When an innovation offers better, cheaper, faster and more relevant alternatives, we know that its adoption will be massive and fast.
The emergence of Bitcoin and blockchains represents a revolution and the beginnings of a new decentralized finance ecosystem. DeFi is a peer-to-peer system that makes financial products available in a decentralized blockchain network without the participation of intermediaries or trusted third parties such as banks or other financial institutions. This system was developed through the Ethereum network, although in recent years, it has undergone a great deal of expansion in other networks as well. It is executed through “smart contracts,” a cryptographic protocol that executes agreements between two parties via a transparent, unalterable record in a blockchain.
Within just a few years, DeFi has grown exponentially to become a revolutionary, decentralized ecosystem that seeks to provide everyone with access to financing outside of traditional financial instruments. According to cryptographic analysis firm DeFi Pulse, the estimated total value locked (TVL) in DeFi contracts has increased almost one hundred-fold in two years, from $9.3 billion in December 2019 to $92.3 billion in January 2021.
In this brief article, we explain why you should know about DeFi and its growth potential as well as the principal risks associated with it.
DeFi, the idea
DeFi is a concept based on the ideal of decentralization behind blockchain. In practice, it means the birth of financial ecosystems where anyone can create and participate in financial products ranging from liquidity markets, to loan systems, to insurance, to decentralized exchanges (DEX) and diverse applications that offer practical solutions between blockchain and the real world.
Imagine, for example, that we wish to apply for credit. Instead of going to a bank, we can use a DeFi platform to apply for a loan whose terms are set out in a smart contract. As it is a decentralized platform, the borrowed money comes from other people who contribute liquidity and obtain a return which is also established through the same system of smart contracts. But DeFi goes further and is transforming other fields. One such example is the Nexus Mutual insurance model, a decentralized alternative to insurance available through the Ethereum network where people can share the risk, based on smart contracts, without having to go through an insurance company. Ultimately, DeFi eliminates the intermediary as well as most of fees, charges and penalties in the interest of decentralization.
The potential of DeFi
As we have emphasized, the most salient aspect of this type of financing is decentralization. What does decentralization mean in the field of finance? It means that there is no central or higher agency that imposes guidelines over and above the protocol on these platforms.
By its own dynamic, DeFi is open to everyone, even to people with no bank account. Anyone with a device and an internet connection can operate in decentralized finances. Trading can even be done in fully decentralized exchanges, such as Uniswap or Balancer, where anyone can create or add liquidity in created or customized pools or liquidity groups and obtain profit percentages from transactions. But DeFi goes further and even transforms other areas such as mutuals. For example, Nexus Mutual is a decentralized insurance alternative that allows beneficiaries to share risk with no need for an insurance company.
This explains the emergence of the decentralized autonomous organizations (DAO), organizations that regulate the functioning of the platforms themselves through a decentralized approach in which the community participates in operation and decision-making through governance tokens or utility tokens. The DAO have been able to raise a large amount of capital and have expanded their activity beyond the protocol. For example, in November 2021, a DAO was set up and subsequently raised more than $3.7 trillion to bid on a copy of the United States constitution in an auction at Sotheby's.
The question that arises at this point is, how secure are DeFi, and how reliable are their high yields?
Challenges for the future of DeFi and risks
Most DeFi platforms offer high yields, but they also carry great risks. The chief problem is protocol security. During 2021, there were numerous hacks, contract exploits, and malicious contract scams that were able to extract liquidity from the protocols on DeFi platforms, amounting to losses of some $10 billion according to ImmuneFi, a DeFi security platform and bug bounty service.
Added to this is the volatility of the cryptocurrency market price. Many protocols have established mechanisms that ensure some stability in the face of market volatility and price fluctuations. One solution is stablecoins, which, for the most part, have parity with the dollar and are increasingly becoming more well-established as a blockchain element.
We must also factor in other issues, such as asset custody, blockchain scalability, liquidity in these markets, or the increase in additional costs of gas tariffs for transactions (especially on the Ethereum network), an aspect that has led to the development of other layers that successfully address this issue.
It is also important to bear in mind that, although many DeFi platforms run on blockchains (such as Ethereum), they are not actually fully decentralized. This means that these protocols or platforms have some centralized point that allows administrators to have control over certain situations where intervention is required. One example is MakerDao and its stablecoin DAI, a protocol designed to facilitate the creation of financial applications on Ethereum. However, more and more DeFi projects are being consolidated and are fully decentralized; one such project is Anchor Protocol and its stablecoin UST in the Terra blockchain.
DeFi, the financial revolution
However, despite the risks posed by DeFi, their potential for growth is very high. For this reason, one of the primary challenges this year will be regulation. While DeFi are based, to a certain extent, on traditional financial markets, they actually operate through another system in which other stakeholders come into play. It should be noted that the first dedicated decentralized platforms with express authorization for institutions (Aave Arc) that are embedded within a regulatory framework have also recently appeared, and this trend will become more common as the adoption of cryptocurrencies increases. In this regard, we believe that only those projects which are adapted to regulation, or those which are completely decentralized, will stabilize. What is certain is that there will be less and less room for projects that are not defined one way or the other.
DeFi is creating revolutionary changes in finance, investment, and the way money is moved. The ecosystem is independent, central banks no longer control transactions, and no government or regulator has the ability to block digital accounts or assets if they are stored in the blockchain. There are no borders. Anyone with a device and a network connection can participate. Instead of having to keep their cash or funds in the custody of a bank account, users retain ownership of their digital assets in their own non-custodial wallet.
For the first time, users have control of their funds. The paradigm has already changed; we just haven't realized it yet.