If you work in the banking industry or are interested in finance, you’ve probably heard about DeFi in recent months. The what???
DeFi for “Decentralized Finance” (or Decentralized Finance in French ☺) refers to a movement to create an ecosystem of financial services running on blockchain networks in a fully decentralized way.
In this way, DeFi can be seen as the expansion of a decentralized system known to all: Bitcoin. Yes, if we summarize Bitcoin in a very simple way, it is a decentralized pair-to-pair payment system that frees itself from banking institutions as well as from trusted third parties (I invite you to read the Bitcoin white paper that just celebrated its 13th anniversary). DeFi’s services are based on the same principle.
Let’s look at and analyze the 6 essential characteristics of DeFi.
1. DeFi is by nature decentralized
This is the holy grail that few blockchains have achieved (Bitcoin or Ethereum). Decentralization means that there is no single entity that ensures and validates the transactions of the blockchain network. For DeFI, the principle is the same: no central authority has control over the proposed service. The management of the service is based on a distributed governance among its stakeholders. Instead of a CEO or a Board, a DAO (Decentralized Autonomous Organization) is set up to ensure the governance of the service.
Great, but what is the point of such a system?
Well, from a technological standpoint, the more decentralized a network is, the more it limits single points of failure. As a result, the chances of a successful attack on the network decrease, as well as the censorship of the network becomes impossible. From a governance point of view, manipulation of a service by one person or entity (to manipulate numbers for example) becomes impossible, but more importantly, any participant in the governance can submit a proposal to evolve a financial service to a vote.
💡 Attention point: for a governance to be solid, it must be properly programmed on the blockchain to avoid bitter failures like TheDAO in 2016. Questions will also arise vis-à-vis the regulator: who can be held liable in the event of a breach of the law? All governance token holders? It is unlikely. The road to building a clear legal framework will therefore be long.
👉 In conclusion: the DeFi services are decentralized technologically but also organizationally. Any user of a service can also become a contributor (by voting, by involvement in the project, etc.).
2. DeFi is based on a permissive system
Basically, anyone can connect to a DeFi service to use it. In other words, you don’t need any authorization to access it. But is it really accessible to anyone? Well… yes, you can’t stop a criminal or fraudster from using these services since no KYC is required.
💡 Attention point: let’s not jump to conclusions here! The cliché argument would be to say “DeFi is like Bitcoin, it’s mostly used on the Dark web and for illicit activities”. It would be reductive to think in this way. The figures show us the opposite: according to the latest report “Crypto Crime Summarized” by Chainalaysis issued last January, only 0.34% (or $10 billion) of the transaction volumes in cryptocurrencies were related to criminal activities. However, according to an estimate by the United Nations (source: Forbes), dollar transactions connected to money laundering and illicit activities would represent 2% and 5% of global GDP (or $1.6 to $4 trillion).
Projects to set up decentralized KYC are underway to address this issue, but there is no reliable solution at the moment. This also raises questions about the KYC performed by banks, especially for individuals. Perhaps you have opened an account with a neo-bank. All the documents provided during the KYC are copies/scans. Have you ever wondered how the bank ensures that the person in front of their screen is the same as the one on the ID copy?
👉 In conclusion: DeFi is available to anyone, regardless of nationality, income level or geographical location.
3. DeFi is fully transparent
Here’s a concept that citizens are increasingly attaching importance to. Transparency is an inherent feature of many public blockchains. In practical terms, this means that all transactions and accounts of a blockchain are searchable. All you have to do is go to the explorer of the blockchain (the Bitcoin or Ethereum explorers for example).
Once a financial service is running on a blockchain, you can consult all the transactions performed by this service as well as its source code to understand how it works. These are the famous “smart contracts”, an overused term because they are neither more nor less than programs that automatically execute a set of actions if all the pre-requisites are met. The intelligence of the contract is therefore correlated to the skills of the developer. And of course, once the smart contract is issued on the blockchain, it is impossible to modify the code. DeFi’s financial services are therefore nothing more or less than computerized and open source protocols.
But transparency does not necessarily mean understanding. Who today, apart from a developer, is capable of interpreting lines of code?
For those who don’t have the skills, it is difficult to really understand how DeFi’s sometimes very complex protocols work.
👉 To sum up: all the transactions and the mechanics of how a DeFi service works are totally transparent, still you need to have the skills to understand them.
4. DeFi services are interoperable
This is certainly the heart of the philosophy behind DeFi. All the services being open source, it is quite possible to copy them, to improve them or to associate them with other services. This is for example the case of the decentralized exchange protocol Uniswap which has been copied and pasted by Sushiswap (yes, these names do not sound very serious…). Same thing for the lending/borrowing platforms, Compound and CREAM finance.
💡 Attention point: it would be reductive, however, to limit interoperability to “wild” copy/paste. Imagine that you have a mutual fund investment under a management mandate that gives you a gross annual return of 5% and that a manager offers you the possibility to optimize this return to 12% by lending your assets to a third party. In traditional finance, this case is obviously inaccessible for the clients of a retail bank.
In DeFi, it is the ABC of any investor. This is where the notion of interoperability takes on its full meaning. Protocols such as Yearn.finance or StakeDAO offer you fully automated return optimization strategies that rely on protocols such as Uniswap or Compound. Where it would take months to get two players in traditional finance to cooperate on services, only a few weeks are needed in DeFi.
The numbers speak for themselves: the number of DeFi platforms has risen from around 100 in 2020 to 369 in 2021 (based on the number of DeFi tokens).
This offers an infinite field of possibilities and organic growth but also brings a risk of dependency. What would happen if a failure in one platform were to spread across the protocols that operate it? On this aspect, insurance platforms like Nexus Mutual or Opium.finance have emerged in DeFi and offer the possibility to insure against certain risks (hacking, total liquidation of these assets, etc.).
👉 In summary: DeFi works on the same principle as Legos. Each service can plug in and leverage existing services.
5. DeFi cuts out the middleman
This is one of the promises of DeFi, namely to eliminate intermediaries and their associated costs. Accessing a service on DeFi does not require the use of an intermediary. Instead, users interact with lines of code, or more precisely, the “smart contracts” that define the rules for using the service. Any interaction not provided for in the code cannot be processed.
Let’s take a concrete example: when a company or an individual wants to obtain a loan, he must necessarily call upon a bank or even a broker if he wants to obtain the best rate. In a sense, the bank is acting as an intermediary since part of the loaned funds come from the deposits of other clients. When the loan is obtained, the borrower will be charged fees (file fees, guarantee fees, brokerage fees, etc.).
In protocols such as Aave or Compound, a borrower will get his or her funds (subject to placing collateral as security) directly from a pool, i.e. a group of lenders. Aave’s smart contracts replace the loan contract and define conditions such as the liquidation of collateral in case of default.
In short, more than a disintermediation, it is a change of intermediary: the bank is replaced by a protocol.
For the users, the interest of this system is multiple:
- Lower costs
A study conducted by the Boston Consulting Group and Crypto.com in 2020 showed that 95% of the interest paid by borrowers was returned to lenders on DeFi lending platforms compared to only 20-30% in traditional finance.
Figure 1 : CeFi vs. DeFi lending value chain: DeFi disrupts Lending by offering p2p, low-cost lending options.
- Keeping full control over your funds
Using the example above, a lender can withdraw funds from Aave or Compound at any time. Conversely, a bank can block payments from its customers under the guise of protecting their interests or suspicion of fraud. This is impossible in DeFi. An important paradigm shift takes place as the responsibility for the funds is shifted from the intermediary to the users. In case of fraud, theft or even an error (loss of password) caused by the user, it is the latter who is solely responsible and not his bank.
- A solution for the most unbanked countries
The realization of profits in the traditional financial system relies on intermediation. Financial players do not develop much in areas where low-income populations live because they cannot use them. In addition, there are administrative constraints (the need to provide identification, proof of residence and income, etc.) to open a bank account, imposed by regulations or internal bank policies. However, DeFI is not currently delivering on this promise. When comparing the top 20 countries that have adopted DeFi and those that are most unbanked, only 3 countries are found in both lists (Brazil, China, India).
- Free yourself from the trust of intermediaries
No longer having to trust an intermediary to provide this service. This is in line with the philosophy of Bitcoin, which is to free oneself from banking institutions as trusted third parties. That’s why it’s called a “Trustless” system.
👉 To sum up: in DeFi, the protocols replace traditional financial players such as banks.
6. DeFi is based on a “Trustless” philosophy
Most blockchains have been designed to allow users to interact with each other (peer-to-peer) even if they do not know or trust each other. By extension, this is also the case with DeFi. Not having to worry about trusting a third party is ideal. But, is it a reality? Trust in a financial service can be based on its reputation, past performance and a legal framework (for example, the monetary and financial code in France that protects consumers). Of course, in the event of a dispute, the interpretation of the law remains at the discretion of the judge.
For DeFi, “Code is law” as they say. The user must therefore trust the code. But how? Auditing companies in the blockchain sector are flourishing and increasingly sought after to verify DeFi protocols.
💡 Point of caution: for all that, 15 of the 40 DeFi protocols hacked in 2021 were audited. We can assume that trusting a protocol is like trusting the developers who designed it. Let’s voluntarily put aside the small proportion of malicious people who would try to deceive users. Behind each line of code there is a human being, any human being being being by nature fallible, a protocol (i.e. a set of lines of code) can be fallible. There is a contradiction on the websites of DeFi’s services which advocate on the one hand a “Trustless-based” system and on the other hand put forward the background of the project team and their investors. This is a desire to rely on the reputational aspect to inspire confidence in users.
A “Trustless” service is therefore more an ideal than a real characteristic. Just as in institutions where interventions are sometimes necessary to cancel a posteriori, unilaterally, an illicit transaction, it is necessary to accept that interventions by agents (such as developers) are also necessary in DeFi. Beyond an ideal, it is an ethic to be integrated in the construction of a DeFi service just as banks have a code of conduct and a CSR policy.
👉 In summary: DeFi brings a paradigm shift. It is no longer the financial intermediaries that should be trusted but the protocols.
Conclusion: more than a trend, is DeFi a revolution in the financial sector?
DeFi is positioned as an alternative to the traditional financial system. Even if it proposes interesting solutions to solve some of its problems like:
- Empowerment of users/customers by giving them back control over their funds and also the possibility to be a participant in the governance system of the services they use
- Better cost efficiency through disintermediation
DeFi opens up new issues:
- How to regulate a decentralized governance system? For example, what territoriality should be applied to a stateless service?
- How can we prevent the use of these services for illicit activities (terrorist financing, money laundering, etc.) thanks to a reliable KYC?
It would be a mistake to sweep these issues under the carpet thinking that DeFi is just a trend. It is based on a technology, the blockchain, which was born 13 years ago and is still in its infancy. If we compare it to the Internet, it took more than 20 years between the sending of the first email and the creation of the first e-commerce sites in the 90s.
In the space of 2 years, the Total Value Locked, i.e. the total assets placed on DeFi protocols, has increased by almost 5,000% and now stands at 270.42 billion. Admittedly, this is still a drop in the bucket compared to the 90.7 trillion in financial assets under management at the end of 2020. This can be explained by the interoperability of services enabled by the blockchain, the absence of restrictive regulations and an excess of liquidity caused by central banks’ policies over the last 2 years that has been injected into the sector via private players.
Figure 2: Total TVL (source: Defillama)
At KYC Consulting, we believe that DeFi presents interesting opportunities for financial institutions. For example, they could offer better performing financial products based on DeFi, while guaranteeing the protection of their clients’ funds.
It is interesting to note that, according to Chainalysis, an expert in blockchain data analysis, transactions made by large institutions on DeFi protocols in Q2 2021 represented more than 60% of total transaction volumes.
As the latest example, SG Forge, a subsidiary of Societe Generale, published a proposal via the MakerDAO protocol’s governance module to make a loan in stablecoin DAI. It’s a safe bet that initiatives like this will multiply in the coming month.
In the next article, we will explore the different services of DeFi with very concrete examples.
Federico Alberelli, Senior Manager