Launched today (6 April), the Recovery Loan Scheme (RLS) ‘provides financial support to businesses across the UK as they recover and grow following the coronavirus pandemic’.…
What is DeFi?
DeFi stands for “Decentralised Finance”. To break this down, we need to understand the term decentralised, and how this differs from the current way that financial services operate.
There are currently a number of different financial institutions in the marketplace geared to tender to consumer need. We have banks for holding, securing, transferring and loaning money. Asset managers safeguard client monies and use their knowledge to increase client wealth with their educated decisions. Credit card companies provide consumers with a line of credit for use at a varying interest expense. Stock markets allow individuals and industries to invest their money for future growth. There are large numbers of intermediaries offering different services, all finely tuned for the purposes they serve, but from a technological perspective they are not particularly efficient.
It is quicker to send an anvil to China than it is to transfer money there. This is an example of the productivity paradox gone mad, numerous business processes leading to inefficiencies. International companies require numerous bank accounts in all the countries in which they operate. Transactional costs are always increasing. Monopoly economics utilised by the weight of financial institutions results in no incentive to reflect or improve on efficiencies.
On Christmas Eve I was called by an individual with a kind Australian accent, claiming that fraud had been committed on my account, immediately asking for some personal details to pass security checks. In my typical obstinate manner, I asked him to prove that he was calling from the bank. At this he said that the number he was calling from was the same as the general enquiry number printed on my debit card. I asked him for a number to call him back on (knowing full well the bank have dedicated fraud lines), at which he started to get shirty with me, asked me why I was being so difficult, and that I could call back but I would be waiting for hours before I got through to an advisor that would be able to help me. He seemed to get more heated with my insistency, so I hung up. After calling HSBC’s fraud line moments later my suspicions were confirmed, the call was indeed fraudulent.
Risky. Antiquated. Inefficient. Exclusive. Slow. Centralised.
You still haven’t answered your first question Ben
I know, I’m getting there. I felt it important to establish our frame of reference.
Blockchain technology is bringing about profound change to finance. It is decentralised by virtue of its distributed network, meaning that no one institution can control, manipulate or monopolise it and as a result provides a number of efficiencies:
- Speed – Last week I sold some of my stake in an ETF. It took over a week following the sale for the monies to be deposited into my bank account for my own personal use. In contrast, I can send value via Bitcoin to China in ten minutes (the time it takes on average to clear and settle transactions in that period on the blockchain network). One ledger, transferring value, recording the details. Pretty confident it will beat that anvil I mailed at the same time…
- Risk – In conventional systems, transactions are subject to settlement risk (the trade or transaction will not complete as a result of an issue or error in the system) or counterparty risk; how do you know that the other side of a transaction is going to settle on the other side? Instant entries on the blockchain can eliminate these risks, and visibility of these transactions within the ledger could provide instant reconciliations and eliminate agency risk.
- Trust – Financial systems built on blockchain would be able to establish trust through historical transactions on the chain. This would allow parties who are not known to each other to transact with each other, identity can be verified without intermediaries, and further information could be accessed on the chain regarding historical transactions.
- Cost – the blockchain clears and settles value transfers and does so continuously to keep its ledger up to date. Santander had previously estimated that if it were to harness this same capability, it would eliminate an estimate $20 billion in back-office expenses without changing their underlying business model.
How does DeFi work?
All of these are made possible using smart contracts, programs that run on the blockchain that can execute automatically when certain conditions are met. These allow developers to build functionality that extends past receiving or sending cryptocurrency.
There are many decentralised finance distributed applications (DeFi DApps) in the marketplace today. Some allow for borrowing and lending of cryptocurrency to other users and earn interest on lending such as Compound. Augur the “your global, no limit betting platform” allows users to bet on a wide range of real-world events, such as sports, economics, and elections. PoolTogether is a protocol for no-loss money games powered by Ethereum, where 1 ticket is given to every 1 DAI sent, the smart contract that holds the money is turned into an interest saving account, at the end of every week a winner gets selected by the smart contract and the interest earned by the staked DAI gets sent to the winner, including the money used to purchase their ticket. The losers also get their money back from ticket purchase. No loss lottery.
If you were to do a quick google search for DeFi you might see the words ‘experimental’ or ‘open finance’, but with the higher interest cryptocurrencies as a source of value, we are moving from the experimental to the practical. It is one of the most active sectors of blockchain with over $8 billion locked in smart contracts, and we are witness to a brand new global infrastructure for financial activity.