The term decentralised finance, or DeFi, has been mentioned increasingly in the media. In this post, we take a look at what it is and how it might impact the world of finance.
To its evangelists, DeFi promises to democratise the provision of financial services through the use of smart contracts, cryptoassets and distributed ledger technology. To its detractors, DeFi presents a new battleground for ‘legitimate’ financial services firms against unregulated blockchain-fuelled impostors. While the reality will of course sit somewhere between these extremes, DeFi is forcing market players and regulators alike to reassess how financial services can, and should, be made available to consumers.
The many forms of DeFi currently defy strict definition, but at a very high level the concept involves the use of smart contracts and algorithms in ways that approximate different types of financial transactions involving digital assets and derivative products, without the need for a trusted intermediary. Picking this apart, broadly speaking, the term refers to financial services provided in accordance with the following characteristics:
- Delivered over distributed ledger technology – DeFi products and services take the form of software and protocols which sit on top of the decentralized foundations of blockchain technology, and rely heavily on the implemention of blockchain-based smart contracts and algorithms.
- Using decentralised assets – DeFi technology provides users of cryptoassets and tokenised assets with new ways to create, manage and transact in those assets as well as traditional securities, with the DeFi protocols prompting settlement according to the usual processes (e.g. over the Ethereum blockchain for Ethereum-based assets and tokens).
- Without the direct involvement of an intermediary that is a natural or legal person – crucially, DeFi services don’t require any third party intermediary to take custody or control of user assets or funds, as all transactions are executed and recorded through smart contracts and algorithms according to the DeFi protocol’s predetermined rules. So for example, looking at trading, in a traditional transaction on a stock exchange, a transaction would involve a series of intermediaries (brokers, clearing members, custodians). A DeFi exchange such as UniSwap seeks to cut out the middle men so that trades are executed directly peer-to-peer, from wallets held directly by the traders.
- Through the use of direct-to-user applications and interfaces – DeFi services are made available to users directly through decentralised web applications (dApps) and wallets. These dApps and wallets may be created and managed by a traditional controlling entity (eg a natural or legal person), a community or a decentralised autonomous organization (DAO) although these controlling entities would typically define the terms of the protocols that apply, rather than defining the terms of any particular transaction using those protocols.
The financial services that may be replicated through DeFi are numerous and growing with the increasing sophistication of the technology and protocols that support DeFi. The most popular examples of DeFi protocols replicate credit products, savings accounts and trading services.
Where next for DeFi?
DeFi activities represent the cutting edge of financial technology, and in many ways DeFi shows the cryptosphere at its most potent and complex. Currently, DeFi activities appear to make up only a tiny fraction of the crypto assets market, (which, in all respects other than news column inches, is itself dwarfed by the ‘traditional’ financial services industry or ‘trad-fin’) - however the DeFi area is rapidly growing in popularity and sophistication, by some estimates growing almost tenfold in the past year, and some of the true opportunities and risks of this emerging trend are only starting to become apparent.
Needless to say, regulators are starting to take notice of DeFi.