Decentralized Finance (DeFi)
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DeFi basics
Decentralized Finance (DeFi) refers to financial services provided by software maintained by a network of computers all over the world.
It operates on computer code that has fixed, publicly verifiable rules, and is not controlled by a small group of people behind closed doors.
This is opposed to the banks and institutions in the traditional finance (TradFi) industry where a board of directors, CEO, and employees have the power to dictate the manner in which you can or cannot access the money you keep with them.
With crypto technology, we can now replicate - and even improve - the financial services we use today.
Rather than subject our hard-earned money to the whims of the TradFi institutions, with DeFi we can choose the exact manner in which our money is kept, accessed and used.
"OK... but why should I care about DeFi now?"
To put it bluntly: there's money to be made.
Though the DeFi ecosystem is relatively young, it has matured enough for there to be good risk-reward opportunities to capitalize on.
Think of it like the discovery of a new continent. You don't want to be among the first settlers because the risk of failure is high; You want to wait for the first couple of settlements to be established before joining in. This way, the risk-reward is much more favourable.
Right now I'm seeing some lucrative opportunities that will exist for the foreseeable future... but they won't last forever. I'll talk more about this shortly.
Lower costs, better efficiency
TradFi institutions operate physical offices, which means that - at the very least - they have to pay for thousands of staff, rent, and utilities.
DeFi, on the other hand, can replace all of these costs with less than 50 coders.
To get a sense of what this means, let's compare the centralized exchange Coinbase with the decentralized exchange Uniswap.
(Although Coinbase is a crypto exchange, its centralized structure means it behaves more like a TradFi institution.)
Coinbase (centralized) - as of Jul 2021
24-hour transaction volume: $2.1 billion¹
Number of employees: over 1,200²
Transaction volume per employee: $1.75 million
Uniswap (decentralized) - as of Jul 2021
24-hour transaction volume: $350 million³
Number of staff: 38⁴
Transaction volume per employee: $9.2 million
Based on these numbers alone, Uniswap is 500% more efficient than Coinbase. Over time, I expect this disparity to increase because software scales easier, faster, and cheaper than humans.
DeFi characteristics
TradFi | DeFi | |
|---|---|---|
Privacy | Personal information required | No personal information required |
Transparency | Decisions/processes are opaque | Anyone can view the software (smart contract) code |
Fairness | Some services available to the wealthy only | Everyone has equal access to all services |
Openess | Transactions across borders restricted | No transaction restrictions |
Speed | Fund transfers can take days/weeks | Fund transfers take minutes |
Cost | Wire transfers cost around $30 | Wire transfer equivalent costs around $0.50 |
Immutability | Rules can arbitrarily change | Rules cannot be arbitrarily changed |
Custodial | The institution controls your assets | You control your assets |
Point of failure | Risk is concentrated in an institution | Risk is distributed across a global network |
Logically, DeFi is the superior option.
But there are a few things that are holding back mass adoption at this time:
1) Regulatory ambiguity: It is unclear how governments will respond to DeFi. But given that DeFi cannot be shut down (since it has no centralized point of control), and that The World Economic Forum has published a usability report about it, my guess is that like Bitcoin, it will come to be accepted by most countries.
2) User friendliness: As things stand right now, DeFi is not particularly user-friendly. Most likely, you'd need someone with experience to help you get started on it. As the industry continues to grow and mature however, the onboarding process will be improved and DeFi services will be a lot easier to use.
3) Fear of uncertainty: People are - rightfully - hesitant about managing funds with new technology, especially with one that exists outside the TradFi industry. This is, in my view, the biggest obstacle to fast DeFi adoption. Logically, DeFi makes a lot of sense. Emotionally though, people who don't understand it will naturally be afraid of it. Thankfully, the cost of testing DeFi applications is low. And once you get a taste of how much better it is than TradFi services, you'll never want to go back to the latter again.
In my view, it's only a matter of time before DeFi transactions become widely accepted. And by the time that happens, I hope to be well positioned to benefit from it.
What services does DeFi provide?
Eventually, almost all financial services we use today will have a DeFi equivalent that's cheaper, faster and more secure.
Here are some examples of DeFi services that are available today:
- Stablecoins (cryptocurrencies pegged to the USD): Dai, USDC
- Borrowing/lending: Aave, Compound
- Insurance: Etherisc, Nexus Mutual
- Prediction markets: Polymarket
- Decentralized exchanges: Uniswap, 1inch
- Asset management: TokenSets
- Portfolio dashboard: Zapper, Rotki
- Margin trading: dYdX, Bitmex, Bitfinex
- Crowd funding: Gitcoin grants
- Payments: Sablier, Tornado Cash
Prediction: DeFi will largely replace TradFi by 2035
Just like how the internet displaced traditional print media, so too will DeFi replace TradFi.
Take a moment to grasp the implications of this.
The global banking system is currently valued at $90 trillion⁵ while the entire crypto ecosystem is valued at less than $2 trillion; The whole crypto ecosystem (not just DeFi) is valued at less than 2% of the TradFi banking system.
This is to say that we're still early into the game, and there's a LOT more room for DeFi to grow. In the coming decades, a large portion of the $90 trillion market cap of the TradFi industry will flow into DeFi.
Next, let's take a look at how we can benefit from being early adoptors of DeFi.
Next: Lending