interest rates based upon the moment-to-moment demand for the asset.[1]

"Decentralization" refers to the lack of a central exchange. Smart contract programs for the DeFi protocols themselves are run using open source software by a community of developers and programmers.[6] DeFi has attracted large cryptocurrency venture capitalists such as Andreessen Horowitz,[1] Bain Capital Ventures and Michael Novogratz.[7]

One example of a DeFi protocol is Uniswap, which is a decentralized exchange or dex that runs on the Ethereum blockchain and allows for the trading of hundreds of different digital tokens that were also issued on the Ethereum blockchain. Rather than relying on centralized market makers to fill orders, Uniswap's algorithm incentivizes users to form liquidity pools for the tokens. A development team writes software for deployment on Uniswap, but the platform is ultimately governed by its users. Because no centralized party runs Uniswap, there is no one to check the identities of the people using the platform. It is not clear what position regulators will take on the legality of a platform like Uniswap.[8]

Criticism

Blockchain transactions are irreversible, which means that an incorrect transaction with a DeFi platform or even deployment of smart-contract code containing errors cannot always be easily corrected.[2] Coding errors, and hacks, are common.[9][2] In 2020, one platform known as Yam Finance quickly grew its deposits to $750 million before crashing days after launch due to a code error.[2] Additionally, the code for the smart contracts that implement DeFi platforms is generally open-source software that can be easily copied to set up competing platforms, which creates instabilities as funds shift from platform to platform.[6]

The person or entity behind a DeFi protocol may be unknown, and may disappear with investors' money.[6] Investor Michael Novogratz has described some DeFi protocols as "ponzi-like."[7]

DeFi is largely non-compliant with Know Your Customer (KYC) and other anti-money laundering (AML) rules.[1]

DeFi has been compared to the initial coin offering craze of 2017, part of the 2017 cryptocurrency bubble.[9]

Inexperienced investors are at particular risk of losing money using DeFi platforms due to the sophistication required to interact with such platforms and the lack of an intermediary with a customer-support department.[9]

References

  1. ^ a b c d e f g "'DeFi' movement promises high interest but high risk". Financial Times. 2019-12-30. Retrieved 2020-10-06.
  2. ^ a b c d e f g h i "Why 'DeFi' Utopia Would Be Finance Without Financiers: QuickTake". Bloomberg. 2020-08-26. Retrieved 2020-10-06.
  3. ^ Ehrlich, Steven. "Leading 'Privacy Coin' Zcash Poised For Growth Following Placement On Ethereum". Forbes.
  4. ^ a b "What's 'Yield Farming'? (And How Do You Grow Crypto?)". The Washington Post. 2020-07-31. Retrieved 2020-10-05.
  5. ^ "Crypto Is Beating Gold as 2020's Top Asset So Far". Bloomberg. 2020-09-22. Retrieved 2020-10-05.
  6. ^ a b c "Crypto Exchange Gets Millions After Copy-Paste of a Rival's Code". Bloomberg. 2020-09-11. Retrieved 2020-10-06.
  7. ^ a b "Novogratz Plows Ahead In DeFi Amid the 'Gamifying' of Crypto". Bloomberg. 2020-09-29. Retrieved 2020-10-06.
  8. ^ Kharif, Olga (October 16, 2020). "DeFi Boom Makes Uniswap Most Sought-After Crypto Exchange". Bloomberg.com. Bloomberg. Retrieved 7 November 2020.
  9. ^ a b c "Boom or bust? Welcome to the freewheeling world of crypto lending". Reuters. 2020-08-26. Retrieved 2020-10-06.
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