What Is DeFi?
Overview
Whether you’re looking for a DeFi index fund, the best best crypto investment, or are simply new to the cryptoverse, understanding the basics of Decentralized Finance (DeFi) is essential to building a cryptocurrency investment strategy. The total market cap of all DeFi projects is valued at over $39 billion according to coingecko, and DeFi is responsible for a broad range of use cases that will continue to disrupt the traditional finance (TradFi) industry. This article will cover the basics of DeFi.
What is Decentralized Finance (DeFi)?
In the simplest terms, Decentralized Finance (DeFi) is the ability to transact peer-to-peer without centralized intermediaries. While peer-to-peer transactions have been possible for centuries in-person, such as at a local farmer’s market, they are complex to manage at a global scale with geographically separated parties. Fortunately, DeFi solves the peer-to-peer complexity challenge using blockchain technology which includes the underlying protocol. Blockchains can be thought of as a public, transparent accounting ledger that records transactions in real-time and is replicated across a distributed network of computers. The blockchain is managed by rules encapsulated in, and enforced by, the blockchain’s protocol.
To illustrate DeFi and its advantages over traditional finance (TradFi), let's first look at an online purchase in the legacy, TradFi system. From a customer’s perspective, the goal of a purchase is simple: send money from their bank account to the merchant’s bank account in exchange for goods or services. The figure below, according to cardknox, illustrates the typical data flow required to process an online transaction.
In the legacy TradFi ecosystem, a plethora of intermediaries are required behind the scenes to ensure a customer can send money to a merchant. Various intermediaries include:
A customer’s bank which stores a customer’s money
The payment gateway that acts as a communication hub for all other intermediaries
The card network (i.e. Visa, Mastercard, AMEX) that connects the payment gateways (point-of-sale terminals) to banks
The merchant’s bank that stores the merchant’s money
After the customer’s bank balance or credit limit is confirmed, a transaction is approved and finally money is transferred from the customer’s bank to the merchant’s bank all with the help of the payment gateway that relays information through the web of aforementioned stakeholders. Each intermediary adds to the customer or merchant’s overall cost.
How About Cost?
Every intermediary mentioned above has to stay in business, so they each charge a fee:
A customer’s bank: Makes money between the spread of the interest offered to a depositor, and the interest the bank receives on loans backed by deposits. They charge other fees too, such as account maintenance fees, overdraft fees, various processing fees, etc.
The payment gateway: Charges a setup fee, monthly service fee, transaction fees, and/or charge-back and cancellation fees. Payment Service Providers (PSP) are online alternatives, but they also charge similar recurring fees.
The card networks (i.e. Visa, Mastercard, AMEX): Charge fees typically in the ballpark of 1.5% - 3% that are typically passed onto the consumer.
The merchant’s bank: Receives money from credit card transactions on behalf of the merchant and charges an account maintenance fee that is typically on a yearly basis.
It is reasonable to assume that most, if not all, fees are reflected in the final price that consumers pay.
Does a More Efficient Alternative Exist?
With DeFi, the number of intermediaries required are greatly reduced or eliminated completely! Hence, peer-to-peer. Let’s explore DeFi alternatives to the intermediary TradFi services:
Self-custody wallets: These remove the reliance on a bank by giving a person, group, or organization full and exclusive access to the funds in their crypto wallet(s) without revealing their identity. For merchants, this removes the need for a merchant account which lowers the business’s operating costs.
In the online transaction scenario, a traditional bank would serve the same purpose, but requires custody of funds to be shared with the bank and its employees, and customers also lose their privacy.
There are other services banks offer such as borrowing and savings account yields that also exist in DeFi. More on that later.
Blockchain Technology: A blockchain is simply a history of all transactions, and that transaction history is synchronously stored on numerous computers around the globe. This synchronized, distributed model is the antithesis of traditional, centralized banking.
Decentralized Applications (DApps): Are the software application layer on top of a blockchain which connects wallets to blockchains, and ultimately wallets directly to each other. DApps verify crypto wallet balances, initiate transactions eventually recorded to the blockchain, and can also act as automated market makers that facilitate more complex financial transactions.
Which TradFi intermediary is replaced? Payment Gateways and Card Networks. Rather than use a payment gateway, the blockchain’s protocol communicating with a DApp serves as the communication hub between the sender and receiver of currency. And, the blockchain network in concert with the blockchain protocol validates and records transactions. This is sometimes referred to as the payment rail.
A network of blockchain nodes that validate and record transactions effectively replaces the traditional payment rails composed of banks, gateways, and card networks.
The figure below, from The Wall Street Journal, further illustrates how a DeFi transaction occurs on the Bitcoin network.
Source: The Wall Street Journal
As we can see, DeFi simplifies transactions that require sending/receiving of money by consolidating communication into a single software executable - the blockchain protocol.
More DeFi Use Cases
The peer-to-peer sending and receiving of money supports cross-border transactions which, according to Allied Market Research, are expected to grow from $701.93 billion in 2020 to over $1.2 trillion by 2030. Growth is being driven by changes in digital payment infrastructure and increase in mobile payments—both inherent characteristics of DeFi.
There are also numerous DeFi use cases, including:
Privacy retainment throughout a customer’s financial journey thanks to private/public key cryptography
Interest bearing “savings” accounts that offer much higher interest rates compared to a TradFi retail bank
Decentralized exchanges with order books managed by automated market makers rather than a brokerage house or other human in-the-loop
Lending marketplaces which return loan interest to individual lenders using peer-to-peer technology, rather than giving the majority of loan interest to a bank
Tokenization of real-world assets that enables hard assets to be fractionalized which creates a plethora of new use cases such as selling, use as collateral, etc.
Borrowing marketplaces that offer loans collateralized with on-chain crypto assets such as tokens/coins, NFTs, and even real-world assets
Compared to traditional payment rails, the digitization of assets coupled with blockchain technology introduces superb efficiencies that open up a vast array of use cases. DeFi is one of the most important sectors of crypto and understanding DeFi should be part of a broader crypto investment strategy since DeFi has the potential to completely disrupt the traditional financial space.
Stablecoins are a critical component of DeFi. For a primer on stablecoins, here is a brief overview.
